Three Undiscovered Small-Cap Gems

	Paul Tracy Street Authority.com
Special offer from StreetAuthority.com: Winning picks are up 242%, 189% and 135%. FREE Report--HIGH-GROWTH GAINS FROM LOW-TECH STOCKS.

Well-known large-cap stocks like Dell (DELL), Wal-Mart (WMT) and Microsoft (MSFT) are carefully covered by legions of Wall Street analysts. Analysts scrutinize each and every tidbit of news surrounding these companies, from earnings reports to the latest buying and selling activity by corporate insiders. What's more, almost every mutual fund in America, and many foreign funds, already own an enormous stake -- institutional ownership of these large-cap stocks often approaches levels of around 90% or more.

In general, however, these large-cap names tend to be extremely mature companies. And as we all know, as companies mature their growth rates tend to slow, which normally leads to lower returns for investors. What's more, if a stock is already widely followed by the Street and widely owned by mutual funds, then there's less idle buying power on the sidelines to force share prices higher.

The story is just the opposite for small-caps though. Small companies often fly under the radar screens of large banks and mutual fund companies. As these companies grow and become more prominent, that leaves room for institutional buying power to move in and push the shares strongly higher. What's more, small-cap companies usually have more room to grow -- they haven't yet exhausted their potential or expanded geographically as much as they can.

Below, my staff and I will look at three relatively unknown small-cap stocks with a great deal of growth potential. All have a shot at becoming the large-cap bellwethers of the future, powering solid gains for investors in the process.

LIFE TIME FITNESS (LTM, $27.00)

Business Overview
Life Time Fitness operates around 40 fitness and health centers in 8 states. The company's fitness centers are located mainly in suburban areas and average a little over 100,000 square feet in size. That's roughly the size of your average Home Depot or Target Superstore and a little smaller than most Wal-Mart locations.

Life Time's centers include traditional fitness club facilities such as exercise equipment and weight rooms. In addition, most of the company's clubs also include spas, healthy cafes, personal training facilities and large pools complete with water slides.

Life Time began operations in 1992 but is relatively new to the stock market -- the company went public via an initial public offering (IPO) in July of 2004.

Competitive Advantages
LTM has a number of major competitors in the fitness and health club market. Some of these competitors are far more established than LTM; Bally's Total Fitness, for example, already boasts 418 centers located in 29 states.

However, LTM offers a number of advantages over many of its rivals. More specifically, the company's fitness centers offer a broader range of services at a lower price than the competition. Consider that most health clubs are a fraction of the size of the average LTM center; for comparison, the average Bally's club is closer to 30,000 square feet, about one-third of the size.

This size reflects the broader range of services offered at LTM centers, especially at the company's newest, most modern facilities. This includes equipment like rock-climbing walls and basketball courts -- items rarely found at your average fitness center. Also important is that by increasing the size of their facilities, customers have reported fewer problems with long waiting lines to use exercise equipment. Best of all, despite the extra services, the firm has still managed to keep its prices roughly in line to slightly lower than industry norms.

This advantage is reflected in the company's ultra-high customer retention rates. According to LTM's initial offering prospectus, the firm's retention rates were a full 6.3 percentage points higher than the industry average in 2001 and 5.7 percentage points higher in 2002.

Growth Drivers
My staff and I see two main growth drivers for LTM. First, the company remains relatively small and underexposed geographically. With just 40 fitness centers in 8 states, LTM has yet to fully expand its footprint across the country. In fact, there are plenty of markets that are totally untouched by LTM. For example, to date LTM hasn't opened a location in two of its largest potential markets, California and New York.

My staff and I believe the company has scope to grow by simply replicating its business model in new markets. This year the company opened five new locations, and next year LTM plans to open six. Even better, the company raised around $80 million in its IPO this summer -- enough to help it fund even further expansion in the coming years.

Secondly, my staff and I believe it's a mistake to ignore the company's potential for further organic growth from its existing locations. Consider that in its most recent quarterly report, LTM reported growth in membership dues of about +22% year over year -- an impressive figure. But even more interesting was the near +30% growth in so-called "in-center" revenues. The firm derives these revenues from services like its café and spa facilities. As a result, in-center revenues are making up an increasingly larger chunk of total company revenues. Last year in-center revenues stood at 22% of the total. This year the company is looking at a number closer to 25% of revenues -- a significant jump for a single 12-month period. Thanks to rapid growth from these lucrative activities, LTM's overall growth rate should remain strong in the years ahead.

Valuation
LTM has been no wallflower since its July IPO, climbing nearly +30% from its first day's close of trading. Nevertheless, the stock still looks like a bargain considering its tremendous growth potential.

Analysts peg long-term growth at close to +24% and the stock is currently trading at a little less than 26 times 2005 earnings. That gives LTM a P/E-to-growth (PEG) ratio of just over 1 -- very cheap for such a high-growth stock. Earnings should top $3 per share within the next five years. Assuming the company earns a market multiple of about 20 times earnings, the stock should be worth north of $60, more than double the current price.

We also like the company's low institutional ownership. Institutions hold only about 30% of the firm's outstanding shares. That ratio should rise as the company gains scale and develops a longer operating history (both of these items should help support the share price).

CENTRAL EUROPEAN DISTRIBUTION CORP. (CEDC, $28.15)

Business Overview
CEDC is headquartered in the U.S. but derives the vast majority of its revenues from Poland. The company is Poland's largest liquor importer and distributor. In addition, the firm has expanded into the liquor distillation business in recent years by buying up several Polish vodka distillers.

If there's one product that just about any bar, restaurant, nightclub or convenience store needs to sell to be profitable, it's alcohol. CEDC distributes liquors to about 31, 000 such businesses in Poland. The company not only distributes locally produced Polish beverages, but has also branched out into major international brand names.

Competitive Advantages
CEDC has no real competition in the Polish market right now, and the barriers to entry in this market are very high. Back in 1997, when the company first broke into this market, the Polish liquor distribution business was highly fragmented with literally hundreds of small "mom-and-pop" style distributors operating around the country. In addition, as a result of Poland's communist years, the government was actually still the main national supplier of liquor.

This system was ill-suited for a modern capitalist economy. Hundreds of small distributors had little negotiating power with larger alcohol producers, especially the big foreign producers. And none of these small players were taking advantage of potential economies of scale in logistics and delivery.

CEDC changed this system by acquiring a host of small distributors using money raised in its initial public offering (IPO). By integrating operations, CEDC saved money and improved services. Even better yet, the company quickly developed enough scale to negotiate favorable distribution contracts with foreign suppliers.

CEDC's remaining domestic competition consists exclusively of small distributors that haven't yet sold out to CEDC. None have the scale advantages to compete effectively with CEDC. In addition, CEDC continues to expand its enormous market share through further acquisitions -- including 4 new acquisitions in the past year alone.

As my staff and I mentioned above, the Polish liquor distribution business is marked by large barriers to entry. CEDC made the wise move of retaining many of the local managers at the distributors it acquired in the late 1990s. These managers have the local relationships with bars, clubs and restaurants; relationships that are key in the liquor business. It would be difficult for even a well-capitalized foreign competitor to break that lock-hold.

Growth Drivers
Eastern Europe -- and Poland in particular -- are attractive growth markets. Poland was admitted to the European Union (EU) in May 2004, a move that will likely bring increased political stability as well as an influx of foreign investment. Trade barriers and import tariffs also came down completely after the May 1st EU accession date. And the potential for economic growth is high given the country's rapid modernization after years of communist rule.

Not surprisingly, consumer spending is on the rise in Eastern Europe and consumers are demanding more and better quality goods. This will be a major earnings driver for CEDC. Traditionally, 70% of company sales have been of cheaper domestically produced liquors. But that's starting to change -- the company has now negotiated contracts with some of the best-known foreign producers, including Johnny Walker scotch and Jose Cuervo tequila. These products carry far higher profit margins than liquors produced in Poland. Therefore, as the nation becomes wealthier, CEDC's business mix should continue to shift more in favor of high-margin imported liquors.

Helping this process: the removal of one of the most punitive import tariffs in Eastern Europe -- a tariff on imported liquor. After May 1, CEDC reported an immediate +40% jump in sales directly attributable to the removal of the tariff.

Valuation
Analysts expect CEDC to post growth of between +17% and +18% over the long term. The company's current P/E based on 2005 earnings is around 18, yielding a PEG ratio of just 1.

In five years, CEDC should be earning well north of $3.50 per share. And there's upside to that figure if the company's business mix continues to shift in favor of higher-margin product offerings, applying a conservative multiple of 17.5 times yields a price well north of $60 per share, making CEDC a very attractive small-cap play.

AMERICAN SCIENCE AND ENGINEERING (ASEI, $39.57)

Business Overview
ASEI makes x-ray and scanning systems that the government uses to screen packages and vehicles crossing U.S. borders, as well as cargo at American ports. The firm offers three basic product lines: CargoSearch, Inspection Systems and ParcelSearch.

The company's CargoSearch systems are installed at borders or ports and are designed to screen air, sea and land cargo. That would include vehicles, pallets, seaport containers and railway cars. Meanwhile, the firm's Inspection Systems can be mounted inside a truck and used while the truck is in motion -- this allows the screening of vehicles without impeding traffic excessively through a border. Finally, ParcelSearch, as the name implies, is used by the Postal Service to scan mail and packages.

Competitive Advantages
The defense and government contracting businesses are all about relationships and proven technology. This is one reason why the government tends to go back to the same contractors repeatedly when awarding new deals. ASEI has certainly proven its ability to garner key contract wins, as it is one of only a handful of companies that sells sophisticated X-ray systems to the government.

ASEI is an established player in the screening business, having been involved in this market since the late 1950s. Even better, the company has been quite successful at garnering new contracts in recent months. That includes a recent order worth $25 million for its inspection vans and an additional $13 million contract for service and repair of an existing ASEI system.

The firm's rapid-screening technology, which it has dubbed Z-Backscatter, also seems to be a particularly defensible niche. Very few other companies offer anything similar to this type of technology. This is part of the reason why the company has won so many contracts in recent months from both the U.S. and foreign governments.

Growth Drivers
ASEI's numerous growth drivers make it a particularly attractive investment proposition. President Bush recently signed the 2005 Homeland Security Appropriations Act into law. This bill provides for $28 billion in additional, discretionary spending by the Homeland Security Department next year. Given that Bush has proven his commitment to higher spending on homeland security, most analysts agree that the second Bush term will be a boon for companies that sell defense and security equipment to the U.S. government.

Even better, a primary focus of this new homeland security spending bill involves defending the nation's ports and borders. Both have been identified as key weak points that remain vulnerable to terrorist activity. Meanwhile, it's also important to ensure that security operations don't unduly slow cross-border commerce. As a result, a good chunk of this new spending will fall on companies like ASEI that sell products tailor-made for border and port protection.

Valuation
Thanks to an increased volume of government contracts, ASEI is expected to earn $1.13 per share this fiscal year (ending March 2005). Longer-term, analysts are looking for growth of nearly +30% annualized. Some of that growth is even locked in by long-term government contracts.

Based on projected 2005 earnings (for the fiscal year ending March 2006), the company trades a little over 21 times earnings. This is actually a considerable discount to ASEI's long-term growth rate, giving the company a PEG of under 1. Assuming ASEI's increased pace of contract wins continues to catch investors' attention, we can easily see the company trading at a more industry-average PEG of 1.1 to 1.2. Based on next year's projected EPS of $1.84, that would put the stock well over $60 per share.

----------------------------

We sincerely hope you've enjoyed today's look at three undiscovered small-cap gems. Please stay tuned for our next full issue, which we'll publish on Monday, December 20th. In it, my staff and I will bring you an in-depth special report entitled: "StreetAuthority's Top Ten Stocks for 2005 and Beyond." Good investing in the week ahead!

Paul Tracy will be available to take your questions until Monday, December 13. Please use the form below to submit your questions.