My Favorite Stock for 2007

It's go-out-on-a-limb time again -- the time when I pick my favorite stock for the coming year. My previous picks were JLG Industries, which more than tripled after I recommended it in September2004, and Scientific Games, which rose 51% after I endorsed it a year ago. I no longer own either one and am, in fact, selling short Scientific Games.

Before I tell you why I love Investools (symbol IEDU), an investment-education company, I want to apologize for several things. As I write, the stock is $11.77, and I bought it three years ago at $2.21. Sorry for not telling you about it sooner. Also, in March 2003 I mocked the company, which was then marketing seminars under the CNBC University name, among others, for its seemingly simplistic approach. Whether that criticism was valid doesn't seem germane. The company says 98% of its customers are satisfied.

Awful earnings

I believe the market has undervalued Investools for years. Why? Investools operates in the sleazy investor-education business. Investools isn't sleazy, but it does use infomercials to say it can turn people into great investors. Those who sign up pay hefty fees for seminars plus about $50 a month for access to its online Investools toolbox. In addition, as Sameet Sinha, a bullish Kaufman Bros. analyst, puts it, the company's earnings record is "terrible." Not only does Investools always spill red ink, but the more business it books, the more money it loses.

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Here's the explanation: When a customer pays for an Investools seminar, the company gets cash up front, but it defers almost all of the revenue because it must continue serving the customer for another 12 or 24 months. The deferred revenue becomes a liability, which triggers the losses.

But free cash flow (earnings plus noncash charges minus the capital expenditures needed to maintain the business) -- a critical number when assessing a company -- is strong and has been growing quickly for years. Investools should generate $1.22 per share in free cash flow in 2007, says analyst Richard Fetyko, of Merriman Curhan Ford. That means the stock is trading at about ten times next year's free-cash-flow estimate, a significant discount to the overall market's price-to-free-cash-flow ratio. But Investools is growing about twice as fast as the market, so the shares deserve to sell at a premium price.

In the past year, Investools has improved its business model. Not long ago, it had to share nearly all its revenues with partners, such as CNBC and Business Week, that marketed Investools' seminars under their brand names. Eventually, most of the company's business will be under its own name. That should boost profit margins.

In September, Investools made a move that could transform the company. It agreed to acquire online broker Thinkorswim for $340 million. Initially, the market freaked, given that the deal seemed to value Thinkorswim at a lofty 30 times 2006 earnings. But recognizing the broker's growth potential and the likely synergies between the two firms, investors reversed course and began bidding up Investools shares.

Growth strategy

By some accounts, Thinkorswim is the best retail options broker in the country. It has grown rapidly with almost no marketing. Investools will be able to give it a big marketing push -- and will gently try to steer its 250,000 graduates toward using Thinkorswim.

In October, Bank of America announced it would offer commission-free online trades to some customers. Will that kill Investools as a stock? No, say analysts Sinha and Fetyko. Brokerages that offer value-added services, as Thinkorswim does, should continue to thrive. Bottom line: Investools could generate strong growth for years, so the stock, in my view, remains undervalued. It could double in two years.

Columnist Andrew Feinberg writes about the choices, challenges and frustrations facing individual investors.