Seeking Small-Cap Moats: Exponent

One of the best parts about researching small-cap stocks is coming across a fantastic niche business that most investors have yet to hear about. Now and then you'll find a firm with a solid balance sheet, a good management team, a potential economic moat, and a long growth runway, that's covered by only a few sell-side analysts--and in some cases no analysts at all.

Though these situations tend to be rare, if you can identify such companies before the rest of the market catches on--and pay a good price for them, of course--it can make a big difference in your portfolio's long-term returns.

Indeed, this is why two of the 13 "signs of a perfect stock" outlined by former Fidelity Magellan manager Peter Lynch in his classic One Up on Wall Street are, "It's got a niche," and "The institutions don't own it, and the analysts don't follow it." By the time a company has diversified its operations and has 20 analysts covering its every move, the opportunity for outsize gains has likely passed.

With this in mind, I was particularly surprised (and encouraged) that this month's small-cap stock only had four sell-side analysts officially covering it, given its very profitable niche in the engineering and scientific consulting industry.

Profiting From Failure
Founded in 1967 by a Stanford University professor, Exponent (EXPO) was known as Failure Analysis Associates until 1998. Today, with more than 670 employees possessing advanced degrees (including 450 Ph.D.s) who cover more than 90 disciplines from electrical engineering to epidemiology, there's a good chance that Exponent can solve any problem a given company has. In any given year, Exponent handles 6,000 to 7,000 projects, with the largest 20% of projects typically accounting for about 80% of annual revenue.

Approximately 60% of Exponent's business is "reactive" in nature, meaning that customers contact the company in the event of litigation, complex insurance claims, product recalls, and other difficult scenarios, to better understand the problems they face.

What's particularly attractive about the reactive business is that customers are often in a disadvantaged bargaining position. They are in crisis mode and need their problem resolved quickly, making price a secondary concern. With more than 40 years in this field, Exponent is regarded by many as a premium provider, and it is able to price its services accordingly.

The remaining 40% of the business is "proactive" in nature, meaning that Exponent can help customers design new products (such as tablet computers and drug delivery systems), ensuring regulatory compliance, developing risk management programs, and the like.

Further, companies don't stop having problems in a recessionary environment. Unsurprisingly, then, Exponent's returns on equity and profit margins remained quite solid through the financial crisis years--especially considering the bankruptcy of two major customers in  General Motors (GM) and Chrysler. 

Return on Equity and Net Margin, 2008-13
	2008	2009	2010	2011	2012	2013
Return on Equity (%)	17.8	15.9	16.5	17.7	18.5	17.1
Net Margin (%)	10.1	9.7	11.1	12.0	12.7	13.1
Source: Morningstar

Reputation and Track Record Point to a Moat
Though Morningstar doesn't currently cover Exponent, and the company hasn't been vetted by our moat committee to produce an official Morningstar Economic Moat Rating, I'm of the opinion that Exponent possesses at least a narrow economic moat (that is, the company has an expected competitive-advantage period of at least 10 years).

At face value, there appears to be little about Exponent's business that can't be replicated by a competitor with deep pockets. Just hire a bunch of Ph.D.s and watch the magic happen, right?

Well, it's not quite that simple. Learning to organize the diverse scientific backgrounds of all those Ph.D.s to effectively solve an array of complex problems doesn't happen overnight, and it takes many years to develop a premium reputation in the industry. Exponent does have competitors that specialize in one field or another, but arguably no engineering and scientific consulting firm has the breadth of services that Exponent offers. Finally, a would-be competitor needs not only to attract relatively scarce engineering and science talent, but also to retain it during periods of slow demand. Exponent, for example, is able to attract and retain talent by providing consistently complex and challenging projects; in periods of slower demand, Exponent encourages its specialists to conduct research, appear at speaking engagements, and sit on standards committees--all of which build the specialists' personal brand value and allow the firm to charge higher prices.

Establishing a reputation for reliability and building a track record of execution simply can't be accomplished overnight, and customers with big problems will likely be reluctant to hire an unproven firm to do the work. A mistake on a major project could easily run into the tens or hundreds of millions of dollars, and companies may figure it's better to pay for a high-quality provider up-front. Because of these factors, I'd argue that Exponent's durable competitive advantage is derived primarily from the intangible-asset economic moat source.

Building From What It Has, Not Acquiring What It Does Not
Exponent's management team has also done a fine job on the capital-allocation front. Acquisitions are rare--Exponent hasn't done one in 10 years--and the company has instead focused on developing its core business by expanding and enhancing existing capabilities. The balance sheet has been consistently debt free, as well. Though Exponent has traditionally returned cash to shareholders through share repurchases, it also established a modest dividend program in 2013. In early 2014, it meaningfully increased the quarterly payout to $0.25 per share from $0.15 per share, and I think further double-digit annual dividend growth is in store over the next few years.

As of the most recent proxy filing, executives and directors own about 5% of the outstanding shares, which should help align management's interests with shareholders'. It's also reassuring that Exponent has a deep bench of executive talent--the eight named executives have been with the company for more than 20 years, on average. If one or two retire or leave the company, then, it shouldn't result in high transition costs.

Risk and Valuation: Look for a Margin of Safety
The biggest risk to Exponent's moat is an impaired reputation as a result of negligence, the disclosure of confidential client information, damaged evidence, and so forth. Consequences would likely take the form of expensive lawsuits and lost business from prospective clients. Because of this meaningful risk, those interested in Exponent should require a decent margin of safety before investing in the company. 

Valuation Ratios
	EXPO	S&P 500	EXPO Five-Year Average
Price/Earnings	26.2	18.0	21.9
Price/Book	4.0	2.6	16.2
Price/Cash Flow *	16.4	10.9	16.2
Source: Morningstar, Data as of 04/16/2014  (*) Price/Cash Flow uses three-year average

The trouble is that Exponent consistently trades with a premium to the market and rarely trades at a deep discount. A premium multiple seems justifiable given Exponent's steady and strong performance and long growth runway, however, so it's unlikely that you'll see Exponent in the "value" section of the Morningstar Style Box anytime soon. If you're interested in investing in Exponent, I'd recommend you keep an eye out for pullbacks, and perhaps split your target investment amount across three to five entry points (bearing in mind transaction costs, of course). I'd consider the stock a very good deal below $55 per share, but would consider a starting position below $65.

Other stocks highlighted in this series:

• Sun Hydraulics  
• John Bean Technologies
• Culp Inc.
• Badger Meter
• US Ecology

Todd doesn't own shares of any company mentioned. You can follow him on Twitter at @toddwenning.