Motley Fool Rebound Report

7 Small-Cap Rockets for the New Bull Market Published by

The Motley Fool, Inc.

2000 Duke Street, Alexandria, Virginia, 22314, USA

Published July 2009

The studies in this book are not complete analyses of every material fact regarding any company, industry, or investment and they are not “buy” or “sell” recommendations. The opinions expressed here are subject to change without notice, and the authors and The Motley Fool, Inc. make no warranty or representations as to their accuracy, usefulness, or entertainment value. Data and statements of facts were obtained from or based upon publicly available sources that we believe are reliable, but the individual authors and publisher reserve the right to be wrong, stupid, or even foolish (with a small “f”). It is sold with the understanding that the authors and publisher are not engaged in rendering financial or other professional services. Readers should not rely on this (or any other) publication for financial guidance, but should do their own homework and make their decisions. Remember, past results are not necessarily an indication of future performance.

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Editors: Denise Coursey, Tracy Dahl, Cindy Embleton, Joey Muffler, and Rik Silverman Product manager: Sam Moore Cicotello Design and production: Sara Klieger Cover design: Dari Fitzgerald Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market

Contents

Introduction...... iv b y An d r e w Su l l i v a n

BJ’s WHolesale Club...... 1 b y Ch a r l y Tr a v e r s

Compass Minerals...... 3 b y J o e Ma g y e r

Darling International...... 5 b y To d d We n n i n g

Holly...... 8 b y J im Gi l l i e s

Houston Wire & Cable...... 11 b y R i c h Gr e i f n e r

Teledyne Technologies...... 14 b y An d r e w Su l l i v a n

Waste Connections...... 17 b y M i c h a e l Ol s e n

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e iii Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market Introduction By Andrew Sullivan, CFA (TMFRedwood)

All big companies were once small, and that’s not just positions that should grow over time. All but one have beaten something fledgling CEOs’ mothers tell them. Consider the the market since they started trading, and five of the seven have growth of The Walt Disney Company (NYSE: DIS). In 1965, already knocked the ball out of the park, as you can see below. 10 years after Disneyland opened, Warren Buffett bought 5% of Disney for $4 million. Today, buying 5% of the company would Outperformance Stock S&P Name Ticker Since (percentage set you back more than $2 billion. Return Return points) Even though we can’t directly compare those numbers Holly HOC 1989 475% 179% 296 because of share dilution, you get the idea: Investing in a big Darling International DAR 1994 91% 98% (7) company before it becomes big means big returns. That was BJ’s Wholesale Club BJ 1997 140% (1%) 141 true in 1965, and it’s true today. Happily for us, many small companies are on sale right now — the Russell 2000 small-cap Waste Connections WCN 1998 304% (17%) 321 index is down 32% from a year ago, making this an excellent Teledyne TDY 1999 217% (35%) 252 time to go small-cap shopping. Technologies Compass Minerals CMP 2003 292% (14%) 306 Beating the Competition Houston Wire HWCC 2006 (17%) (26%) 9 & Cable Small-cap stocks can act like Miracle-Gro for your portfolio Data as of 6/29/09. Start dates are earliest available pricing data. — a little dose for a lot of extra growth. From 1926 to 2008, small-cap stocks returned 11.7% annually, compared with Read on to learn more about these seven companies’ 9.6% for large caps and 5.7% for long-term government bonds, competitive advantages and superior growth potential. according to Ibbotson Associates. And they do even better as the economy improves. In the year after each of the past 10 The Foolish Bottom Line recessions, small-cap stocks rose an average 28%, while large- cap stocks returned 19%, according to T. Rowe Price. We all want to position ourselves for the market rebound, and investing in fast-growing small caps with an enduring Those relative returns look mighty attractive, but that doesn’t competitive advantage is a great way to do so. The seven stocks mean we can simply write off the bigger fish: Large caps pack a we’ve hand-picked for you all have the goods to grow — and mean competitive punch. That’s why to be a successful small-cap are trading well below our estimates of their true value. Getting investor, you need to own the strongest, toughest little companies in on a few of them now just might make you an early investor out there — the ones with the biggest competitive advantages. in the next big thing.

After all, there’s no sense in chasing growth unless the Foolishly, company can protect its competitive position. So for this special report, we searched for the fiercest small-cap companies around — and found a salt miner, an electrical cable distributor, a warehouse operator, an oil refiner, a high-tech powerhouse, and two waste-services companies. You’ve probably never heard of most of them. But they all have strong, defendable market Andrew Sullivan

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e iv­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market BJ’s Wholesale Club By Charly Travers (TMFBreakerCharly)

BJ’s Wholesale Club With an economy on the ropes, unemployment at high levels, and consumers struggling to make ends meet, saving money on necessary products is more important NYSE: BJ than ever. That’s why warehouse club operator BJ’s Wholesale Club (NYSE: BJ) Website: www.bjs.com stands out as an attractive shopping destination for consumers — and an excellent FINANCIAL SNAPSHOT opportunity for Fools who want a safe, steady, small-cap investment with oodles of room for growth. Recent Price...... $32.64 Market Cap...... $1.8 billion Cash / Debt...... $40 million / $1.6 million About the Company Data as of 6/29/09 BJ’s introduced the warehouse club concept to the New England area when it WHY BUY launched in 1984. If you’ve ever walked into one of these behemoth stores and bought a 20-gallon drum of ketchup, you know how warehouse clubs work. They’re best • This warehouse retailer should thrive in a difficult economy as consumers hunt known for giving members bulk quantities of goods at a lower price than they can get for bargains. at their local supermarkets or department stores. Because these chains move immense • A slow and steady grower, BJ’s has signifi- volumes of products, they have significant buying power with suppliers. As a result, cant long-term potential to expand. shoppers can land excellent deals on all sorts of items, from food and beverages to TVs, computers, and even jewelry. BJ’s has grown steadily over the past two decades, and • The share price gives us an attractive up- side with only a moderate amount of risk. today, it operates 180 warehouse clubs, all of which are on the East Coast.

About the Sector

Like other warehouse clubs, BJ’s also charges members an annual fee to get into its stores. Its base plan, called Inner Circle, costs $45 per year while its Rewards Membership, which is aimed at high-volume buyers, costs $80. Competitors Costco Wholesale (Nasdaq: COST) and Wal-Mart’s (NYSE: WMT) Sam’s Club charge comparable fees and employ very similar business models. Warehouse clubs essentially make all of their profits from these membership fees and not from selling products, so attracting new members and keeping renewal rates high among existing members is critical for this business model.

These clubs also carry fewer stock-keeping units (SKUs) than traditional stores. BJ’s and Costco have 7,000 and 4,000 SKUs, respectively, while a traditional supermarket carries 45,000 SKUs, and a supercenter (think Target (NYSE: TGT) or Wal-Mart) offers more than 100,000 items. But in exchange for sacrificing variety and consumer choice, warehouse clubs give members deals on popular items they frequently buy, such as cereal, soda, toilet paper, and laundry detergent. Offering them such a compelling value keeps them coming back again and again, allowing these stores to generate very high sales volumes and inventory turnover.

Thesis / Opportunity

BJ’s has done a great job of accomplishing exactly that. It’s a slow and steady grower with a history of strong returns on capital, and it uses the cash it generates to open new stores that earn attractive returns. With only 180 locations, the company also has room to expand across the country — in the United States, there are nearly 400 Costco stores and more than 600 Sam’s Clubs. But don’t expect BJ’s to catch up

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 1 Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market overnight. This conservatively managed business opened just The reality is that BJ’s will continue to expand. Because the four stores in 2008 and expects to open six to eight in 2009. company generates attractive returns, this growth will improve its intrinsic value over time, which should reward shareholders with Of course, BJ’s doesn’t have to depend solely on new store a price of around $50. openings to improve its business. For one, it can boost sales at its existing locations — each store currently generates about $56 Risks / When to Sell million in sales per year. While that may sound like a lot, this lags both Costco and Sam’s Club by a wide margin. Each Sam’s Club The risks associated with this business span far beyond brings in about $75 million a year in sales, while Costco delivers getting squashed by a falling 20-gallon drum of ketchup. First, a staggering $142 million. BJ’s has been increasing its per-store BJ’s operates in an extremely competitive industry with notably revenue by 3.2% annualized over the past five years; one way it strong peers such as Costco, Wal-Mart, and Whole Foods can continue this trend is by signing up more members. At the (Nasdaq: WFMI), among many others. All of these companies end of the first quarter of 2009, it had 9 million cardholders. share an intense focus on serving their customers and providing a compelling experience and value proposition. Costco and Wal- If BJ’s can continue its profitable expansion and improve the Mart in particular are notoriously efficient and well managed. economics of its current locations, it will create heaps of value However, this competitive threat is nothing new. BJ’s has thrived for shareholders for many years. for years, even in the presence of these formidable foes, and there’s no reason to expect that to change. Financials and Valuation That said, there are some more pressing issues. As I stated FY2004 FY2005 FY2006 FY2007 FY2008 earlier, BJ’s business model depends upon its ability to sign up new club members and collect annual membership fees. Once Revenue (billions) $7.4 $7.9 $8.5 $9.0 $10.0 it has a member in its system, it needs to make sure that person 155 163 172 177 180 Store Count sticks around year after year. As with any subscription model, Revenue Per Store (millions) $47.6 $48.6 $49.4 $50.9 $55.7 an inability to sign up new members and a decline in renewal Members (millions) 8.3 8.6 8.7 8.8 9.0 rates would be a big warning sign that the business is in trouble. But management reported in BJ’s first-quarter earnings call that The company has been able to grow revenue at a compound renewal rates were coming in stronger than expected. Because annual rate of 7.9% over the past five years by boosting its store renewals account for 80% of member fee revenue, I view that count, attracting new members, and hiking its membership fees. as a sign that BJ’s is providing its shoppers with the value they Moreover, this modest growth rate could conceivably persist for demand in the midst of a tough economic environment. a very long time, because at its current expansion pace, it would take BJ’s more than 30 years to get its store count up near where I would sell if this business begins to falter and show signs Costco’s and Sam’s Club’s are today. of deterioration. An exodus of members, the evaporation of already-thin margins, and repeated declines in comparable-store Instead of trying to guess how fast BJ’s will grow and making sales would be noticeable signs that this investment thesis has assumptions about the returns it will generate along the way, gone awry. On a brighter note, if the thesis plays out as expected, I valued the company based on the free cash flow it produces shareholders will earn plenty of money to bring with them on with its existing store base. By my estimates, BJ’s will need $80 their next BJ’s shopping excursion. And if the company becomes million for maintenance capital spending per year. This represents overvalued — say, more than $50 per share anytime in the next the money it will need to keep its stores and distribution facilities three years — I’d recommend selling. in their current condition. After backing out maintenance needs and stock option compensation from operating cash flow, BJ’s The Foolish Bottom Line has averaged $135 million in free cash flow over the past three years — that is, cash that shareholders can take out of the BJ’s is a well-managed company that profits from a proven business without impairing it. business model. It has a pristine balance sheet, and it generates loads of cash that it can reinvest in building new stores that Even without adding new stores, the company can slowly earn attractive returns on capital. When all of these qualities are bump up that free cash flow by boosting the revenue at packaged together into one business, they usually don’t come its existing locations. If it adds new members or raises its cheap. But at today’s price, BJ’s stock offers investors a super- membership fees further, for example, and manages to increase sized opportunity at a warehouse club price. free cash flow by 3% per year in perpetuity — roughly the rate of overall economic growth — the shares are worth $34 today. The Motley Fools owns shares of Costco Wholesale.

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Compass Minerals By Joe Magyer (tmfjOEiNVEStor)

Compass Minerals Oil, gas, silver, coal. If man, mule, or machine can strip it from the earth, I’ll follow it. As the Fool’s resident natural resources buff, I’m constantly on the prowl for unloved NYSE: CMP commodities and the companies that produce them. As swingin’ as that sounds, the sad Website: www.compassminerals.com truth is that only a select few commodity dabblers are fit to produce winning long-run FINANCIAL SNAPSHOT returns. Commodity production is capital intensive, and busts happen. Every now and again, however, a diamond in the rough comes along with the characteristics of a true Recent Price...... $53.87 winner, and that is exactly what I have discovered in my recent digging. Meet Compass Market Cap...... $1.8 billion Minerals (NYSE: CMP), one of the best commodity plays you’ve never heard of. Cash / Debt...... $117.4 million / $486 million Data as of 6/29/09 The exceptional commodity producer with market-beating prowess possesses two WHY BUY traits. First, the commodity it drills for, digs up, or otherwise procures and sells has • Compass’ stock has been unfairly enduring demand. Finding substitutes is difficult, and there’s next-to-no chance of the squashed as a result of commodities’ at- material becoming obsolete. And second, these rare birds can produce these commodities large collapse. cheaper than their peers, thanks to a mix of better processes and high-quality, low-cost • The company has truly unique assets reserves. There aren’t many companies that fit this bill, and most are well-known titans with decades of low-cost production like ExxonMobil (NYSE: XOM) or BHP Billiton (NYSE: BHP). ahead of them. • Salt and potash demand and prices are Imagine my surprise, then, when I stumbled across Compass Minerals, a small cap poised to rise over the long haul. that boasts unique low-cost reserves of two commodities with fantastic prospects for long-run demand. Even better? It offers a 2.7% yield and is under the radar of most Wall Street players.

About the Company

When you go looking for commodity investments, salt and sulfate of potash (SOP) probably aren’t the first two ideas that come to mind. Yet, Kansas-City based Compass has built an empire atop giant piles of salt … and fertilizer. Led by CEO Angelo Brisimitzakis, Compass is the largest SOP producer in North America and the largest salt producer in both North America and the U.K., operating 10 production and packaging facilities across the U.S., Canada, and the U.K. Its Goderich, Ontario, mine is the world’s largest rock salt mine, while its Winsford, Cheshire, mine is the largest in the U.K.

According to Compass, there are more than 14,000 uses for salt (not including tequila shots). In fact, of the 15,000,000 tons of salt that Compass produced last year, 81% went to states and municipalities to keep their highways ice-free. The other 19% was used for consumer and industrial purposes. Incredibly, the company’s salt reserves are so vast that management believes there is more than a century’s worth of reserves at most of its production facilities, including the key Goderich mines.

But while salt sales made up 80% of Compass’ total 2008 revenue, the skyrocketing price of SOP (a high-end specialty fertilizer) helped to push fertilizer sales up to nearly 20% of last year’s total sales. Compass produces its SOP in its solar ponds at the only source of naturally occurring SOP in North America: The Great Salt Lake. And for those of you who are also Luddites when it comes to technology, don’t sweat that “solar” tag. Compass has been producing SOP at its solar ponds since 1967. And just like with its seemingly infinite supply of salt, management believes it can continue to produce SOP

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 3­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market at current levels at this facility to no end. Or, at least, well beyond 2005 2006 2007 2008 the confines of any cash-flow model yours truly has devised. Revenue (millions) $742.3 $660.7 $857.3 $1,167.7 Operating Margin 19.3% 17.3% 16.8% 23.5% About the Sector Salt Avg. Price ($/ton) $52.78 $52.35 $55.59 $61.19 I probably don’t need to sell you on the demand for salt, but I SOP Avg. Price ($/ton) $259.56 $292.39 $321.82 $595.75 will anyway. Compass believes that North Americans consume about 38 million tons of salt each year, while the U.K. market Compass carries $482 million in long-term debt, none of which sits at about 2 million tons annually. U.S. salt demand, which is matures before 2013. That slug of debt is nothing to sneeze at relatively seasonal thanks to high winter demand for de-icing salt, given the potential volatility of salt volumes and SOP prices, but has crept up at about a 1% annual clip over the past couple of I’m comfortable with it given that Compass has $117 million in decades. Prices, meanwhile, have grown at between 3% and 4%. cash and its operating profits have covered interest payments at least a couple of times over each of the past few years. SOP is the wild child of the Compass family. Global potash Compass’ valuation is eye-catching right now. The shares fertilizer demand has been creeping upward thanks to growing are down nearly 37% from their 52-week high, and I peg them populations, and prices practically exploded last year when that as worth $72 a stub, or about 34% above recent prices. That’s growing demand smashed into tight, controlled supply. Canada’s assuming relatively conservative baseline prices of $59 per ton for PotashCorp (NYSE: POT), which controls 22% of global salt and $300 per ton for SOP, both of which are less than trailing potash capacity, is to potash what Saudi Arabia is to oil. The annual results. This is especially true for SOP, for which Compass company is able to manipulate industry prices by constricting pulled an average price per ton of nearly $600 in 2008. If Compass and loosening production at its whim. That’s great news for sees long-run SOP prices trend closer to $400 per ton — which I secondary producers like Compass, which effectively piggybacks think is entirely plausible — my valuation estimate would increase on PotashCorp’s competitive strength. New supply takes a lot of to $82 a share. I recommend buying below $58 a share. cash and time to bring online, which means that Compass should benefit from fat margin prices on its SOP for quite some time. Risks / When To Sell Like any commodity producer, Compass’ profits are dependent Thesis / Opportunity on the prices of what it produces. The company’s pitch is pretty straightforward: An unheralded, Over a short time horizon, unseasonably warm winters hurt de- low-cost producer of essential (salt) and prized (SOP) minerals icing salt prices and volumes. Over a longer horizon, increased with an attractive valuation (more on that shortly). Compass’ domestic salt production capacity could pressure prices, as mines, including the cherished Goderich site, sit conveniently could meaningful climate change. One sneaky risk would be the next to rivers and lakes, equating to fast and cheap transportation. development of a common substitute for highway de-icing salt. That’s key given salt’s low value-to-weight ratio (about $60 per Given salt’s proven effectiveness and low cost, though, color me ton), and it prevents distant competitors from chipping away at skeptical that it will be knocked from its mantle anytime soon. Compass’ pricing strength. Finally, the leases to Compass’ production facilities are highly That Compass’ key mines have more than 100 years worth of stable, but there is always the possible (albeit small) risk that production ahead of them is mind-boggling. Let me put this in they won’t be renewed. The company’s prized Great Salt Lake context: While most commodity producers have only a few years facility, home of all of Compass’ SOP production, is dependent worth of reserves in the ground and must constantly spend their on an annual renewal that must be approved by the state of Utah. Seeing as how this lease has been renewed each year for more time and money on maintenance efforts, Compass should be able than four decades, combined with the amount of jobs and tax to produce salt and SOP at current levels for literally decades. revenue it provides the state, it is hard to imagine the company losing this facility. Still, it is a remote possibility. Financials and Valuation

The company’s revenues and profits spiked in a big way The Foolish Bottom Line in 2008 (as the nearby table shows). But while I’d like to Compass Minerals is the little engine that could. There’s no spin a yarn here about innovation and the triumph of the whiz-bang, bleeding-edge technology here — and that’s why entrepreneurial spirit, the reality is simply that Mr. Market I love it. Its mines will still be producing the same ol’ salt and was willing to pony up for salt and SOP. That’s fine by me, of fertilizer for decades. In the meantime, you just keep collecting course, though I’m expecting salt and SOP prices to come back your growing dividend checks as Compass’ engine quietly hums down to earth thanks to the recession. along, with your portfolio in tow.

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Darling International By Todd Wenning (tmfPhila)

Darling International If you happen to be eating at the moment, be forewarned: This write-up may make you want to put your fork down for a spell. With that disclaimer out of the way, let’s NYSE: DAR talk about the wonderful world of rendering animal waste. According to the National Website: www.darlingii.com Renderers Association (yes, there is such a thing), when it comes to food-producing FINANCIAL SNAPSHOT animals — those that wind up as cutlets, steaks, and hamburgers at your local supermarket — only one-half to two-thirds of their live weight actually becomes food Recent Price...... $6.66 Market Cap...... $547.6 million for us humans. The rest is left over as scrap. Cash / Debt...... $38.2 million / $36.3 million That adds up to around 59 billion pounds of animal waste in the U.S. and Canada Data as of 6/29/09 each year. But thanks to rendering, we have an environmentally friendly and useful WHY BUY way to recover and recycle all those scraps. Sparing the colorful details, rendering is a • Darling International collects food waste technique that converts animal waste into byproducts that can be made into useful goods and renders or recycles it into usable — everything from pet food and fertilizer to plastics and biofuels. products such as animal feed, biofuel, and soap. It’s also a very lucrative business. Today’s rendering industry generates $3.5 billion • Major clients include McDonald’s (NYSE: per year and has plenty of upside potential. And there’s no other company more MCD), Costco Wholesale (Nasdaq: COST), dominant in this space than Darling International (NYSE: DAR). and Burger King (NYSE: BKC). Plus, Darling is uniquely positioned to serve the burgeoning biofuels industry. About the Company • The company has a solid balance sheet, A Chicago family founded Darling in 1882 during a meat-packing boom in the United consistently has positive free cash flow, States. Then, as now, the country faced the problem of what to do with thousands and dominates a niche market that isn’t appealing to competition. of tons of animal waste. Of course, one man’s trash is another man’s treasure, and more than 100 years in this unsavory industry has yielded tremendous results. Today, Darling has around 1,900 employees, provides services to more than 116,000 food establishments, and is the largest independent rendering company, with 81 locations and 43 processing plants in 42 states.

It operates two business segments: rendering and restaurant services. The rendering business made up 72.5% of 2008 sales and focuses on the collection of raw materials from butchers, grocers, and processors, then turning the waste into finished products such as BFT (bleachable fancy tallow), yellow grease, protein, and hides that can be marketed and sold to goods manufacturers. Darling’s restaurant services business made up the other 27.5% of sales and provides cooking oil and grease collection services, plus environmental compliance services, to restaurants nationwide. These clients include major chains such as McDonald’s (NYSE: MCD), Waffle House, and Burger King (NYSE: BKC). And as we can all attest from experience, there’s a lot of grease to be found in those fine dining establishments!

Both lines of Darling’s business are capital-intensive — the company maintains a fleet of 960 tractor trailers and owns or leases 43 processing facilities across the country. The location of these facilities is key, because waste must be processed within 24 hours in most cases to avoid spoilage. To further broaden its geographic scale, Darling has made eight strategic acquisitions since 2003, from Southern California to the New York metropolitan area. While the need to increase and maintain such infrastructure is costly, it also serves as a fairly high barrier to entry for would-be competitors.

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 5­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market Finally, Darling also boasts management that is tenured and 42% to 45% in a rocky economy. The shares have naturally experienced in the food industry. Chairman and CEO Randall slumped to reflect this reality and currently trade at valuations Stuewe has run the show for more than six years and spent the last seen in 2002. earlier part of his career at ConAgra Foods (NYSE: CAG) and Cargill. CFO John Muse has been in his current role since 1997. Metric Current Multiple Both of these top executives have led the company during a six- Price-to-Earnings (trailing 12 months) 14.4 year period when sales and profits more than doubled on top of Price-to-Book 4.1 very strong financials (more on those in a moment). Price-to-Free Cash Flow 14.0 About the Sector *Data as of 6/29/2009. Competition for Darling primarily comes on the collection end Those ratios are still quite compelling, even after the 148% of the business and not as much on the sales of finished products. gain in the stock price since its low of $2.82 in March 2009. Regional collection operations such as Baker Commodities on the West Coast and Griffin Industries in the Southeast compete At a market cap of less than $550 million, Darling still has a directly with Darling in rendering and restaurant services, and lot of room to grow, especially if energy and commodity prices some major slaughterhouse operators have their own in-house continue to rise over the next decade. Using a discounted free rendering facilities. Fortunately, with increasing environmental cash flow-to-equity model and assuming 8% to 10% annualized and compliance regulations, there’s enough business to go net income growth over the next decade with growth slowing around. Additionally, Darling is the only recycling and rendering thereafter, this stock looks to be worth $11 to $14 a stub. company with a national, coast-to-coast footprint and can leverage better economies of scale than its competition. Risks / When to Sell Darling’s business is tied to many external factors that are Thesis / Opportunity largely out of its control, so be prepared for a bumpy ride. First, The beauty of Darling’s business lies in its “cycle of there are significant government regulations from a number sustainability,” as the company calls it. For example, waste from of agencies, such as the U.S. Food and Drug Administration, slaughtered animals is rendered into fertilizer, which helps grow the United States Department of Agriculture, and the U.S. grains that in turn feed the animals slated for slaughter down the Environmental Protection Agency. In addition to state and road. It’s a vicious cycle for sure, but also more sanitary and eco- local regulations, nearly every step of Darling’s business, from friendly than alternatives. collection to the operation of the company’s vehicles, is subject to government oversight. Compliance with these rules is costly and Another huge opportunity for Darling lies in green biodiesel can slow down growth plans. fuels that can be made from yellow grease and tallow waste. On that front, Darling has teamed up with the city of San Francisco The second major risk is that of food-borne viruses. Consider to build a green biodiesel plant that could help fuel the city’s how quickly the public’s perception of pork changed in light of municipal buses. What makes green biodiesel a likely alternative the swine flu pandemic or how mad cow disease hurt the beef to petro-diesel is that they’re essentially indistinguishable in industry. Less public consumption of meats leads to fewer raw energy content and usability, but biodiesel generates far fewer materials for Darling to convert to usable products. emissions. As a top producer of the commodities that make this friendly fuel, Darling in essence “owns the oil field” and is Finally, Darling’s business is highly cyclical and tied to capable of churning out 150 to 200 million gallons a year. the commodity, energy, and agriculture markets, as well as to consumer spending patterns. As we’ve seen over the past year, Financials and Valuation these markets can be highly volatile and can lead to uneven sales and earnings growth. But given Darling’s upside potential over As I noted earlier, Darling’s growth is supported by solid the next decade and maybe even beyond, this is one stock that’s financials. The company has been free cash flow-positive since worth the bumps. 2002 and carries just $31 million in long-term debt and $38 million in cash. Gross margins have held steady in the mid-20% The Foolish Bottom Line range for the past decade, but Darling has become more efficient in recent years, which has provided a boost to operating margins While it’s hard to talk about this line of business without and profitability. feeling a bit queasy, Darling is nonetheless a well-run company that dominates a necessary and promising niche industry. It The past few quarters haven’t been so kind, as prices for should be particularly appealing to growth-focused investors Darling’s products, such as yellow grease and BFT, plummeted who seek an eco-friendly company that’s actually profitable.

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 6­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market Moreover, shareholders would get a bonus if green biodiesel catches on in transportation.

The best strategy for building a position in this very jumpy stock is to buy on dips or, if you’re an advanced investor, write out-of-the-money puts to take advantage of the volatility premium.

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Holly By Jim Gillies (TMFCanuck)

Holly Do high prices at the pumps leave you bruised and battered? Have you considered the possibility of selling blood to pay for gas? Wondering if your next commuter vehicle NYSE: HOC will be a recumbent tricycle? Before resorting to such drastic measures, consider an Website: www.hollycorp.com investment opportunity that might allow you to profit from higher gasoline prices: Holly FINANCIAL SNAPSHOT (NYSE: HOC).

Recent Price...... $17.71 About the Company Market Cap...... $887.3 million Cash / Debt...... $90 million / $200 million* Holly is a petroleum refiner. It buys crude oil — which isn’t terribly useful straight Data as of 6/29/09. from the ground (try pouring it into your tank) — and runs that crude through its *Cash and debt are net of consolidated Holly labyrinthine pipelines and process units. What comes out are the hydrocarbons we know Energy Partners debt, and updated to reflect and love: gasoline, diesel, asphalt, and myriad others that either lubricate machinery or credit line repayments, recent asset sales to become raw materials for plastics, solvents, or fibers such as nylon. (Your nylon raincoat Holly Energy Partners, and recent debt issuance. and umbrella? Yup, oil.) WHY BUY Powering all of this activity are Holly’s two refineries — Navajo in New Mexico • Our love affair with gasoline and diesel fuel aligns nicely with Holly’s multiyear and Woods Cross in Utah — and the company recently completed the purchase of a expansion plans. third refining facility in Tulsa, Okla. Combined, these assets will be able to refine up to 216,000 barrels per day. • The crack spread has widened to allow Holly to generate copious amounts of cash. In addition, Holly has a 41% interest in Holly Energy Partners (NYSE: HEP), • Current share price is well below the a master limited partnership (MLP) that owns many of the distribution assets (i.e., replacement value for Holly’s assets. pipelines) that Holly and competitors use to transport raw materials and finished products. Holly spun out Holly Energy Partners in 2004 to reap tax benefits. (MLPs avoid federal and state income tax.) Holly Energy is also the preferred conduit when Holly wants to sell certain assets.

About the Sector

It’s important to be aware of the quirks of the oil industry when considering an investment such as Holly. Let’s start with the most important part: how Holly makes money.

When you’re in the business of buying ingredients, creating products from them, and selling said products, you want to be certain of one thing: that the price you get from your sales is higher than the price you paid for the raw materials. In the oil industry, this price difference between crude oil and the products it goes into is called the “crack spread” or refining margin. But there’s a hitch: Crude oil and most of its refined end products are fungible commodities — that is, one unit of each is generally indistinguishable from any other. Because of this, refiners have little control over input or output prices. (No one’s going to pay a premium for “Holly-blended” gasoline.)

Refining is also very competitive and capital-intensive — a company must invest gobs of money to comply with environmental and safety regulations. For example, Holly will have to shell out $150 million at its Tulsa facility to meet diesel fuel ultra-low sulfur requirements. That’s something we just need to accept as “the cost of doing business” in this line of work.

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 8­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market Existing refineries, on the other hand, are somewhat protected. Financials and Valuation A new refinery hasn’t been built in the United States since 1976 because of the aforementioned environmental concerns, as well The crack spread is our bogey. For the decade ended in 2007, as community opposition. So, it’s often cheaper for prospective that metric averaged just shy of 20% of the selling price of acquirers to buy existing facilities. At the same time, demand for refined products. Then in the first half of 2008, along with the refined products has gone in a certain direction since 1976 (hint: run-up in crude costs (yes, even sour), profitability crashed — not down). So, existing refineries are in something of a sweet but it has rebounded so far in 2009. spot — in all but the most dire of economic circumstances, they First 2008 should be able to sell whatever they can produce. Q1 2005 2006 2007 Half (Full 2009 2008 Year) Thesis / Opportunity Average Crude Cost $56.50 $64.43 $73.03 $109.03 $97.87 $43.30 The price of a barrel of oil by itself isn’t a big concern to ($/barrel) Holly. What the company does care about is that prices of refined Refining Margin $12.62 $15.78 $16.74 $8.35 $10.96 $11.93 products rise as quickly (or more quickly) or fall as slowly as (or ($/barrel) more slowly than) those of oil. Refining Margin (% of refined product 18.3% 19.7% 18.6% 7.1% 10.1% 21.6% sales) The five years ended in mid-2007 were a golden age in this respect — oil prices rose steadily, but not so fast as to lap refined Holly is midway through a multiyear capital spending product prices. So, as the economy hummed along, Holly’s refining program. The amount it has committed to additional refining margin stayed in a nice, steady range, and the company minted and pipeline equipment over the next three years is around $460 cash. Then 2008 happened, oil prices went on their $140-plus tear, million. That’s likely a higher commitment than the company and refined product prices didn’t keep up. The crack spread, umm, will be able to produce organically. Fortunately, it has some cracked, and even after the economy went off the rails, it didn’t cards to play. recover as the demand for refined products fell faster. Aside from copious self-generated cash flows and its credit So, the Holly investment thesis is simply that things will line, Holly has just issued some eight-year debt. It also has a return to a sense of “normalcy” and that crack spreads will rather unique way of recovering capital: Remember when I return to historical levels (and they, indeed, did in the first mentioned Holly Energy and its mission to own assets that earn quarter of this year). In addition, Holly has invested hundreds stable, safe cash flows? Once Holly constructs such an asset of millions of dollars to boost capacity at its Navajo and Woods (pipelines, for example), it typically sells that asset to Holly Cross refineries, and the thesis also assumes that this extra capacity will be filled as the world keeps hankering for more Energy. Holly is expected to raise approximately $100 million refined hydrocarbons. This should be perfectly attainable. this way in 2009 and an additional $200-plus million in 2010. (While I am all about “green” energy, the fact remains that So how do you value a company like this? I use various tools. hydrocarbons still offer the biggest bang for the energy buck First off is Holly’s replacement cost: If you want to build a — not to mention that it’s hard to drive with that solar panel duplicate Holly, that would set you back roughly $4.6 billion — blocking your windshield). Even better, there are a couple of yet the market currently values Holly at less than $1 billion. We extra hooks to sweeten the proposition. can’t expect refiners to trade at par with their replacement cost. First, Holly specializes in refining “sour” crude. Oil prices (Their capital-intensiveness sees to that.) But even if the stock quoted in the mainstream press are typically for easy-to-refine traded at a more traditional price (say, 30% to 50% of the cost of (and yummier sounding) “light, sweet” crude. Sour crudes building a new refinery), that would still be considerably higher contain significant quantities of sulfur impurities, which makes than today’s share price. them a bit tougher to refine. But they also typically sell at a discount to their sweet counterparts, so sour refiners can pocket a Moreover, Holly’s trailing EBITDA of $295.7 million includes wider refining profit. the softness that occurred in the latter part of 2008 and no contribution from Tulsa (more than $150 million in 2008). Nor Second, the Navajo overhaul is part of a broader, multiyear, does it include any contribution from the still-to-be-completed growth capital investment initiative to increase refining expansion capital projects (which Holly has estimated at more capacity, open up new markets (building additional distribution than $340 million). Yet Holly has an enterprise value of just pipelines), and diversify product offerings. Holly’s recent 3 times the EBITDA on its two refineries (leaving out Tulsa). refinery acquisition fits here beautifully, because the Tulsa Assuming no growth aside from the incremental gains from the facility produces comparatively more diesel, as well as a line of capital expansion program, I estimate that Holly is trading for higher-margin specialty lubricant products. less than 2 times the 2012 “new plateau” EBITDA — far too

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 9­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market cheap. Projecting a multiple of 4 times on that EBITDA suggests that the stock will double in that period, and perhaps more, since Holly spent most of the past decade at EV/EBITDA multiples in the range of 6 times to 10 times. In short, buy right and sit tight.

Risks / When to Sell Holly appears to have its expansion ducks in a row, but its plans are considerably more aggressive than ones it has historically undertaken. Watch to see that it doesn’t hit any financing snags along the way.

Also, as the new projects come on line, Fools should watch for incremental bumps in EBITDA profits, backed by cold, hard cash generation. (You’ll be able to see this on the statement of cash flows.) If that doesn’t materialize, it may be prudent to watch from the sidelines while you re-evaluate management’s capital allocation skills.

Of course, the best-case scenario is that we sell on valuation. An enterprise-value-to-EBITDA multiple that exceeds 6 times my 2012 EBITDA estimate (which would leave Holly with an enterprise value of around $4.5 billion) probably signals overheating — and a good time to take money off the table.

The Foolish Bottom Line Gasoline is likely to remain rather popular, regardless of the new (smaller) car revolution that’s going on in Detroit. Furthermore, I don’t see any evidence that refineries will become any easier to build anytime soon. Holly sports a profitable base; ambitious, forward growth plans; a solid management team; and a decent balance sheet. Add it all up, and Fools now have at least one reason to smile at the pumps.

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Houston Wire & Cable By Rich Greifner (TMFTenacious)

Houston Wire & Cable Predictable. Straightforward. Repetitive. Nasdaq: HWCC Those attributes may make for a boring summer blockbuster (*cough* X-Men Website: www.houwire.com Origins: Wolverine *cough*), but they’re three traits I love to see when I evaluate businesses. And Houston Wire & Cable (Nasdaq: HWCC) has them in spades. FINANCIAL SNAPSHOT

Recent Price...... $12.69 HWC has no financial derivatives, no foreign currency adjustments, and no off- Market Cap...... $223.9 million balance-sheet arrangements. Instead, it has a simple, easily understandable business with Cash / Debt...... $0 / $22.6 million strong competitive advantages, an experienced management team, plenty of recurring Data as of 6/29/09 revenue, and the shortest annual report you’ll ever read. Let me plug you in. WHY BUY About the Company • Houston Wire & Cable has a simple, straightforward business model, solid As you might imagine, Houston Wire & Cable is one of the largest distributors of financials, and an experienced, wire and cable in the United States (and yes, the company is based in Houston). But shareholder-friendly management team. I’m not talking about Radio Shack speaker wire or office-grade Ethernet cable. Rather, • The company enjoys a strong competitive the company deals in specialty wire and cable — products that have to meet complex position thanks to the value it creates for engineering requirements and electrical codes. It’s the type of stuff you’d find in a both its customers and suppliers. Its best- petroleum refinery, coal mine, or water treatment plant — products designed to endure in-class customer service and unrivaled inventory help keep competitors at bay. exposure to moisture, caustic materials, and extreme temperatures. HWC carries more than 23,000 unique items in its inventory — so if you need 15,000-volt interlocked • The EPA estimates that the U.S. must aluminum armored power cable, you’re covered — each of which can be custom-cut to invest $390 billion over the next 20 years to overhaul its wastewater systems. exact specifications and shipped to the job site the same day the order is received. Houston Wire & Cable stands to benefit as the country invests in repairing its ag- And HWC doesn’t hawk only third-party products. The company has developed a ing infrastructure. line of low-smoke, zero-halogen cable called LifeGuard, which offers superior flame resistance and reduced toxicity compared to conventional cables. Management believes there is a significant opportunity for this cable in industries where equipment protection is critical, such as power generation, wastewater treatment, and data centers. The sales figures remain a competitive secret, but the company has said that demand for this high-margin cable is growing at a faster clip than the rest of its products — and the total market opportunity could be as high as $1.4 billion.

About the Sector Think of the company as a middleman between electrical distributors (who sell all sorts of electrical equipment and supplies) and wire and cable manufacturers. That position gives HWC key competitive advantages to create value for both customers and suppliers. With its massive inventory, the company offers its distributor customers the product breadth and depth that no single wire or cable manufacturer can match. In addition, it offers better customer service than the manufacturers and faster delivery, thanks to its 11 regional distribution centers.

The electrical distribution market is highly fragmented, with more than 4,200 regional companies, most of them small-fry. Wires and cables are bulky and heavy — and thus expensive to ship and cumbersome to store. It doesn’t make sense for electrical distributors to tie up precious capital in a niche product that will consume so much warehouse space. Therefore, rather than order straight from the manufacturer, most

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 11­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market electrical distributors have decided to team up with HWC. In 2010 budget includes $3.9 billion for water infrastructure 2008, the company served about 3,200 customers, including improvements, and that is likely just a drop in the bucket. virtually all of the top electrical distributors in the United States. The Environmental Protection Agency estimates that the U.S. must invest $390 billion over the next 20 years to overhaul its This middleman is in little danger of being disintermediated wastewater systems. from above, either. Thanks to its dedicated sales staff and nationwide distribution network, the company allows its wire and The recently enacted $787 billion stimulus package included cable suppliers to run a leaner operation. And because it aggregates substantial funding for infrastructure improvement projects. orders from many individual customers, the manufacturers can There’s not much history to help forecast how much of this plan their production schedules more efficiently. business is headed HWC’s way, but it’s safe to assume that rebuilding the energy grid and other spending will be a catalyst HWC faces competition from industrial equipment suppliers for the company. such as Fastenal (Nasdaq: FAST), MSC Industrial Direct (NYSE: MSM), and W.W. Grainger (NYSE: GWW), but none And although the short term likely will continue to be a of these companies provides the specialized products, services, challenge, there are signs of light at the end of the fiber-optic and know-how that HWC’s customers require. Customer service tunnel. Management points to the 350 new customers added in is a key competitive advantage for HWC — witness last year’s the past year as evidence that HWC continues to capture market 99.8% order accuracy rate and 99.9% on-time delivery record. share from competitors. And although the company’s project Those stats help explain why it enjoys such strong long-term backlog has included delays and cancellations, Sorrentino relationships, most of which span more than two decades. In fact, claimed that HWC booked “record large project commitments” in CEO Chuck Sorrentino can’t recall losing a single customer or the first quarter of 2009. supplier in the 11 years he has been with the company. That’s the beauty of HWC’s business model. It would be Financials and Valuation extremely costly for a competitor to replicate the company’s The first thing you’ll likely notice on HWC’s balance sheet is enormous inventory and broad distribution network, and it would the cash balance — or the lack thereof. That zero isn’t a typo; the be difficult to undermine the powerful relationships that the company relies on a combination of operating cash flow and a company has formed over the past three decades. revolving credit facility to cover its expenses and working capital investments. All the cash generated from day-to-day operations is Thesis/Opportunity reinvested in the business, used to pay down debt, or returned to These days, HWC is hurting on two fronts. First and foremost, shareholders via share repurchases and a 2.8% dividend. the poor economy and limited credit availability have reduced And that’s not the only surprisingly small number found in the demand for wire and cable in many of its end markets. This financials. Over the past five years, the company has averaged makes sales harder to come by and fosters aggressive price just $500,000 in annual capital expenditures. Establishing a best- cuts among the competition. Second, a sharp decline in copper in-class inventory and distribution network cost a lot up front, prices — a key ingredient in its inventory — has short-circuited but now that these advantages are in place, they’re rather cheap its margins. Its gross margin in the first quarter of 2009 was just to maintain. With such minimal reinvestment needs, HWC can 21%, a steep decline from the company’s historical 24% to 25%. afford to heartily reward its shareholders. But these short-term concerns are distracting investors from what promises to be a very profitable future. Remember, HWC However, while this is a straightforward business, pinning a doesn’t deal with the distressed residential or commercial precise intrinsic value on this company is a challenge. That’s markets. Instead, the company targets industries like power because demand for HWC’s products and services is dictated generation and infrastructure that are less sensitive to economic in large part by its end users’ capital spending levels. As you pressures. And these areas will provide plenty of demand for can see from the following table, when the economy is firing specialty wire and cable in the years to come. on all cylinders, HWC is hugely profitable. However, during a downturn, its end users tend to defer capital expenditures or cancel For example, HWC sells many products used in the projects altogether, dampening the company’s profitability. construction of a power plant and the related pollution control equipment. The company is positioned to benefit from 2004 2005 2006 2007 2008 expenditures for new power generation, as well as federal Revenue (millions) $172.7 $214.0 $323.5 $359.1 $360.9 mandates to reduce toxic outputs from power-generating facilities Operating Margin 6.6% 10.6% 16.5% 13.8% 11.2% (three cheers for coal scrubbers!). Return on Invested 14.4% 22.6% 35.7% 29.0% 23.2% And there is a strong current in favor of improving our nation’s Capital outdated water infrastructure. President Obama’s proposed Sources: Company filings, analyst’s calculations

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 1 2­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market To keep things conservative, I modeled a 25% revenue decline for 2009 and no growth in 2010, and I kept HWC’s margins low as it continues to work the expensive copper out of its inventory. Assuming a recovery in 2011, then 5% annual growth for five years, 3% growth for an additional three years, and just 1.5% terminal growth, HWC is worth a shade over $15 per share. Under a set of less punitive — but still conservative — assumptions, I peg the company’s intrinsic value at $18 per share.

Risks/When to Sell As we’ve seen, HWC is exposed to two major risks: cyclical demand for its products and services, and fluctuations in commodity prices, primarily copper and petrochemical products. Fortunately, both of those risks are short-term concerns, and they’re already priced in to the stock at today’s prices.

I wouldn’t sell due to either of these factors. However, I would sell if HWC were unable to maintain its relationships with its customers and suppliers. It has a diversified customer base, but the company is heavily dependent on a few key suppliers. If HWC were to lose one or more of these relationships, I would be concerned.

The Foolish Bottom Line Houston Wire & Cable has everything I look for in a small-cap company: a straightforward business model, strong competitive advantages, experienced management, sound financials, and even a nice 2.8% dividend. In addition, the company figures to benefit from supercharged spending on utilities and infrastructure projects. Here at the bottom of the business cycle, investors are overlooking HWC. But with a series of catalysts on the horizon, don’t be surprised if this stock produces electrifying returns over the next three to five years.

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Teledyne Technologies By Andrew Sullivan, CFA (TMFRedwood)

Teledyne Technologies Infrared sensors for spacecraft. Cruise missile engines. Remote-controlled underwater vehicles. Nope, I’m not talking about the latest Star Trek movie or Janet NYSE: TDY Jackson’s wardrobe. These other highly engineered products offer investors something Website: www.teledyne.com even more enticing. First, they require a tremendous amount of technology and FINANCIAL SNAPSHOT know-how to produce. They’re also essential components of important missions, from monitoring pollution to securing our freedom. And they’re all made by Teledyne Recent Price...... $33.28 Technologies (NYSE: TDY), a gem of a company with a stellar pedigree and proven Market Cap...... $1.2 billion track record of outperformance. Cash / Debt...... $21.8 million / $355.6 million Data as of 6/29/09 Companies like Teledyne usually don’t come cheap. But the market’s panic-induced WHY BUY selling spree has put everything on sale — even stocks of companies that have limited exposure to the broader economy. Teledyne isn’t completely immune, but 40% of • Teledyne produces highly engineered mis- its sales are to the U.S. government, a stable base of business that should allow it to sion-critical, niche products for regulated and growing markets. manage the recession with ease. In the meantime, the market’s mania has given Fools an opportunity to invest in this solid business at a discount price. • Its vast technology portfolio has untapped potential. About the Company / Sector • A diverse product mix and a chunk of sales (40%) from the government provide One look at Teledyne’s product line will make you feel like you’ve just entered Techie stability in a rocky economy. Heaven: You’ll find everything from underwater sonars to ejection-seat sequencers that fling military pilots out of aircraft. This vast pool of technology also makes for a pretty complex business. It’s one thing to discuss a popular clothing brand, for example, but when you start chatting about the investment opportunities in nanocomposite scaffolds, that’s when the cocktail party clears out. I’m not one to pick up my jester cap and leave a good party. So rather than listing all of Teledyne’s products, I’ll keep things simple and focus on the markets this technology serves. The main ones are defense, commercial aviation, oil and gas, nuclear energy, and environmental and industrial monitoring. None of these markets grow at Google- like rates, but they exhibit fairly predictable growth — for example, defense spending has increased at a 5.4% annual rate over the past 50 years. It also helps that the recession-resistant U.S. government is Teledyne’s biggest client. Some of the company’s commercial businesses, such as oil exploration, are more sensitive to economic conditions, but Teledyne has the management expertise and cash flow to push through soft markets. While its advanced technology might lead you to assume that Teledyne is a relatively new company, it, in fact, has a remarkable pedigree. Drs. Henry Singleton and George Kozmetsky founded Teledyne Inc. (Teledyne’s predecessor) in 1960 to capitalize on the digital electronics revolution. Only six years later, the company made it into the top 300 businesses on the Fortune 500 list. And from 1963 to 1990, Teledyne rewarded shareholders with a 20.4% annual return compared to the 8% return of the S&P 500. Even Warren Buffett has lauded Singleton for his extraordinary record of capital allocation. After Singleton retired, Teledyne merged with metals business Allegheny Ludlum, and in 1999, the company spun out its electronics and systems engineering businesses as Teledyne Technologies. Since then, CEO Robert Mehrabian has been leading the

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 14­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market company through another chapter of growth. Mehrabian is a This kind of expertise — and the growth opportunities that former professor of metallurgy and mechanical engineering and come with it — are what private or corporate buyers look for was the president of Carnegie Mellon University from 1990 to when they acquire businesses, and Teledyne has plenty of it. I 1997. The owner of eight U.S. and 40 foreign patents, he has haven’t considered any of these benefits in my valuation, and delivered a 217% return (about 14% compounded annually) since the stock looks cheap without them. However, given Teledyne’s Teledyne became an independent company, while the S&P 500 innovative nature, it’s likely that we’ll see some pleasant lost 35% over the same period. surprises from new technology applications over time.

Part of this growth has come from acquiring businesses that Financials and Valuation complement Teledyne’s existing product lines. This strategy creates value because the assets Teledyne acquires are usually In the five years from 2004 to 2008, Teledyne earned an worth more in a larger organization than on a stand-alone basis, average 15.6% on capital and 20.3% on equity. Annual revenue as it has more muscle to bid for contracts and more resources growth averaged nearly 18%, and operating earnings grew even to improve efficiency. Teledyne has invested $900 million in 28 faster at 32%. As we now know, these years were abnormally acquisitions since 2001, and it has paid off. I expect this strategy strong for just about any business, so I don’t expect this type of to continue. growth to return soon. Sales should fall in 2009, but over time, Teledyne should resume a healthy growth trajectory. Thesis / Opportunity TTM Q1 Calendar Year 2004 2005 2006 2007 2008 The nearsighted market has smacked Teledyne’s shares 2009 down almost 50% from their 52-week high despite the fact Revenue Growth 14.7% 19.8% 18.7% 16.0% 14.9% 12.4% that the company has two critical things going for it: (1) strong EBIT Margin 6.6% 8.3% 8.7% 10.0% 10.0% 9.4% competitive positions that protect current profits, and (2) a vast 14.9% 17.7% 15.1% 15.2% 15.3% 12.4% technology portfolio that should provide growth opportunities. Return on Capital Return on Equity 17.3% 21.8% 21.2% 20.5% 21.0% 19.2% Teledyne’s competitive strength is its ability to make highly Source: Capital IQ; TTM = trailing 12 months. engineered, niche products for demanding missions where reliability counts. (If you’re building an ejection-seat sequencer, In addition to slowing growth, investors are concerned there can’t be mistakes.) Potential competitors typically need about operating losses in Teledyne’s airplane piston engine specialized, hard-to-obtain certifications to even get a foot in the business. This segment doesn’t make up a huge portion of door. For example, only 16 other companies in America have Teledyne’s sales, but it does have a meaningful impact on the the same nuclear manufacturing qualifications Teledyne has. company’s bottom line. In addition, there was a $232 million Given this small playing field, customer relationships and a track deficit in Teledyne’s pension and postretirement plans (as of record of success are critical — and Teledyne’s performance has December 2008), and cash contributions to these plans will been excellent. reduce Teledyne’s free cash flow. Indeed, the company expects to contribute $117 million to its employee pension plan in 2009 You’ll find another example in one of its subsidiaries, Teledyne (before a $46 million tax benefit). Brown Engineering. This company has the system design know-how to protect government facilities against all methods But it’s important to recognize that Teledyne won’t be of attack, whether they’re from chemical or nuclear weapons or shoveling large amounts of cash into these pensions indefinitely, even cyberspace. When the U.S. Department of Defense turns because its contributions eventually will shore the plan up to to you to solve its most challenging problems, that’s a very acceptable levels. Therefore, I’ve valued the company based on significant competitive advantage in my book. These types of its annual free cash-generating ability excluding the pension, a capabilities ensure that Teledyne will continue to deliver solid figure I peg at $120 million, or $3.25 per share. At the current returns to its shareholders. price, the shares trade at just 10 times this number (a 10% yield).

But the kicker in Teledyne’s hand isn’t visible on any financial What’s more, even though 2009 will be difficult for free statement. Its many subsidiaries are veritable storehouses of cash flow, earnings will be solid. I forecast $2.50 per share, cutting-edge technology in areas such as optics and sensors, which works out to a P/E multiple of a mere 13 times, a missile defense, small engines, and subsea communications. They discount compared to the average of 17 to 23 over the past have technologies that increase the range of space telescopes such five years. Considering Teledyne’s strengths and the fact that as the Hubble, defend against missile attacks, power unmanned these earnings are depressed, the price is right to invest in this aerial vehicles, locate hidden stores of oil and gas under the company. In fact, all of the factors above suggest the shares are ocean, and carry out other important tasks. worth at least $45.

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 1 5­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market Risks / When to Sell I’ve mentioned the cash pension funding requirement, but this year and last year, Teledyne made extra contributions that should alleviate some of this need. Another risk is the aforementioned piston engine business, which is operating at a loss because of huge declines in sales. General economic malaise is likely to keep demand soft, but I expect Teledyne to cut back on expenses to trim down operating losses. Its position as one of only two main providers of these engines certainly helps.

On the subject of managing costs, Teledyne also carries a slug of debt from its various acquisitions. Its debt-to-capital ratio was 40% at the end of the first quarter, and while this is higher than I would like, the overall level is manageable, and the interest rate Teledyne pays on this debt is low.

Teledyne also has exposure to space and missile defense programs that could come under pressure from painful government budget realities. However, the company is diverse enough to handle any potential funding cuts.

The Foolish Bottom Line With Teledyne, you’ve got the best of all worlds: solid profits, barriers to entry that protect those profits, and a wonderful base of technology that could bring lucrative future applications. And now that the shares are off nearly 50% from their 52-week high and trade at a discount to their true value, we have the chance to buy into this solid company — nanocomposite scaffolds and all — at an attractive price.

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Waste Connections By Michael Olsen (TMFagewone)

Waste Connections Tony Soprano always described his profession as “waste management.” Of course, his version involved cement shoes and the Hudson River. But there’s also a profitable NYSE: WCN business for more conventional companies such as Waste Connections (NYSE: WCN), Website: www.wasteconnections.com which haul away and dispose of our residential and commercial trash. FINANCIAL SNAPSHOT Waste Connections isn’t a glamour stock, but it’s nothing to turn your nose up at, Recent Price...... $25.64 either. Trash — in its omnipresence — creates regular, sustainable, and hefty cash flows. Market Cap...... $2.1 billion And because the market is concerned that the amount of waste from construction and Cash / Debt...... $335.8 million / $859.1 million industrial uses will decline, it’s handing us Waste Connections at an attractive price. Data as of 6/29/09 WHY BUY About the Company / Sector

• Trash. It’s stinky, and it’s everywhere — At first glance, there doesn’t seem to be anything unique here. Waste Connections but someone’s gotta haul it away. Waste operates in a highly fragmented market and provides a seemingly easy-to-replicate Connections has carved out a lucrative service — after all, just about anyone can buy a truck with a large, oblong container niche doing just that. attached. So how do you turn trash into treasure and make big money in this business • High internalization rates (matching when, by all appearances, anybody can do it? landfills and hauling routes) foster — and should sustain — profitability that’s The answer comes in two words: landfills and consolidation. among the industry’s best. • The company is poised to benefit from Buying a trash-hauling truck is one thing. But because of the complicated permitting acquisition opportunities brought by the process, the relatively unattractive prospect of a “backyard landfill,” and possible recent merger of Republic Services and environmental consequences (think Sierra Club), new landfills aren’t exactly popping Allied Waste. up these days. As a result, companies that own landfill capacity typically control market pricing (except in municipal systems where towns and counties pay the landfill owner or exclusive contracts exist, or both).

With that in mind, imagine that you operate Mafia Brothers, a local waste hauler. You move trash in Lovelyville, where industry biggie Waste Management (NYSE: WMI) owns the landfill capacity. Waste Management is the only game in town for landfills, and you need to dump your trash somewhere. But the company doesn’t like that you own the Lovelyville route. So what does it do? First, it charges the highest rates it can on landfills. Thus, it becomes uneconomic, or potentially unprofitable, for Mafia Brothers to haul trash. So Waste Management kindly picks up your route. Now consider that roughly 70% of disposal capacity is held by the two largest companies (Waste Management and Republic Services). That means pricing power is pretty tightly controlled.

A recent strain of consolidation has only compounded this effect. Whereas a few major players dominate the industry today, numerous competitors used to populate the waste hauling market, all of them chasing after contracts that weren’t especially lucrative — there was always a bidder who was willing to do the same work for less. However, that has changed over the past several years, thanks to almost continuous industry consolidation (punctuated by the recent merger of Republic Services (NYSE: RSG) and Allied Waste).

This dynamic — consolidation and the advantages from controlling landfills — has benefited the biggies and Waste Connections alike. Instead of undercutting one another,

M o t l e y Fo o l Re b o u n d Re p o r t : 7 Sm a l l -Ca p Ro c k e t s f o r t h e Ne w Bu l l Ma r k e t | p a g e 17­ Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market industry participants have engaged in rational and consistent brethren, at or exceeding 20%. Discipline pays, it seems. Or price increases, slowly but surely accruing ever-greater returns maybe trash does. to shareholders. In addition, this consolidation has created an intriguing opportunity for Waste Connections, which I’ll explain Financials AND Valuation in just a moment. Simply put, Waste Connections prints cash. In addition to Thesis / Opportunity its fat operating margins, organic free cash flow generation (before acquisitions) is similarly robust and has come in notably Waste Connections services 2 million customers across 26 higher than net income on a pretty consistent basis. The waste states: It has 140 collection operations, 44 landfills, 55 transfer management business does have a relatively high percentage of stations, 33 recycling facilities, and six intermodal facilities. fixed costs (garbage trucks either run or they don’t; you can’t I’ve had my eye on this company for quite some time for several really idle them to save money), and there’s good and bad to this. reasons: It has posted strong internalization rates (matching In good times, when companies hike up their prices and volumes landfills with hauling contracts) and boasts an admirable position increase, profitability grows at some rate in excess of sales. In in exclusive agreements, both of which are key to profitability. bad, that can cut the other way. It’s also poised to benefit from unbelievably long, useful lives on its existing landfills and profit from the very same trends as Also, Waste Connections carries a fair amount of debt from its the industry biggies. In fact, the only obstacle that’s held me acquisitions. As of last quarter’s close, its ratio of debt to capital sat back from buying or recommending Waste Connections has been at about 40%. That’s not particularly worrisome, though, because its price. But now that the market is concerned about declining the company’s hearty cash flow should prove more than sufficient volumes of construction and industrial waste, that has changed. to service debt commitments and cover interest payments.

Even better, all that other good stuff is still good — Waste For this year, I anticipate low- to mid-single-digit price Connections’ internalization rate ranks among the industry’s best increases, healthy contributions from the acquired Republic at about 64%. More than 55% of its contracts are exclusive, its Services assets, and declining volumes of waste from slowing landfills are 50 years young, and the industry is still increasing construction and industrial activity. But the long-term picture is its rates at a rational, consistent pace. Plus, there’s now an added much brighter: Waste Connections should capitalize on the strength advantage in the mix: Waste Connections is positioned to reap of its assets, market position, and broader industry dynamics. For the spoils of the Republic Services / Allied Waste tie-up. As a the nine years following this year, I forecast revenue to grow at an consequence of the deal, Republic Services must divest some of 8% organic rate annually from a combination of volume and price its assets for antitrust reasons. That works out swimmingly for increases. With the positive effect of operating leverage, margins Waste Connections, because it recently acquired a group of said should expand just north of 300 basis points. All in, that puts the assets for what looks like song. shares at about $36 to $37 a stub.

In the meantime, it has been successful at carving out a Risks / When to Sell profitable niche in an industry dominated by bigger players. By virtue of its size, Waste Connections is at a disadvantage The biggest risk for waste haulers is the proverbial hand that when going up against giants Waste Management and feeds. A recently improved competitive dynamic — and ensuing Republic Services. So, it doesn’t bother competing with them. price increases — have fostered favorable returns on capital in Whereas these behemoths covet large metropolitan areas, recent years. But if that changes — and competition returns — Waste Connections has gone after smaller, suburban markets watch out. Also, a string of bad acquisitions could saddle Waste characterized by high population growth. It pursues markets Connections with a lot of debt and dilute its profitability. where it can own exclusive contracts, it’s able to match collection operations with a landfill, and/or disposal is municipally funded Under ordinary circumstances, I’d expect the shares to reliably (thereby removing the risk from competitor-owned landfills). — if somewhat sleepily — deliver returns. But if either of the changes happen, I’d sell in a jiff. Moreover, the company has continued to expand with selected acquisitions, a luxury that its larger competitors can’t The Foolish Bottom Line afford without accompanying antitrust scrutiny. It typically targets one of two breeds: haulers with exclusive contracts, or It’s a rare day when you can find a company that consistently landfill space in areas where Waste Connections holds a non- accrues value with fabulous assets, favorable industry dynamics, exclusive hauling contract. a well-grounded strategy, and no cement shoes to speak of — all at an attractive price. But today’s the day. Seize it. These strategies have generated impressive results: Waste Connections’ operating margins are bigger than those of its larger Mike owns shares of Waste Management.

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