Sizzling Small Caps: Can They Keep It Up?

by James Brumley | July 26, 2012 12:24 pm

There’s nobody on the planet who loves to see a small cap stock soar more than I do. Practically no one sees them coming, but once shares make their bullish move, it’s a hoot seeing all the Monday morning quarterbacks say, “I told you so.”

Of course, not all of these red-hot moves are justified by the underlying corporate results, and that’s where it can get tricky for traders. Is it wise, or even safe, to jump on a small cap after a big jump? For that matter, could the company’s numbers even justify higher prices?

That’s the question we’re going to answer for Mellanox Technologies (NASDAQ:MLNX[1]), Six Flags Entertainment (NYSE:SIX[2]), and Lumber Liquidators (NYSE:LL[3]) — three of the market’s hottest (lately, anyway) small-cap stocks.

Six Flags Entertainment

If the tepid economy is crimping consumer spending, somebody may want to tell that to all the people flocking to Six Flags’ theme parks. Last quarter’s revenue was up by 11% on a year-over-year basis, mirroring the 12% improvement in park attendance. Earnings per share grew from 65 cents a year ago to $1.27 this year.

The company has been teetering at the breakeven mark overall, given last year’s and last quarter’s results, but may finally be within reach of net-profitability on an annual basis.

I’m not so sure the 200%+ rally over the past 24 months makes sense, however. In fact, I’m quite sure the near 25% run-up since the end of May has carried the stock well beyond any plausible forward-looking valuation.

As it stands right now, Six Flags Entertainment shares are trading at around 30 times their expected 2013 income. Granted, you own a stock for where it’s going rather than where it’s been, and where Six Flags is going is a whole lot better than where it’s been.

But, the end-zone at least has to be in sight. The theme park operator would have to keep growing at its current rate through 2015 before it could justify its current valuation. That wait could feel longer than waiting in line to ride Six Flags’ Nitro roller coaster in New Jersey[4].

Lumber Liquidators 

Ever heard of a blowoff top? I think Lumber Liquidators just made one. It’s characterized by a downright explosive one-day rally following an already-long streak of solid upside movement. Shares of Lumber Liquidators surged 26% on Wednesday following the 120% beeline run-up over the prior eleven months. That qualifies as a blowoff top in my book.

Problem is, blowoff tops are just that — tops. With nowhere else to go, the bulls abruptly bow out and turn the reins over to the sellers.

Or in simpler terms, it’s the “as good as it gets” scenario. And no, I don’t think the company’s underlying results are going to make this chart an exception to the norm.

To the company’s credit, Lumber Liquidators has been ramping up revenue quite nicely every year since 2007. The company’s earnings have been stagnant since 2009 though.

Yes, on Wednesday the company blew away Q2’s earnings estimates of 28 cents per share by posting a profit of 43 cents, and backed it up with a 19% increase in year-over-year revenue. Like Six Flags, however, shares are simply bloated at nearly 28 times 2013’s expected earnings.

Said another way, there’s no room for error here — the home improvement retailer would have to reach or beat those estimates … something it only does about half the time.

Mellanox Technologies

Last but not least, Mellanox Technologies. The stock’s up over 200% year-to-date, with a good chunk of that gain materializing in the last week thanks to Q2’s earnings results.

The fabless semiconductor manufacturer blew away estimates of 74 cents per share with income of 99 cents per share. The number trounced the 27 cents figure from a year earlier, and the pros expect Mellanox to continue being an industry outlier and grow income as other semiconductor makes struggle.

But still, isn’t a near-triple in price in just a few months more than excessive, if not downright dangerous?

Nine times out of ten, I’d be inclined to agree. In the case of MLNX, however, its semiconductor business is exception-worthy because it’s smack-dab in the middle of the still-expanding cloud computing and high-performance computing markets. It builds inter-connectivity hardware with corporate-level storage and computing power. Let’s put it like this: IBM (NYSE:IBM[5]), Hewlett-Packard (NYSE:HPQ[6]), Dell (NASDAQ:DELL[7]) and Oracle (NASDAQ:ORCL[8]) are Mellanox customers.

EPS is expected to swell from 2011’s $1.07 to $3.72 this year, and to $4.10 in 2013. That translates into a forward-looking P/E of 23, which isn’t cheap, but it is easily justified given the growth rate.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

  1. MLNX:
  2. SIX:
  3. LL:
  4. Nitro roller coaster in New Jersey:
  5. IBM:
  6. HPQ:
  7. DELL:
  8. ORCL:

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