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These 4 Fast-Growing Small Caps Could Soon Become Mid Caps

 December 27, 2012 11:07 AM

It's hard to remember, but today's leading large-cap stocks were once just fast-growing small businesses. Years of double-digit annual sales growth turned these acorns into mighty oak trees.

And if you glance across the 600 stocks comprising the S&P's SmallCap 600 Index, then you'll come across tomorrow's stars as well. Several dozen firms are in the midst of a long-term growth spurt that will likely have them characterized as mid-cap stocks before long. And well down the road, these stocks could be solid citizens in the S&P 500 Large Cap Index. Here are four to keep your eye on...

1) 3D Systems (NYSE: DDD), along with Stratasys (Nasdaq: SSYS), was one of the early pioneers of "rapid prototyping," which allows designers to make a three-dimensional model of virtually any small item. NASA even used a machine to create spare parts in mid-flight if necessary. For many years, this industry was more about hype than reality: 3D Systems' sales hit $126 million in 2004 and by 2009, had actually shrank to $113 million. Since then, you can see this company hitting its stride as sales rose at least 40% in 2010 and 2011. Thanks to acquisitions that augment organic growth, sales likely rose more than 50% this year (to around $350 million) and could approach $450 million by next year.

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There's a counterintuitive way to trade a stock like this. You want to own high-growth stocks when they hit a temporary rough patch. And this stock has risen from $15 to $50 in the past year, thanks to scorching growth, but we've repeatedly seen fast-moving stocks like this take a huge hit when a bad quarter arrives (Netflix (Nasdaq: NFLX) and Chipotle Mexican Grill (NYSE: CMG) being two recent notable examples.) 3D Systems' long-term growth prospects are so robust, you need to track this stock and be ready to pounce when the inevitable quarterly stumble happens.

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2.Akorn Inc.Akorn Inc. (Nasdaq: AKRX) is a generic drug manufacturer capitalizing on the broad range of patent-protected pharmaceuticals that are now going off patent. Akorn, which focuses on ophthalmology and gels, saw its sales shoot up from $76 million in 2009 to a projected $250 million in 2012. Thanks to a robust pipeline, analysts see sales rising to $330 million in 2013 and more than $400 million by 2014. Part of this growth is coming from an aggressive expansion in the company's sales force.

Akorn hopes to grow faster than the rest of the industry by establishing a low-cost beach head. The company's manufacturing plant in India will be capable of producing 10 times more output than its U.S. facility -- and at lower cost. It's already a reasonably profitable business, with gross margins exceeding 55%. That should enable earnings per share (EPS) to power higher, from a projected 50 cents a share in 2012, to more than 80 cents a share by 2014, and perhaps $1 a share by 2015, once the plant in India is working closer to capacity.

3. Carrizo Oil & GasCarrizo Oil & Gas (Nasdaq: CRZO) has been rapidly expanding its drilling program across a number of the leading U.S. shale fields, which is fueling explosive top-line growth. Sales are on track to nearly double in 2012 (to about $400 million), and could exceed $750 million by 2014.

Per-share profits are rising at a commensurate clip, from a projected $1 in 2011 to more than $3 by 2013. So why has this stock fallen from $70 in 2008 to $40 in the spring of 2011 to a recent $22? Because investors are less than impressed by the profit trajectory and instead want to see Carrizo generate robust free cash flow. The company has plowed every cent back into its drilling expansion plans and has never generated positive free cash flow in its history. Management says Carrizo will start to generate positive cash flow later in 2013, and if it can show spending discipline in 2014 and beyond, then the cash flow should rise sharply, finally giving this stock a long-awaited lift.

4. Financial Engines As corporate pension plans slowly disappear, consumers are increasingly tasked with managing their own retirement plans. It's surely a daunting task for anyone that lacks a lot of exposure to consumer finance issues. Financial Engines (Nasdaq: FNGN) was launched in 1996 to help create a series a user-friendly retirement plan web sites, and now has more than $500 billion in assets in tandem with 500 different financial institutions.

As more firms have signed on to help their clients use Financial Engines' software and asset-management program, growth has been remarkably steady. Sales have roughly risen 20% to 25% annually since 2005 and are on track to grow at least 20% in 2012, 2013 and again in 2014, by which time they should approach $275 million.

And this kind of sales growth over a largely fixed cost base is fueling profit gains. Goldman Sachs estimates that EBITDA margins rose two percentage points in 2012 to 23.7% and could approach 25% in 2013. And robust growth can be sustained for quite some time to come, Goldman's analysts say. "Financial Engines is on the verge of broadening its offering to include IRA plans, a market significantly larger than 401Ks," they note, adding that the company should have an easy time simply working with existing partners, rather than trying to market the new offerings directly to consumers.

Risks to Consider: Strong growth begets rising expectations, so these stocks would be punished if there are any growth stumbles along the way.

Action to Take --> When identifying companies capable of sustained growth, you need to focus on those firms that are able to expand sales simply through an expansion of their current efforts. Of this group, only 3D Systems is pursuing acquisitions, but in this instance, these deals only help to expand a robust pipeline of organic growth opportunities.

-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.


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