Hot Growth Companies
Flouting convention comes naturally to Tom Kartsotis. The 40-year-old Texan's resume includes a stint as a professional ticket scalper. In 1984, Kartsotis was scouring Asia looking to start an import-export business when he visited a Hong Kong factory that was churning out lookalikes of $150 European wristwatches for just $35. He cut a deal with the owner and rushed back to Richardson, Tex., to launch Fossil Inc. as a purveyor of moderately priced fashion watches, a growing niche then dominated by Swatch Group Ltd. and Guess? Inc.
Kartsotis struggled initially with designs that were similar to the faux-marble faces and jumbo dials of his bigger rivals. But he soon struck gold with a line of 1950s Americana theme watches that tapped into consumers' appetite for nostalgia. To further differentiate its watches, Fossil packages them in colorful retro tin boxes that have become collectors' items. And it has expanded its distinctive brand into leather wallets, handbags, and other accessories. Coming soon: a push into apparel.
Fossil's innovative designs and ability to respond quickly to fickle consumer tastes--it rolls out 200 new watch designs each year--have generated sizzling growth. Over the past three years, it has clocked average annual earnings and sales growth of 58% and 27%, respectively. With earnings over the past four quarters hitting $52 million on sales of $419 million, Fossil zoomed to No. 41 on Business Week's list of the 100 fastest-growing small companies.
HAND OVER FIST. As Fossil's performance proves, you don't have to be a dot-com to be dynamic. Most of the companies on our Hot Growth list have little to do with e-commerce. What they have is business savvy, single-minded focus, and a willingness to think outside the box. It's a potent combo that has produced something their more glamorous Internet brethren still lack: profits. Our Hot Growth companies are making money hand over fist.
These diminutive dynamos have even outperformed industry giants, generating average annual sales and earnings growth of 51% and 92%, respectively, over the past three years. That compares with 8.7% and 9.6%, on average, for companies in the Standard & Poor's Industrial Index. And these tiny operators have squeezed sky-high returns out of their capital: over the same period an average 22%, while the S&P averaged just 9.2%.
How did companies make the list? We looked at those with sales between $25 million and $500 million. The floor for market capitalization was $25 million.
The 100 companies on our list are a diverse bunch. Many winners rode the high-tech boom, of course. But companies that cater to consumers with money to burn were flush, too. The No. 1 company is Direct Focus Inc., which sells the Bowflex exercise bench, a favorite of baby boomer fitness fanatics. Buff tough guys on parade proved to be money-making entertainment for World Wrestling Federation Entertainment (No. 3, page 182). And there are plenty who hit pay dirt in more pedestrian fields. U.S. Concrete Inc. (No. 9) and Trex Co. (No. 43), a maker of vinyl decking material, are racking up big gains, thanks in part to the surge in construction and home improvement projects.
With standouts in virtually every sector and geographic region, the Hot Growth roster reflects the overall vibrancy of the U.S. economy--and the extent to which entrepreneurialism now permeates American business. "There are lots of terrific, profitable companies outside the tech world that are benefiting from the strength of the economy," says Tucker M. Walsh, portfolio manager of State Street Research Emerging Growth Fund.
About half of the Hot Growth 100 provide computer, telecommunications, or biotech products and services. Many of these supply the picks and shovels to bigger companies that are mining the high-tech Gold Rush. That has been the road to riches for Albany Molecular Research Inc. (No. 4, page 192), which does chemistry outsourcing for drugmakers. Similarly, Zomax Inc. (No. 31) provides marketing, graphic design, and other services to software publishers and computer makers. Diamond Technology Partners Inc. (No. 38, page 188) shines by teaching e-biz strategy to executives at Ford, Goldman Sachs, and other corporate giants. "With big companies downsizing and outsourcing, there are huge opportunities for small companies to do well," says John W. Ballen, portfolio manager of MFS Emerging Growth Fund.
Other tech standouts are software companies surfing Corporate America's tidal wave of investment in information technology with high-margin niche products and services. Their applications may be utilitarian, but their profits are luxurious. SERENA Software Inc. (No. 6, page 194) makes software that helps companies manage huge info-tech projects. NEON Systems Inc. (No. 10) provides tools that troubleshoot computer networks. And Deltek Systems Inc. (No. 23) sells software that helps companies and federal agencies manage their billing and payroll.
Similarly, the handful of telecom companies that made the Hot Growth list make specialized equipment for the new broadband era of high-speed transmission. Advanced Fibre Communications Inc. (No. 19) sells a digital device that provides phone companies with a low-cost method of delivering voice, video, and data to users. Earnings rocketed an average of 181% in the last three years at the company, whose customers include Sprint and France Telecom. Ditech Communications Corp. (No. 55) makes equipment that eliminates echoes that can occur on satellite and mobile-phone calls. And Plantronics Inc. (No. 33) is the world's leading maker of the lightweight telephone headsets that are becoming ubiquitous in offices around the world.
Several of the more low-tech winners are nimble high-fashion businesses that, like Fossil, have their finger on the consumer pulse. Last year's No. 6 company, bebe stores, a retailer that caters to stylish young women, is No. 7 this year. Two trendy women's shoe and accessories companies also scored: Steven Madden Ltd. (No. 62) and Kenneth Cole Productions Inc. (No. 79), last year's No. 61. Companies that target Generation Y shoppers also hit it big. Among them were Pacific Sunwear California Inc. (No. 54), a casual clothing chain, and Hot Topic Inc. (No. 74), a purveyor of music-themed apparel.
BOOMERPALOOZA. Other companies cashed in as confident consumers spent freely on entertainment and leisure goods. Lifestyle company Martha Stewart Living Omnimedia (No. 8) enjoyed the biggest sales gain of the bunch, an average annual 251.4% over the past three years. Others include National R.V. Holdings Inc. (No. 21), which sells luxury motor homes, and Meade Instruments Corp. (No. 24, page 186), a maker of telescopes for amateur astronomers. "People don't haggle over adult toys," says Ronald H. Muhlenkamp, portfolio manager of the Muhlenkamp Fund. What's driving demand for pricey playthings? Says Muhlenkamp: "Baby boomers have money and younger folks don't fear losing their job."
After years of getting snubbed on Wall Street, small growth companies are finally winning some respect. While the Standard & Poor's 500-stock index was up just 6.3% in the year ended May 5, the Russell 2000, a barometer for small-company stocks, climbed 18.1%, the first time it outperformed the S&P since 1993. Why the rebound? Market pros say large-cap stocks had simply gotten too pricey. In recent years, economic jitters in Asia, Russia, and Latin America sent investors running for cover to a narrow range of big-cap stocks. After a series of earnings disappointments, "people finally came to realize that earnings growth for larger companies could not justify valuations," says Ballen of MFS Emerging Growth Fund.
That opened an opportunity for small stocks. Ballen and others think small caps will continue to advance because many are still relatively cheap. According to Merrill Lynch Small Cap Research, measured on a price-to-cash-flow basis, small stocks are selling at a 45% discount to large stocks. Investors also are banking on stronger revenue and earnings projections for smaller companies, which tend to be prime pockets of innovation.
Small-cap fever, especially for dot-coms, set the market for initial public offerings ablaze in 1999. Companies raised a record $69 billion in 543 IPOs in 1999, according to Thomson Financial Securities Data. Our roster of Hot Growth companies was no exception. IPOs were abundant on this year's list--21 of the 100 companies went public in the U.S. after January, 1999.
But entrepreneurs will have a tough time cashing in on their success this year. After a robust start--companies raised $39.6 billion in 188 IPOs through May 12--the IPO bubble burst in the spring after a series of high-profile Internet ventures faltered. The average gain this year from the date of IPO through mid-May was a puny 7%, vs. last year's 194% average jump in post-offering prices from the issue date through the end of 1999. The flood of new stock issues has shrunk to a trickle.
And there are other worries. In 1999, a record $46.6 billion was raised by 409 venture capital funds, up 67% from '98, and the money poured in during the first quarter of 2000, too. But some venture players say the white-hot market is starting to cool. And small caps will take a big hit if the Federal Reserve continues to jack up interest rates. Even without these factors, many highfliers will not be able to manage their torrid growth and will flame out.
But small businesses that have differentiated products and services that can command premium prices will probably ride out the uncertainty in the financial markets. Many are sitting on cash piles that can tide them over and fuel growth. "If you're making money and generating cash, you don't have to worry," says Walsh of State Street. And if the economy keeps barreling along, there will be plenty of survivors in every business sector. As our Hot Growth 100 proves, you don't have to have a dot-com after your name to make it into the big leagues.