Hot Growth Companies
Recessions come and recessions go, but one thing remains constant: Americans love a bargain. No one knows that better than Kathleen Mason, president and CEO of quirky retailer Tuesday Morning Corp., a purveyor of deeply discounted name-brand gifts and home furnishings. Her customers typically line up hours before regular "event sales" that start--when else?--on Tuesday mornings, to snatch up such items as a 20-piece Wedgwood china dinner set for $69.99. And clearly the bargain-hunting extends far beyond those on a tight budget: While Mason was attending a recent charity event at the home of a leading Dallas businessman, the executive's wife proudly showed off the Tuesday Morning treasures that shared space in her cabinets with the family crystal.
Tuesday Morning has thrived in a roller-coaster economy thanks to a keen focus on value and a willingness to break the rules. Who says you can't sell Brio toys and Donna Karan quilts in warehouse-style stores in second-tier strip malls? For that matter, who says you need a regular schedule? Tuesday Morning is closed in the slow months of January and July, and also sporadically shuts stores throughout the year to restock new products, which are typically bought direct from manufacturers trying to unload excess inventories. Occasionally, it buys inventory closeouts from defunct retailers, such as Pets.com Inc. Says Mason: "The customers never know what they're going to find in a Tuesday Morning, but they know it will always be good."
It's also good for the bottom line. During the past three years, profits at the 481-store chain have soared by an average of 27% per year, to $33.7 million. Tuesday Morning's sales rose an average annual 18% during that time, to $665.8 million. The performance was good enough to land the company in the No. 29 spot on BusinessWeek's annual ranking of the 100 fastest-growing small companies.
Like many of the entrepreneurs behind our Hot Growth stars, Mason had to overcome plenty of obstacles to get this company in fighting trim. When the 25-year retailing veteran arrived at the Addison (Tex.)-based chain in August, 2000, from off-price retailer HomeGoods Inc., Tuesday Morning's chief executive had recently died. Goods were piling up in a hodgepodge of warehouses, keeping them from arriving in time for store sales. Mason centralized the operation and added new sorting equipment and computer systems to solve the snafus.
That's typical of the challenges at small, fast-growing companies. They're riskier by definition. But those that rise to the top demonstrate how persistence, deft management, and innovation can overcome self-inflicted woes and economic turmoil. Many of our pint-sized performers also benefited in recent times from focusing on consumers, rather than catering to the industrial or overseas markets that have been harder hit in the downturn. That's true of No. 1 Singing Machine Co., the largest U.S. seller of home karaoke machines, and No. 96 Fred's Inc., a chain of discount variety stores. "Consumers have spent throughout the recession," notes Mark M. Zandi, chief economist at Economy.com Inc.
It shows: Our top 100 boast average annual sales and profit growth of 28.7% and 61%, respectively, over the past three years. That compares with 10.3% sales growth and a 23.8% profit decline for the Standard & Poor's Industrials Composite Index. And the Hot Growth stars averaged 15.4% return on capital vs. a moderate 6.9% for the S&P Industrials.
This stellar performance hasn't been lost on bargain-hunting investors, who have turned away from many overvalued corporate goliaths amid the economic uncertainty and a rash of accounting scandals. The Russell 2000, a small-company stock index, has risen 29% since March, 1999, vs. a 14% drop for the S&P 500 index. And fans of small-company stocks argue that this recovery still has legs. The recent run-up still lags far behind the surge for small-caps through the first three years of the '90s bull market, when the Russell 2000 grew 118%, notes Satya D. Pradhuman, chief small-cap strategist at Merrill Lynch & Co. With valuations still at historically low levels, that should mean a few more years for these small-cap stocks to run, he predicts. "There is a shift back to the philosophy that small is good," agrees Michael Balkin, who co-manages the William Blair Small Cap Growth Fund, one of the best-performing small-cap funds over the past two years.
To find the hottest of the bunch, BusinessWeek starts with publicly held companies that have sales of $50 million to $1.5 billion. We rank them based on their sales and earnings growth and average return on capital--a measure that shows how effectively they're using their funds. We take those readings over three years, to make sure they're more than just a flash in the pan. Candidates must have a stock price greater than $5 and a market cap of more than $25 million. We knock out companies with recent declines in financial results or whose stock price has underperformed the S&P Industrials over the past year and the year to date. Those with the best track records move to the top of the heap.
That screening has produced our typical collection of diverse dynamos--from toy shops to trucking companies, computer wholesalers to concrete manufacturers. Thirty-two companies are making a repeat performance from last year's list. That includes No. 2 Nautilus Group Inc., a direct marketer of exercise equipment--formerly named Direct Focus--that has parlayed the acquisition of various exercise and nutritional brands into a hefty 42% average return on capital over three years. Chairman and Chief Executive Brian R. Cook says this seller of such infomercial mainstays as the Bowflex exercise bench and Nautilus Sleep Systems got an unexpected bounce from the "nesting effect" of people spending more time at home after September 11.
Of course, small companies aren't immune to broader business challenges. Technology and telecom companies are sparse in our rankings this year. A wave of bankruptcies and downsizings has swamped both sectors. And the tech universe could provide slim pickings for small-cap investors for some time. The number of tech initial public offerings fell off a cliff in the past two years--from more than 252 in 1999 to just 22 in 2001--as the market regrouped after having focused on Internet and telecom-related outfits at the expense of more "basic" players in semiconductors and other segments.
Still, some tech standouts are beating the odds with a strong niche or diversified customer base or both. No. 17 QLogic Corp. makes chips, switches, and other products that help companies more efficiently manage their data storage. Growth in so-called storage networking has begun to slow, but it has not hit a wall like sales of personal computers. Even in a tech recession, QLogic's products are being snapped up by such customers as Dell Computer Corp. and Sony Corp. for use in their machines. As a result, the company beefed up profits by an average 39% a year for the last three years, while sales grew at a 46% clip. No. 47 UTStarcom Inc., the sole communications company in the pack, has flourished by serving emerging Asian markets with its wireless phone networks.
Tech services fared far better than hardware and software in this slump. And it helps if you've got a creditworthy customer like the U.S. government. Just ask PEC Solutions Inc., which specializes in integrating the Web into the business of government. Federal contracting dollars compose 95% of its revenues, including deals with the Justice Dept., Pentagon, and Treasury. In the wake of September 11, PEC is building an online system to track the entry and exit of immigrants for the Immigration & Naturalization Service. Such cutting-edge contracts have boosted PEC to No. 8 from No. 30 on last year's list, with 42% average annual profit growth over the past three years.
Most of our Hot Growth hotshots reached the top by swimming with the tide, not against it. That's why there's a plethora of consumer-oriented, service, and health-care outfits. They've proven more resistant to recession than other sectors. And oftentimes, demographics are working in their favor, as well, as they focus on growing populations such as older Americans. No. 4 Chico's FAS Inc., for instance, continues to succeed with its loose-fitting stylish clothes for women over 35. No. 16 U.S. Physical Therapy Inc. treats lots of aging baby boomers and their children at its 168 outpatient physical and occupational therapy clinics.
Or take the slew of education companies on the list, including No. 6 Corinthian Colleges, No. 14 Apollo Group, No. 32 DeVry, and No. 38 Career Education. Widespread layoffs are prompting more workers to upgrade their skills or retrain. More than 15 million students in the U.S. are in post-secondary education programs now, but fewer than half of those are the typical 18- to 22-year-olds who head to college right out of high school, notes Karl Brewer, a co-manager of the William Blair Small Cap Growth Fund. These companies "have figured out how to deliver post-secondary education to specific niches of the market that are underserved by the traditional educational institutions," he says. Apollo, for instance, offers fully accredited bachelor's and master's programs at its University of Phoenix campuses or online--a venue that is especially convenient for working adults. The company's annual sales growth averaged 26% over the past three years, while profits jumped an average 31%.
But where the opportunities are the ripest, the field is often jammed with competition. There, it takes innovation and execution to rise above the crowd. Consider No. 25, P.F. Chang's China Bistro Inc. With a Chinese restaurant seemingly around every corner, how do you reinvent this business? For CEO and Chairman Richard L. Federico the answer is to blend traditional Chinese cuisine with sophisticated settings and superior service. And restaurant managers must take an ownership stake in new restaurants, which lowers management turnover, a perennial industry headache. "There really isn't a branded player in the Asian segment," notes Federico, whose chain dished up average earnings growth of 324% over the past three years on 59% annual sales growth, to $343.9 million in the past 12 months. Now he's cautiously developing a lower-cost, quick-service concept called Pei Wei Asian Diner.
Certainly, some of today's highfliers will crash to earth in the years ahead as they misread consumers, expand too quickly, or stumble in other ways (below). Some will disappear through acquisition--No. 51 Immunex Corp., for instance, is being swallowed by drug maker Amgen Inc.
But others will move up to the big leagues. Oracle Corp. and Cisco Systems Inc. were once among our small-cap stars. "There's probably a company or two on your list that will be very important to the economy 15 or 20 years from now," says Thomas W. Laming, chief equity strategist at Buffalo Mutual Funds. Spotting those gems now is almost as much fun as snaring a bargain at Tuesday Morning.
By Wendy Zellner
With Stephanie Anderson Forest in Dallas and Catherine Yang in Washington