3 Small-Cap Stocks With Big-Cap Potential

MarketsMotley Fool

Small-cap businesses, although historically riskier investments with less-proven business models, offer a compelling investment opportunity compared to mid- and large-cap companies over the long term. Investors stand to be well rewarded if they can uncover small caps that overtime dominate their markets and eventually turn into massive companies and large-cap stocks. With that in mind, three Motley Fool contributors think Baozun (NASDAQ: BZUN), Iridium Communications (NASDAQ: IRDM), and Webster Financial (NYSE: WBS) are all small-cap stocks with big-cap potential.

A Chinese growth stock ready to bounce back

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Jeremy Bowman (Baozun): 2018 was a rough year for Chinese stocks, and Baozun was no stranger to the malaise. Shares of the e-commerce facilitator fell more than 50% from their peak over the summer on a broader sell-off that pushed the Shanghai Composite down 25% for the year due to a decelerating Chinese economy.

However, Baozun's fundamentals remain appealing. The company provides e-commerce services including IT, warehousing, distribution, and customer service in China to multinational companies like Nike, Microsoft, and Starbucks and leads that market with a share around 25%. That should give it a strong tailwind. The Chinese market is expected to become more attractive to global companies, as it's still growing faster than Western economies, and it's projected to be the world's biggest economy within a generation, passing the U.S.

In its most recent quarter, revenue jumped 24.8% to $161.7 million, and revenue from the higher-margin services segment surged 45.6% to $88.3 million. That drove operating profits up 41.4% to $5.7 million, and adjusted earnings per share increased from $0.09 to $0.13.

Baozun is pivoting from product sales to services, which is improving profitability. With only about half of its revenue coming from services, there is plenty of room for profit margins to expand as services take more share of total revenue.

After the recent sell-off, the stock looks downright cheap at a P/E of 41 based on trailing earnings and less than 20 based on this year's expected earnings. Considering Baozun's strong growth and improving profitability, the stock looks like a bargain at today's price, as concerns about the slowing Chinese economy are already baked into the numbers.

True global reach

Daniel Miller (Iridium Communications): At the top of my small-caps watch list is a company that has potential to turn into a massive company: Iridium Communications. Iridium is the only mobile voice and data satellite communications network that spans every corner of the globe and enables connections between people, assets, and businesses anywhere. Essentially, Iridium offers solutions when land-based wireless networks fail due to remoteness, harsh terrain, or a simple lack of infrastructure.

On Jan. 7, the last satellite for Iridium's NEXT program will launch. It's designed to build out the company's next-generation satellite network, which should provide further subscriber momentum. In fact, during the third quarter, Iridium's total billable subscribers already jumped 15% compared to the prior year driven by Internet of Things companies and government customers. That subscriber growth fueled financial results and drove double-digit revenue and operational EBITDA growth during the third quarter.

Iridium believes its unique low earth orbit (LEO) sets it apart from the competition, as it offers lower latency, adaptable two-way communications, and a better customer experience. Its NEXT satellites will provide significant improvements in transmission speeds and voice quality. The NEXT program didn't come cheap, and launching 66 new operational satellites and 9 in-orbit spares came with a $3 billion price tag, but the company plans to bring its net leverage down to roughly 4.5 times OEBITDA, from a peak of 6.0 times during 2018.

Iridium lowering its leverage and then reaping the rewards from its NEXT satellite program should drive subscribers, revenue, and EBITDA higher in the years ahead, making it a small-cap stock with big-cap potential.

This bank has a hidden gem

Jordan Wathen (Webster Financial): You'll have to look behind this bank's nondescript name to find a hidden gem: This bank is the parent company of HSA Bank, which provides banking services to consumers who want to save money for future healthcare costs with a health savings account.

The beauty of HSA banking is twofold. First, few people care about the interest rate they earn on their deposits into an HSA. Second, once opened, HSAs are one of the rare types of accounts in which the balance grows month after month and year after year. Webster says an average account opened in 2007 is roughly seven times larger than the average account opened in 2016.

Currently, HSA deposits make up about 25% of Webster Financial's deposit mix, but that ratio should only grow with time. In the most recent quarter, HSA deposits grew 14.5% year over year, consistent with the double-digit growth rates it has experienced for several years running. And this is despite the fact that it pays just 0.20% on balances held in HSA Bank, a rate it hasn't changed in years.

Webster has found the crown jewel of the banking industry: a deposit account that generates a recurring source of fee income plus a gusher of deposits on which it pays very little interest.

With a fast-growing treasure trove of low-cost deposits, Webster can be a below-average bank in almost every other regard -- it could make more bad loans, spend too much on fancy offices, and so on -- and still eke out a higher-than-average return on equity thanks to its exceptional HSA Bank business.

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Daniel Miller has no position in any of the stocks mentioned. Jeremy Bowman owns shares of Baozun. Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Baozun. The Motley Fool has a disclosure policy.