Hot Growth Companies

Innovative small-cap companies are turning creativity into profits--and beating the pants off of Corporate America

William J. Prange, chief executive of women's clothier Christopher & Banks Corp. (CHBS ), is on a financial tear. For the past three years, Prange has led the once-floundering retailer on a desperately needed sales and earnings hot streak. When he came aboard in 1994 as a general merchandising manager, the company, then called Braun's Fashions Corp., was a failing chain of drab stores selling low-priced women's wear. It had terrible earnings growth, unmotivated employees, and no clear idea who its target customers were. "We were trying to be everything to everybody, and consequently we meant nothing to anybody," Prange says.

Promoted to CEO in 1998, Prange set to work overhauling the company. He beefed up customer service, redesigned the stores, and focused on clothing that appealed to baby boomer women. Along the way, he renamed the company Christopher & Banks, after one of Braun's private clothing lines. Says Prange: "It sounded classier, and we needed to get away from Braun's image as a budget clothing store." Those changes almost immediately jump-started growth at the clothier. In the years 1998 through 2000, Christopher & Banks had average annual sales growth of 28% and earnings growth of nearly 82%. Over the past four quarters alone, earnings rose 121%, to $25.5 million, on sales of $209.2 million. That performance was good enough to land the company the No. 16 spot on BusinessWeek's ranking of 100 Hot Growth companies. Last year, as Braun's, it ranked No. 70.

Another au courant fashion outfit, Chico's FAS Inc. (CHS ), also jumped onto the Hot Growth list, at No. 6, by targeting baby boomer women with high incomes. Like these retailers, the companies on our Hot Growth list have found a way to rake in cash during both a fast economy and a slow one. They have managed to do it through innovation, a willingness to refocus when times get tough, and by delivering the right product aimed at the right customer. A vibrant market of smart, creative small companies bodes well for a Corporate America struggling through a nagging downturn. "One of the ways we get out of slumps is through innovations, and historically, those innovations come from small-cap companies," says Wells Fargo & Co. Chief Economist Sung Won Sohn.

ON THE RISE. More important, the companies on our list are turning creativity into profits. Overall, the 100 Hot Growth companies have pumped out average annual sales and earnings growth of 42.4% and 80.7%, respectively, over the past three years. Compare that with 11.5% sales growth and 15.6% earnings growth for the companies in the Standard & Poor's Industrials index. And what about their returns on capital? BusinessWeek's 100 Hot Growth companies averaged 20.3%, while the S&P Industrials eked out just 9.3%.

While many of the largest U.S. corporations have seen their growth--and stock prices--stall, plenty of smaller outfits have held their own. The Russell 2000, a small-company stock index, rose 0.81% in the year ended Apr. 30, while the Standard & Poor's 500-stock index slid by 5%. "If you look at the small-cap indexes in general, they have been outperforming the large caps," says Thomas L. Press, portfolio manager for Strong U.S. Emerging Growth Fund.

How did the companies on our list make the cut? BusinessWeek ranks publicly held companies based on average sales and earnings growth and average return on capital over three years. That gives us time to get a fair reading of a company's track record. This year, we looked at candidates with sales of $50 million to $1.5 billion. That's a wider net than last year, when the floor was $25 million and the ceiling $500 million.

After all the numbers were crunched, the ranking revealed a small-cap sector that's still a hotbed of innovation and growth. Our Hot Growth list includes companies from all corners of the economy, from candymakers to chipmakers. The technology sector overall may be hurting, but there are plenty of high-tech winners on hand. The No. 1 company on the list is Optical Communication Products Inc., which racked up a stellar 48% average return on capital over the past three years by selling optical-electronic devices used in building high-speed data networks. The transportation industry is represented by Frontier Airlines Inc. (FRNT ) (No. 14), a low-cost carrier out of Denver that cashed in by focusing on vacationers and budget-minded business flyers. Direct Focus Inc. (DFXI ) (No. 2) generates top returns by direct-marketing of exercise equipment.

While the Hot Growth list includes a broad array of industries, among the strongest were those catering to consumers. Nine of this year's top 20 companies are consumer-oriented. That's up from five last year, when technology companies ruled the roost. The list is filled with apparel stores, footwear companies, sporting-goods retailers, and a bevy of amusement and recreational-service providers. "The interesting thing about the economic slowdown is that consumer spending has not slowed all that dramatically," says Steven G. DeSanctis, director of small-cap research at Prudential Securities Inc.

Indeed, apparel retailers made a strong showing primarily by tapping into two lucrative consumer pockets--working women and teenagers. Christopher & Banks' Prange says "women over 40 are a large and profitable piece of the population." And while teenagers may have less money, many of them spend what they have with abandon. Both Abercrombie & Fitch Co. (ANF ) (No. 15) and American Eagle Outfitters Inc. (AEOS ) (No. 13) have successfully tapped into the teen-clothing market. "They know what teens want, and teens want what they see on Dawson's Creek and music videos," says Morningstar stock analyst Mike Porter.

Many of the info-tech companies in BusinessWeek's ranking dodged the tech-spending slowdown by targeting still-thriving specialized niches. Micrel Inc. (MCRL ) (No. 18) hit a gusher in these energy-conscious times with power-management chips for computers, cell phones, and personal digital assistants. Cabot Microelectronics Corp. (CCMP ) (No. 11) pulled in great returns--average annual three-year sales and earnings growth of 72.1% and 244%, respectively--by providing polishing technology for a new copper-based chipmaking process. "We have a leadership technology position, and that gives us a huge advantage," says Cabot CEO Matthew Neville. But that doesn't mean these companies are immune to the slowdown. Cabot shares took a hit recently when the company reported that the softening market for computer chips had clipped sales by 19% in the second quarter compared with the first.

Some software companies have also managed to outrun the tech slump by specializing. Mercury Interactive Corp. (MERQ ) (No. 43), for instance, cranks out software that lets companies test and monitor their Internet applications. Its annual earnings increased an average of 106% in the past three years. The good news for these companies is that experts say software is likely to be one of the first purchases companies make when tech spending picks up again.

"MEAT AND POTATOES." Keeping a tight focus has also helped the management consultants on our Hot Growth list. They have been able to ride through the tough times--so far--by providing nuts-and-bolts services to specific markets. Professional Detailing Inc. (PDII ) (No. 20) concentrates on sales and marketing services for the pharmaceutical industry, including helping biotechnology companies launch new brands. Its annual earnings growth averaged 69% over the past three years. Maximus Inc. (MMS ) (No. 45) counsels U.S. government agencies on how to improve their efficiency. "These companies do meat-and-potatoes type stuff," says Tom Rodenhauser, president of researcher Consulting Information Services LLC. "The need for that is always going to be there."

Some of the Hot Growth names should come with a flashing yellow light. Several have warned that their breakneck earnings growth will slow along with the economy. And because they're moving so fast, many of these businesses involve risks that can knock them for a loop at any second. Hot fads, for instance, can turn cold. That may spell trouble for Topps Co. (TOPP ) (No. 12), known for its trading cards. The Pokemon card craze has faded, and without new winners, Topps could see slower growth.

Others face more serious issues. Steven Madden, founder of shoe company Steven Madden Ltd. (SHOO ) (No. 27), pleaded guilty in May to charges of securities fraud and money-laundering. The company announced that he will step down as CEO on July 1 but remain chief creative designer. That could be a challenge, since Madden faces a possible prison sentence of 41 to 51 months. He will be sentenced in September.

It has not been an easy year for even the hottest-performing small companies. But life could get easier if it turns out the economy is really bottoming out. But even if the worst is yet to come, our Hot Growth list shows that there are always companies that will find ways to prosper no matter how tough the going gets.

By Darnell Little in Chicago