NEW YORK (Money Magazine) -
It doesn't take an investing genius to pick Microsoft out of a crowd. Now, quickly, guess which fledgling will be the next Microsoft? Or the future Wal-Mart? Or the new General Electric?
Distinguishing Average Joe Inc. from blue-chip-to-be is a trickier task.
Why? Even those companies that show early promise can stumble.
Precisely because spotting budding titans is exceedingly difficult, we usually recommend that individuals stick to established companies. After all, blue chips are blue chips in the first place because they demonstrate consistent earnings growth, don't miss dividend payments and have rock-solid balance sheets.
As a result, blue chips should constitute the bulk of your portfolio.
Pick up a future industry titan before the rest of the market catches on, however, and you have the potential for fatter returns on your investment than blue chips usually deliver.
That's why MONEY set out to find companies with all the promise of becoming the market's Next Big Things. Ultimately, we found 20 companies, which you can see here. Along the way, though, we learned a lot about exactly what makes good growth companies great.
The search commences...
Blue chips don't appear out of thin air. Even before they were crowned blue chips, Wal-Mart and Intel were well known on Wall Street. So we started our search with a list of the 100 stocks that are most popular with mutual fund managers who specialize in mid-size growth companies, provided by mutual fund data tracker Lipper.
Earnings growth is essential. The average company in Standard & Poor's 500-stock index has boosted its earnings 12 percent a year over the long term. So we felt th at our candidates needed to be chugging along at a faster pace (at least 15 percent) -- but not so fast that they would burn out and fade away.
So is topline turnover. Of course, companies can boost earnings by slashing costs, but mere belt-tightening does not a future blue chip make. So we wanted companies with average annual sales growth of at least 10 percent. We looked at actual results for the past three years and estimates for the next two.
Buy on margins. Companies with staying power produce rich profits that fund research and development, marketing and hiring top talent. So we sought those that have high profit margins, both gross and operating. Having a strong gross margin -- the percentage of revenue left after subtracting the cost of making a product -- means that the firm's wares are highly valued or cheap to manufacture. Operating margin -- the percentage of revenue left after operating expenses are subtracted -- is a key gauge of management efficiency.
For both measures, we set the bar high: a gross margin of at least 40 percent and an operating margin of 10 percent. The best companies beat these targets easily.
Market research matters. After talking to fund managers and analysts, we decided to include a few companies that fell short on one of our quantitative screens.
For example, despite a high debt-to-capital ratio of 47 percent (our cut-off is 40 percent), Univision made our list because its media empire caters to America's quickly expanding Latino population.
Amazon.com has lower margins than we would have preferred, but it has been proving recently that its operating model can be profitable and that it may come to rule Internet retailing the way Wal-Mart dominates the brick-and-mortar variety.
We also added a few companies that are favorites of ours and that met our criteria but weren't widely held by midcap growth managers, such as eBay and JetBlue.
In the end, we settled on 20 companies that we believe have strong prospects for becoming the blue chips of tomorrow. Does this mean you should run out and buy them?
No.
With the market having rallied since its lows in March, high-quality, high-growth stocks can be pricey. So to determine which of these companies are trading at attractive valuations, we turned to the PEG ratio, which compares a company's P/E with its projected earnings growth rate. Academic studies have found that growth stocks with P/E multiples that are at or below their predicted growth rate tend to outperform the market.
Below are profiles of five future blue chips that are also good values right now.
...and ends with these top picks
Affiliated Computer Services Processing claim forms sounds about as glamorous as, well, processing claim forms, but one company has turned paper-pushing into an earnings machine.
Affiliated Computer Services -- yes, its name is as plain as its business -- processes insurance claims, loan documents and human-resources forms at its operations in more than 100 countries, including low-cost labor locales such as China, Guatemala and Ireland. It also manages information technology systems for big and small companies.
Since ACS' founding 15 years ago, its ability to handle back-office operations on the cheap has lured scores of corporate customers such as Motorola and General Motors, as well as a number of state governments (ACS operates 14 state Medicaid programs).
The result: Over the past five years, revenue growth has averaged 17 percent, and sales should hit $4 billion this year.
That growth should continue apace as cost-conscious firms and cash-strapped governments look for ways to trim costs and eliminate paperwork. ACS is also expanding into new businesses such as toll collection -- it runs the E-ZPass programs in New York and New Jersey.
Analysts project 20 percent annual earnings growth over the next few years, while the shares sport a P/E of 16 on 2004 profit estimates.
BJ Services The oil business should be humming. The Iraq war drove oil above $30 a barrel. High oil prices are supposed to spur increased exploration -- and higher profits for oilfield service companies.
But this time the exploration boom is missing in action. Caution about the future of the Middle East and the staying power of the economic recovery has oil producers withholding new investment.
In this environment, it helps to have a great niche and great management. BJ Services' expertise is pressure pumping, a highly efficient method of extracting oil and gas from wells.
Its management: a team of veteran oil service executives whose scrupulous attention to detail has widened operating margins from 10 percent last year to 14 percent. An impressive feat in a difficult business environment.
BJ Services has done so well also because it has a strong presence in natural gas drilling in North America, which is up 30 percent so far this year, and its customers are primarily smaller independent producers that have been more active than the energy giants.
That's why it's set to post the strongest annual profit growth of all the mid-size oil service firms.
The stock's up 4 percent for the year (and 27 percent since we recommended it in fall 2002) and is worth more than its recent $33.
Oil service stocks typically trade at a 35 percent to 40 percent premium to the S&P 500, while BJ Services' P/E of 18 merely matches the index's multiple.
Fair Isaac Every time you use a credit card, take out a loan, buy a refrigerator, make a cell-phone call or renew your car registration, chances are a company called Fair Isaac is watching. Fair Isaac crunches massive amounts of data into consumer scores that help lenders decide whether borrowers are creditworthy, and help insurers figure out which customers are likely to file claims.
Credit-card and cellular companies also use Fair Isaac to scour transactions for fraud, and retailers such as DSW Shoe Warehouse use it to identify their most loyal and profitable customers.
Fair Isaac already is the giant in this field -- its service is used in over 75 percent of mortgage decisions, in 95 percent of credit-card transactions and by 80 percent of U.S insurers. But it still has plenty of room to grow. The company is chasing health-care business, where its technologies could automate medical-bill review and help spot fraud.
Gaining health-care clients would diversify its customer base. Fair Isaac is also pursuing international customers; now just 21 percent of revenue comes from overseas.
The stock has been a hot performer, nearly doubling since we last recommended it a year ago (fall 2002). But 23 times earnings is still a fine price to pay for a company where 2003 profits so far are up 80 percent over last year.
Medimmune Giant pharmaceutical companies have been built on small advances. Pfizer got its start in the 1850s by combining almond toffee with santonin to make the medicine for intestinal worms palatable.
The result was one of the industry's first blockbusters. Medimmune looks to have a similar innovation. Every year, 80 million Americans get flu shots. But millions don't because they're afraid of needles. This year Medimmune began selling FluMist--the first influenza vaccine that can be administered without pricking the skin.
Already, Medimmune is one of the rare biotechs that have profits. Last year the company had revenue of $848 million and earnings of $103 million before a one-time charge.
The company's bottom line is expected to more than double this year to $225 million. Most of its sales come from Synagis, which treats respiratory disease in infants, and that's why much of Wall Street derides Medimmune as a one-trick pony.
Its shares trade at a big discount to biotech rivals: The stock carries a PEG of 0.9 based on 2004 earnings, compared with 2.2 for Genentech.
FluMist could change things, though Medimmune has some hurdles to overcome. The nasal spray was approved only for ages five to 49--the group with the lowest vaccination rate. Wal-Mart decided not to carry the product after regulators questioned whether its pharmacists were trained to administer it.
Also, at $60 a pop, FluMist costs three times as much as a flu shot, and only 20 percent of health-plan providers are covering it.
Evergreen Health Care manager Lui-Er Chen, whose fund owns the stock, is betting that these are just short-term problems. Medimmune is working on getting FluMist approved for all ages. Insurers eventually should come around.
Plus, won't plenty of people spend $60 rather than confront their fear of needles?
Xilinx Three years ago, three-quarters of Xilinx's revenue came from the telecommunications business. Its semiconductors were used almost exclusively in high-end routers and base stations that transmit wireless calls.
So when telecom spending collapsed in 2001, investors thought Xilinx was sunk. Its shares fell to $14 from a high of $98 in mid-2000. But less than three years later Xilinx is more than just afloat. In its last fiscal year, which ended in March, the company's sales rose 14 percent to $1.2 billion, and its earnings rose to $126 million, from a loss of $114 million the year before.
Analysts expect Xilinx's earnings to rise another 76 percent to $222 million, or 65 a share, in the fiscal year that ends in March.
Credit Xilinx's speedy turnaround to its flexible chips. The company specializes in programmable logic devices (PLDs). Unlike most chips, PLDs can be reprogrammed on the fly a number of times. As a result, Xilinx was able to quickly reposition its chips for all types of devices.
The company's products are now found in ReplayTV television recorders, Sony Vaio laptops and Nokia cell phones. Consumer-electronics devices now make up a third of the company's sales. Telecom still generates half of the company's revenue, but other industries' demand for the chips is growing fast. Soon Xilinx's chips could be everywhere.
The company has competition in the PLD market, but its latest generation of chips, which have much smaller transistors (about one-tenth the width of a human hair), has been taking market share from rivals. According to Dataquest, Xilinx had 49 percent of the market for PLDs in 2002, up from 38 percent two years before. Its next largest peer, Altera, has 31 percent market share.
Says Doug Foreman, a manager at TCW Galileo, which owns Xilinx stock: "Xilinx operates in a very profitable niche of the chip business that is likely to get much bigger."
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