Small-cap Opportunity in this Market

by Mitchell Clark, B. Comm.

It’s a peculiar market for stocks right now, as economic news is
coming in worse than expected, yet investors are clinging to any small bits of good news. It makes me think that investor sentiment is getting stronger and there’s more upside ahead over the very near term.

You’re hard-pressed to find any news in the marketplace that is actually beating consensus estimates. For most companies, if they show they just beat the Street, it’s highly likely they’ve done so on previously reduced earnings estimates.

One small company that is the exception in this marketplace is ArcSight, Inc. (NASDAQ/ARST). I wrote about this company in early March and September of last year. This small company is in the business of selling information technology (IT) security products to corporate and government customers. I like this industry, because government customers are safe and pay their bills on time. In selling to government customers, once you get into the system and perform as required, a business can have a very successful stream of recurring revenues.

ArcSight’s products are mainly designed to safeguard customers’ IT assets, which include databases, applications, files, servers, desktops, and network devices. Some of the company’s customers include: Defense Information Systems Agency (DISA), the U.S. Securities& Exchange Commission, Verizon, the U.S. Federal Reserve, Xerox, McAfee, HealthSouth, Union Bank of California, Harris, Capital Blue Cross, and the U.S. Dept. of the Treasury.

In its latest quarter, ended January 31, 2009, ArcSight’s revenues grew to 36.4 million dollars, up from comparable revenues of 27.7 million dollars. Net income was a solid $5.1 million, or $0.15 per diluted share, up from net income of $2.4 million, or $0.09 per diluted share, generated in the same quarter last year. The company finished its latest quarter without any debt and with 82.9 million dollars in cash in the bank.

ArcSight is still a very small company, but its latest numbers beat consensus Street expectations and the business is about to achieve the critical size necessary to go after bigger accounts.

At the fundamental level, I think it’s very useful to consider the quality of a business’ customers when making investment decisions, especially when the broader stock market action changes. It’s not too difficult to figure out that investors would flock to a company like ArcSight in a recession. The company is growing profitably and, because of its large customer base of well-heeled government agencies, the prospects for continued profitable growth look good.

As an investor, you always have to be asking yourself questions about your positions and the underlying businesses they represent. Who are the customers? Who spends lots of money on IT security? Who benefits from new homeland security spending? Whose business will be more stable in a recession? All these kinds of questions are critical and they must evolve with the prevailing sentiment in the stock market and your portfolio.