2018 Investing Trend No. 1: Behind-the-Scenes Innovators

Xtreme Drilling (TSX: XDC) NeuLion, Inc. (TSX: NLN) Photon Control (TSXV: PHO) Tricon Capital (TSX: TCN)

Why We Think This Trend is Going to be Massive

Here at Motley Fool Canada, we are big fans of investing in the “pick-and-shovel”-style business out there. By this, I mean that, oftentimes we’d rather invest in industry providers rather than those producing an industry’s final good or service.

In our minds, investing in these types of businesses can reduce our exposure to some of the risk inherent in cyclical industries, consumer preferences and technological changes.

One industry that we feel is best approached in this way is the oil & gas space. Its cyclicality has been on full display over the last several years with the price collapsing from above $100 per barrel in November 2014, bottoming out below $30 for the first time since early 2002.

A key reason why has been technological advancements in the space, which helps drive production higher and costs lower. Looking ahead, given the challenges faced with the electrification of the transportation sector and rising renewable energy, we believe the focus on cost will remain. That’s why the most hi-tech, efficient equipment and services providers should have a distinct advantage when exploration & production companies come calling.

Taking this same blueprint, we’ve eyed the digital entertainment industry as one that deserves our attention given the rapid pace of change taking place thanks to the advent of Over-The-Top (OTT) streaming. Here’s a topic that was very well represented this year at the Consumer Electronics Show in Las Vegas.

In the past year alone, it’s reported that the number of viewing hours of OTT content has more than doubled to 12.6 billion hours! And another industry study expects OTT viewership to eclipse traditional broadcast TV in the US within five years.

The thing is, content producers aren’t necessarily in the business of building online platforms, which is why we’ve had our eyes peeled for behind-the-scenes innovators here. Heck, even Disney (NYSE:DIS) chose to acquire a majority stake in digital streaming company BAMTech for more than $2.5 billion instead of building its own.

With so much at stake for these content rights owners, we envision a multi-billion-dollar battle that is just getting started.

Foolish Bottom Line

For those in the market for micro- and small-cap stocks, behind-the-scenes innovators are an ideal place to start looking. By their nature, they aren’t generally consumer facing and are often followed by fewer analysts than more well known “brands”. This can give curious investors an advantage by exploring the beginning of many industries’ value chains. Below, you’re about to discover four companies that we feel are prime examples of this investing strategy.


Our Top Four Small-Cap Stocks Leading the Way in Behind-the-Scenes Innovation

 

Xtreme Drilling (TSX: XDC)

Why Xtreme Drilling is potentially a Hidden Gem:

Headquarters: Calgary, Alberta
Website: www.xtremecoil.com
Industry: Energy services
Recent Price: $2.13
Market Capitalization: $163.5
LTM Revenue: $55.621
LTM Revenue Growth: 0.26%
3-Yr Revenue Growth: (40.2%)
Cash/Debt: $20.4/$0.0
Insider ownership: 9.1%
Dollar amounts in millions except for recent price
LTM = last twelve months
Data as of: January 12, 2018
Data provided by S&P Global Market Intelligence

Meet Xtreme Drilling…….

When it comes to the Canadian market, you can’t walk too far without bumping into something resource oriented. Thing is, in our opinion, a lot of what you run into within the resource space doesn’t amount to much when it comes to building a fundamental investment case.

The underlying commodities have more impact than anything when it comes to the success/failure of most resource focused companies and we’ll be the first to say, we’re not any good at predicting commodity prices. A skill that I’m not sure exists (regardless of what the financial media might have you believe).

One thing we do know however is that if you are going to invest in a resource oriented company, it’s better do so when the chips are down. A condition that’s prevailed for several years. Which means, now continues to be the time when you want to gain exposure, especially when it comes to the energy sector.

Xtreme Drilling operates a fleet of 13 drilling rigs, providing land drilling services to E&P operators in several basins across the U.S. Rig operators are particularly sensitive to the whims of the industry and one look at Xtreme’s performance in recent years certainly backs this up. Revenues totalled $267 million in 2014 and just $42 million in 2016, with a stock chart to match.

But during 2017, with the price of oil back in the $50-$60/bbl range, there’s reason to believe Xtreme’s performance bottomed out. Indeed, revenue in the most recently completed quarter was more than double what the company booked in Q3’16. And just as the market can punish these companies when business dries up, it can be equally rewarding as things normalize.

Thing is, and herein lies the opportunity, this remains an incredibly cheap stock. Without going into too much detail, an analysis of assets vs. liabilities indicates Mr. Market is virtually giving this company away. With no debt on the balance sheet and activity levels in the U.S. improving, the upside associated with this stock is substantial. And given the valuation, downside protection significant, assuming industry conditions simply remain status quo from here. An equation that’s hard to resist, especially in a market that’s run as it has.


 

NeuLion, Inc. (TSX: NLN)

Why NeuLion is potentially a Hidden Gem: NeuLion is positioned to benefit from cord cutting, mobile viewing, on-demand content, and live streaming—all global trends still in the very early stages of existence.

Headquarters: Plainview, New York
Website: www.neulion.com
Industry: Cable and Satellite
Recent Price: $0.55
Market Capitalization: $151.9 million
LTM Revenue: $118.2
LTM Revenue Growth: (6.6%)
3-Yr Revenue Growth: 21.5%
Cash/Debt: $66.8/$0.0
Insider ownership: 33.41%
Amounts in CAD millions except for recent price
LTM = last twelve months
Data as of: January 12, 2018
Data provided by S&P Global Market Intelligence

Meet NeuLion…

More and more, we’re seeing traditional video content creators seeking ways to distribute their wares on their own terms. And the method du jour for getting their content out there has been online, or over-the-top (OTT), streaming.

However, for most of them, the streaming business is a bit outside their circle of competence. That’s why many (and the number is growing) have begun outsourcing this to specialized streaming-platform builders like NeuLion, Inc.

For investors considering a stake in NeuLion, one could liken it to how we Fools tend to recommend investing in the energy sector—choosing to go with the picks-and-shovels and the pipeline folks instead of the producers themselves.

You see, NeuLion doesn’t run on the costly hamster wheel of paying directors, writers, actors, illustrators, and the like to continually churn out new (and hopefully profitable) content. No, it’s in the business of getting said content from the cutting-room floor to your primary visual cortex.

It does this in a variety of ways across virtually any internet-connected device thanks to its end-to-end digital platform solutions. In fact, it’s the only company of its kind that “owns and operates all pieces of the video workflow.”

Over the last year, or so, NeuLion shares have been under pressure, leaving us with the opinion that it currently provides investors a unique opportunity. This is especially true after the recent sale of certain “non-core” assets, intellectual property and subsidiaries for $41.5 million.

Without detracting from its OTT business, this sale bolsters NeuLion’s financial situation even more so that it already was. Taking this cash into account, NeuLion sports more than half of its market value in cash.

We appreciate this flexibility and safety net-of-sorts, given that, despite its promise, this industry is still relatively new. And, while NeuLion has a distinct head start and technological advantage, uncertainty remains.

For us, though, OTT streaming appears to be a vast ocean of opportunity, and a company with this much cash and over 30% insider ownership is one worth taking a much closer look at for long-term investors.


 

Photon Control (TSXV: PHO)

Why Photon Control is potentially a Hidden Gem: Well-positioned in the semiconductor manufacturing ecosystem to benefit from rising demand driven by a proliferation of connected devices.

Headquarters: Richmond, BC
Website: www.photon-control.com
Industry: Electronic Equipment and Instruments
Recent Price: $1.88
Market Capitalization: $207.3
LTM Revenue: $41.791
LTM Revenue Growth: 44.3%
3-Yr Revenue Growth: 25.5%
Cash/Debt: $27.0/$0.0
Insider ownership: 4.6%
Dollar amounts in millions except for recent price
LTM = last twelve months
Data as of: January 12, 2018
Data provided by S&P Global Market Intelligence

Meet Photon Control…….

Take a look around at your current surroundings and highlight a few of the more prevalent product brands that you see. To name a few that are in plain sight on this end: Dell, Apple, Under Amour and Logitech. Thing is, underlying the products that carry these brand names, an entire ecosystem of companies we’ve never heard of exists.

For instance, within my Dell computer there are Intel microchips. I know this because there’s a shiny “Intel Inside” logo staring up at me, a rare bit of branding in the relatively anonymous world of technology components. Digging further, while Intel products make up a small percentage of the components within this computer, there are a number of components that go into each one of its chips. And underlying those components exists yet another layer. And so on.

You want to talk about “hidden”? We need to go to that fourth layer to find where Photon Control exists.

Photon Control offers a collection of products to the capital equipment manufacturers who count the Intel’s of the world as their end customers. To perhaps better conceptualize (and steal a simile from the company’s CEO), think of Photon Control as a company that makes headlights for Audi, which is a maker of capital equipment (automobiles). Essentially, Photon Control’s products are used to manufacture the equipment that’s in turn used in the manufacture of semiconductors.

We’re of the mind that demand for semiconductors is going up. Something that’s likely to spur the entire underlying ecosystem, of which Photon Control has a bit, though growing part.

Beyond this pull-through demand dynamic however, there’s a business here that contains many attractive attributes. You see, once Photon’s offering becomes involved in a manufacturing process, that process tends to run for five- to seven-years, which means a stream of annuities more or less constitute the company’s top line. And the secular growth associated with semiconductors isn’t the only game in town when it comes to Photon’s opportunity. Some combination of expanding its reach with current customers, increasing the number of customers it serves and even entering new markets all together is a likely part of this company’s future.

Like any ecosystem, pitfalls exist but colour us intrigued by the risk/reward equation that Photon Control offers.


 

Tricon Capital (TSX: TCN)

Why Tricon Capital is potentially a Hidden Gem: The company has quietly cobbled together a vast collection of single-family rental homes throughout the southern U.S. that serves as a highly unique asset.

Headquarters: Toronto, Ontario
Website: www.triconcapital.com
Industry: Financial
Recent Price: $11.07
Market Capitalization: $1,492.1
LTM Revenue: $136.9
LTM Revenue Growth: 18.4%
3-Yr Revenue Growth: 1.5%
Cash/Debt: $9.7/$315.9
Insider ownership: 4.5%
Dollar amounts in millions except for recent price
LTM = last twelve months
Data as of: January 12, 2018
Data provided by S&P Global Market Intelligence

Meet Tricon Capital…….

While it’s portfolio of single-family rental homes are the crown jewel and account for 60% of the company’s $4.7 billion of assets under management (AUM), perhaps it’s best we begin our introduction with the legacy Tricon Housing Partners (TPH) business, which accounts for 30% of AUM.

Historically, Tricon was a company that took in institutional money from entities like pension plans and insurance companies, and invested that money – as well as its own – alongside residential real estate developers primarily across the southern U.S. As indicated, the TPH business continues to this day and perhaps most importantly, has a secret weapon of sorts in the form of a 51% stake in Johnson Development Corp., a Houston-based developer of master planned communities.

Through this stake in Johnson, Tricon plans to continue along its current path, investing both for itself and its established third-party institutional investors. Tricon will bring the capital, while Johnson provides the development expertise and project management.

What we believe is the more exciting side of the business however – Tricon American Homes (TAH) – is where we find the portfolio of approximately 16,594 single-family homes that’s been assembled both organically and through the recent acquisition of Silver Bay Realty Trust. As indicated, these homes are scattered throughout the U.S. south, from Georgia to California, and are targeted at a midmarket clientele with annual income of $50k-$95k per year.

Describing TAH’s opportunity as “vast” is somewhat of an understatement. Residential real estate in North America has always been rather mom-and-pop. Portfolios as big as Tricon’s haven’t existed in the past and are still very rare. Tricon expects to add to its portfolio through distressed sales, traditional retail channels, and bulk acquisitions, if it can find them. Distressed sales alone, however, which have averaged about 800,000 per year in the U.S. since 2005 (about 500,000 per year outside of the crisis years), should provide enough supply to make a difference to Tricon, and its shareholders, for years to come.

A continued accumulation of rental homes across the current footprint, as well as continued success developing new properties, will carry the day for Tricon. Toss in a 2.2% dividend yield and a great total return scenario begins to take shape.


David Gardner owns shares of Walt Disney. The Motley Fool owns shares of Walt Disney and Tricon Capital. David Kretzmann owns Disney and Under Armour. Taylor Muckerman owns NeuLion and Under Armour. Iain Butler owns NeuLion.