Look at your finger. Yea, that’s right, take a look at all those grooves and patterns on it.

No one on earth has that same pattern. What’s more, beneath the outside layer of skin, to where the “live” layer is, lies a unique pattern that identifies you regardless of whether you actually have any visible fingerprints or not!

This is probably one area of technology that you rarely, if ever, think about, but fingerprint security technology is getting better and better with more uses being found for this growing industry in everything from PC’s and home security systems, to cell phones and checkout stands.

I’ve found an exciting and fast-growing company that was on my watch list that is the leader in this industry called AuthenTec (Nasdaq: AUTH).

(Please note that AuthenTec is NOT yet a formal buy recommendation, but stay tuned.)

How do AuthenTec fingerprint sensors work

AuthenTec sensors use a unique semiconductor-based fingerprint reader that uses small RF (Radio Frequency) signals to detect the fingerprint ridge and valley pattern, thus capturing sharp and clear fingerprint patterns from the live layer of skin just beneath the surface.

The RF electronic imaging mechanism, called TruePrint technology, makes AuthenTec’s sensors less affected by common skin surface conditions — including dry, worn, calloused, dirty or oily skin — that can impair the ability of other sensors to acquire accurate fingerprint images.

This approach, which is in marked contrast with optical, thermal and DC capacitive solutions that read the surface of the skin, gives AuthenTec sensors significant advantages in image quality and in the protective coatings that the sensor can image through.

AuthenTec’s patented TruePrint technology sensors are the ONLY sensors on the market that read this live layer of skin beneath the actual surface!

Oh, and in case you were wondering, because I know some of you are, you CANNOT cut someone’s finger off and swipe it through one of AuthenTec’s sensors like the movies!

Specifically, TrueFinger — part of the TruePrint technology - ensures that only real, live fingerprints are read by converting the properties of the skin into digital data which are delivered to the host computer for analysis.

Because of this approach, anyone who attempts to swipe the finger of a dead person in order to access their important physical or logical data would not succeed in getting past TruePrint.

Now that that’s out of the way…

The Power of Touch

AuthenTec’s TruePrint technology was first developed in 1998 and has been getting better, cheaper and more reliable ever since.

As you can see from the image above, all of the sensors are about the size of a dime, or much smaller and are found in a range of devices.

The best part is that TruePrint sensors are more accurate than traditional fingerprint sensors because they actually scan beneath the surface of the skin, rather than just looking at the surface.

While there are several types of silicon-based fingerprint sensors on the market today, including surface-reading sensors that use either the electrical or thermal properties of the skin surface to detect the fingerprint ridge and valley pattern, AuthenTec sensors are the only silicon sensors that read beneath the skin surface.

Because of this innovative approach, AuthenTec’s TruePrint technology offers many benefits, including the most accurate and reliable imaging available today.

This is what attracted me to the company when they came public this summer.

By now you’re probably wondering in what sorts of devices you can find AuthenTec’s products right?

While AuthenTec’s applications for their sensors are growing, they come in 3 primary segments as outlined below: PC’s and Peripheral devices, Wireless Devices, and Access Control.

Sensors for PC’s and Peripheral Devices

In the PC market, fingerprint biometrics has emerged as the most popular biometric technology to protect critical computer information, enable convenient security and ensure convenience and personalization.

AuthenTec sensors are used in 200 different models of notebook and tablet PCs, including those made by 10 of the world’s top PC manufacturers.

Their sensors have also been used in a wide range of peripherals devices, including PC keyboards, memory keys, portable hard drives, and password managers.

Some of their customers for the PC’s and Peripherals segment include: Acer, LG, Samsung, Motorola, Lenovo, HP and others.

Sensors for Wireless Devices

In wireless devices, AuthenTec sensors are used in more than 95 percent of all biometric cell phone models to protect the physical device, stored files and secure mobile commerce transactions.

As the demands of the wireless market continue to grow, service providers are introducing new and more powerful wireless devices — making wireless platforms even more valuable – and vulnerable to fraud or theft.

By installing a simple, small and discreet sensor on a phone, AuthenTec can protect the data inside from being pilfered and not detract from the phone’s functionality, usefulness or aesthetics.

In fact, by incorporating this technology on more and more phones, especially those used in business settings or to conduct business (think smart phones, etc.), AuthenTec can tap an ever growing market here and abroad and expand the ubiquity of fingerprint technology where people need it the most.

Some of their customers for the Wireless Devices segment include: Casio, Fujitsu, Hitachi, Samsung and others.

Sensors for Access Control

In access control, AuthenTec’s sensors are used worldwide to protect homes, corporate buildings, government offices, airports, and other facilities.

Their sensors have been designed into a wide range of access control devices, including multiple biometric door locks, smart cards, remote RF entry keys, time and attendance readers, and other devices.

In addition, their sensors are also used in the U.S. government’s largest biometrics implementation for the U.S. Census Bureau whereby 500,000 fingerprint sensor-equipped PDAs will be used to gather information for the 2010 census.

You can see where this segment can go in terms of growth, as every house in America and around the world can implement these biometric readers for added security, convenience and aesthetics on anything from front doors, to gates, light switches, you-name-it.

Some of their customers for the Access Control segment include: Black and Decker, Biometrx and others.

Let’s Talk About the Company

Addressable Market

According to a report from Frost and Sullivan, AuthenTec enjoys a massive market opportunity. The market for fingerprint sensors is expected to grow 50.6% annually, to $2 billion by 2013.In addition, these devices are becoming cheaper and more mainstream and it won’t be long before we see AuthenTec’s fingerprint technology in every walk of life, from not only PC’s and cell phones, but also in things that perhaps are in the works or we might look to in the future such as unlocking car doors (or even starting the engine!), various remote control devices like TV remotes, garage door openers and the like, and a multitude of other applications that I haven’t even thought of or are underway as we speak.

In fact, AuthenTec is the recognized volume supplier leader of biometric fingerprint sensors worldwide — shipping nearly two thirds of all sensors sold in the PC, wireless and access control markets during the past five years.

The company continues to win new designs with the world’s Top 10 PC manufacturers as its fingerprint sensors have now been integrated into more than 200 PC models.

Company Growth: 20 Million Sensors and Counting

Man, is AuthenTec growing fast!

According to a recent press release:

“…on July 27 (2007) the company shipped its 20 millionth fingerprint sensor, an industry record. The milestone shipment was made during a record-setting July in which AuthenTec shipped over a million sensors, more than any other month in the company’s history.

These record shipments have been driven primarily by strong customer demand for AuthenTec’s small, highly accurate and cost-effective fingerprint sensors for the PC market. The company continues to win new designs with the world’s Top 10 PC manufacturers as its fingerprint sensors have now been integrated into more than 200 PC models. Also contributing to record shipments is the continuing successful ramp of AuthenTec’s newest sensor - the AES1710 (at right) for the cell phone market - bringing Power of Touch® features to consumers, including security, convenience, personalization and navigation.

…Highlighting the company’s rapid growth, AuthenTec reached the 20 million shipment milestone only one year after shipping its 10 millionth sensor, announced in July 2006. AuthenTec shipped more than 3 million sensors during its second quarter, equaling the total number of AuthenTec sensors shipped during all of 2005….

“Although we’re proud of setting another high-water mark for the industry with our 20 millionth sensor shipment, we believe the market for fingerprint sensors is just beginning and that the most significant growth opportunities are still ahead,” said AuthenTec Chairman & CEO Scott Moody. “This achievement is a testament to the differentiation our fingerprint technologies and products bring to PCs, cell phones and other products made by our customers - the world’s leading consumer electronics companies.”"

I really don’t think there’s too much more I can add to that! AuthenTec is the true classic case of a small, fast-growing, niche company in the eary stages of their expansion.

Financials: Look at These Numbers

I have been watching this company ever since they came public back in June of this year. I suppose everyone else was waiting just like I was, to see a couple of quarters of earnings announcements and SEC filings to get a better handle on the company, their track record, and financial strength.

Oops…

A few months ago, the company’s CEO was BUYING shares in the company. Yep, that’s right, the company just came public, and he was BUYING more shares on the open market! That was when the stock was around $10 per share (it’s now around $16).

Too bad I didn’t notice that until I recently started doing some more digging around.

In addition, AuthenTec was recently added to the Russell 3000 index (October 2nd), and sure enough the day after that happened, mutual funds and ETF’s that track this index, had to purchase shares to re-balance their funds, not to mention the added press coverage and institutional money that now had their sites turned on this stock.

Oops again…

Because AuthenTec is a small cap stock with low volume, this surge in activity made the stock price rise quickly as these funds had to hurry and add to their positions.

Add to that their just recently announced earnings and the favorable press releases that we mentioned above, and this stock has made a significant move in the last 30 days.

Either way, the numbers look really great. Here’s the highlights from their latest earnings announcement on October 29th, 2007:

• Revenue for the third quarter of 2007 was a record $15.1 million, representing an increase of 84 percent when compared to $8.2 million in the third quarter of 2006 and an increase of 23 percent as compared with revenue of $12.3 million in the second quarter of 2007 (amazing sequential growth from quarter to quarter).
• They had their first profitable quarter ever, earning Under Generally Accepted Accounting Principles (GAAP), $517,000, or $0.02 per diluted share. This compares to a net loss of $2.6 million, or $3.83 per diluted share, in the same period one-year ago and a net loss of $6.7 million in the second quarter of 2007, or $7.37 per diluted share, which included a charge for the change in the fair value of preferred stock warrants of $5.9 million. Earnings per diluted share for the third quarter were computed using 30.1 million shares. Since they weren’t public for the comparison quarters, obviously there is a large discrepancy in the earnings per share. From here on out though, the comparisons will be using roughly the same number of diluted shares.
• On a non-GAAP basis, net income for the third quarter, which excludes stock-based compensation charges of $342,000, was $859,000, or $0.03 per diluted share. This compares to a net loss of $1.4 million, or $0.07 per diluted share, in the third quarter of 2006 and a net loss of $571,000, or $0.03 per diluted share, in the second quarter of 2007. (Non-GAAP earnings and financial numbers are a way for a company to better assess the true performance of their business because they don’t have to account for stock-based compensation and other elements that appear to drag down their numbers, but in fact are not as material to their core operations.)
• Third quarter 2007 gross margin was 47.6 percent, compared to 40.0 percent in the same period a year ago and 45.0 percent in the second quarter of 2007. Gross margin expansion resulted from improved manufacturing efficiencies and the favorable effect on product mix of newer higher margin sensors. (Higher margins mean more profit, and expanding margins are a great sign of a company that is becoming more efficient, and selling products for higher cost.)
• Operating cash flow during the quarter was $2.0 million and cash, cash equivalents and investments totaled $67.0 million as of September 28, 2007. (The company has NO debt, and in fact added $2 million to their coffers in this latest earnings period, again, wonderful stuff.)

Business Outlook:

From their press release:

“Based on the continued strong demand for our fingerprint sensors and our growing pipeline of design wins, we are increasing our fourth quarter revenue outlook to a range of $15.2 million to $15.5 million, the mid-point of which would equate to a 63 percent increase from the same quarter last year. Correspondingly, we are also raising our revenue guidance for the fiscal year to a range of $51.9 million to $52.2 million, up from $33.2 million last year,” stated Mr. Moody (Chairman and CEO).

“ In order to continue this momentum we plan to accelerate our investments in R&D during the fourth quarter to support several new product developments and other initiatives. Accordingly, we expect our non-GAAP earnings per diluted share to be in the range of $0.02 to $0.03 in the fourth quarter, an improvement from a loss of $0.03 per diluted share in the fourth quarter of last year.”

So what else can I say? Nothing.

They beat analysts expectations, raised guidance, expanded their margins, are free cash-flow positive, have no debt, and are growing fast.

All the ingredients of a small, nimble company that I look for when looking for a long term investment….but…

Not time to buy yet!

Let’s take a look at this chart:

That is a pretty significant run-up in about 30 day’s time, about 60% by my calculation.

This often happens with small companies that start accelerating their growth, expanding their margins, making more profit, and are in a niche field with little competition that can impact their business.

Once people get on the bandwagon, it can be a fun ride to the top, which is what PeakStocks.com is all about.

However…in this case, I am not comfortable at all with the run-up in the shares, regardless of the news that has come with it (all good for sure).

Here Are Some Numbers to Think About

• Price to Sales Ratio (P/S):

AuthenTec’s market cap (total shares oustanding times the share price) is about $440 million dollars. At this level the valuation of the company represents a price-to-sales ratio (their market cap divided by their total sales) of about 9, based on trailing sales.

Now, since we don’t want to look backwards but forward, we then have to take into account what their growth will look like in the coming year.

Taking that into account, their FORWARD (P/S) ratio for the next 4 quarters stands at about:

$440 million market cap / $66.2 million in sales (according to analysts estimates) = 6.6

Looks better right? Well, consider this: The average price to sales ratio in their industry is about 4, so they are trading at about a 65% premium to the average company in their industry.

Now, that’s not such a bad number considering they are expecting growth of about 50% or more for the next year or so.

Usually such valuations are justified because company’s peers are growing much slower, but it no longer feels like a good deal, but more of a FAIR deal, which means we have more downside risk.

Then again, AuthenTec beat sales estimates for this past quarter by about 12%, so if we say that analysts are wrong and underestimating the future sales potential over the next 4 quarters by about 10% (they also raised estimates), then that would make the total sales be closer to $72.82 million, which would yield a P/S ratio of:

$440 million/$72.82 million in sales = 6.04

This is getting better, at about 50% premium to their peers, but still a little rich for my liking AND this calculation assumes 10% sales growth ABOVE analysts estimates, which is no small feat.

• Price to Earnings ratio (P/E)

AuthenTec just started earning a profit.

Granted, it looks like they will start earning a higher and higher profit as we go along (they just turned the corner in their business), but for now, they are negative in terms of their trailing earnings, and forward earnings are going to be low for awhile as a result.

Analysts are pegging their earnings to be about $.19 per share in 2008 (yep that’s more than 1 year away!) and $.41 per share in 2009!

O.K, fair enough, you pay for the future of a company, not the past, so let’s look at those numbers:

At $.19 per share in earnings next year (2008) at Friday’s closing price of $16.54 per share, their P/E ratio (The Price of the shares divided by the expected Earnings per share) would be about 87.

At $.41 per share in earnings in 2009, their forward P/E ratio would be about 40.34.

The industry average is 27.79 (since there aren’t any direct competitors that are a pure-play like AuthenTec a direct measure is not possible.)

Using this metric, AuthenTec looks overvalued and rich, but again, a fast growing company (the average growth in their industry is about 15%) deserves to be valued higher.

In addition, these numbers can change because AuthenTec has BEATEN analysts estimates their first 2 quarters as a public company, by $.03 each time.

If they beat estimates by $.02 per quarter (taking a more conservative estimate) over the next 8 or so quarters on average, then the forward P/E ratios change to 61.26 (assuming $.27 per share in ‘08), and 29 (assuming $.57 per share in ‘09).

This makes their shares look much more reasonable, but that far out there is way more risk in them missing earnings (which will hammer the stock price) or some other business event happening (not to mention a slow-down in the business itself), that would bring these estimates into question, so again, the risk/reward proposition is not quite to my liking on this measure either.

• Price to Earnings Divided by Growth (PEG):

The last number that I would like to use is what’s called the PEG multiple.

This takes into account the Price to Earnings (P/E), divided by the growth in percentage terms. So if a company has a forward P/E of 60, and they are growing their earnings by 60% per year, then their PEG ratio is 1.

A good measuring stick to use for risk/reward ramifications, is to look for a forward PEG with some downside protection, so anything around 1 or less is usually considered less risky (although there already is plenty of risk involved when looking that far out ahead, which is why you want a lower PEG multiple and not a higher one).

In 2008 analysts expect AuthenTec’s earnings to grow to $.19 per share over a loss this year (2007) of about $(-.04). Now obviously, we can’t use a negative number to calculate growth, but we’ll go with this in absolute terms, and pretend the growth is about 500% (assuming they would earn a “positive” $.04 this year which would grow to $.19 next year).

This yields a PEG of (87/500) = .174, which is really ridiculous and is not justifiable. This is why these kinds of companies are extremely hard to value in their early stages (and why we can profit from this discrepancy).

Analysts and other investors are using their “best guesses” to estimate FUTURE earnings potential, and thus assign all kinds of crazy numbers and multiples to come up with what a “fair” price for the stock is.

So, for the sake of argument, let’s then take the more sane measurement of the ‘08 vs. the ‘09 numbers.

In this case we get the predicted earnings growth from fiscal year 2008 to fiscal 2009 as:

Expected earnings in 2008 = $.19

Expected earnings in 2009 = $.41

———————————————

Difference in earnings = ($.41 - $.19) = $.22

Earnings growth = (Difference in earnings) $.22/(Previous year’s earnings) $.19 = 115% growth

So, the forward PEG for 2009 is: (P/E for 2009, calculated earlier) 40.34/ 115% growth = .35 PEG

which again, is extremely low.

Like I said, anything around 1 (sometimes for really fast growing companies, ahem, like this one, you might pay up to 1.5 PEG), and certainly anything UNDER 1 is a steal.

However, here’s the catch: when using the PEG ratio, the calculation is usually taken out for 3-5 years. In other words, sure AuthenTec’s growth is absolutely stunning when looked at what COULD happen over the next 2 years or so, but what happens after that when year over year comparisons are harder to make?

If the growth in earnings per share slows to 50% the following year (2010), and then to only 20% in 2011, and so on?

Well, if we look at the analysts expectations for this company (and to be honest I think they are conservative), they are giving AuthenTec a forward growth estimate of 30%.

That changes things. Now the calculation above looks like this:

Forward PEG for 2009 is: (P/E for 2009, calculated earlier) 40.34/ 30% growth (according to analysts 3-5 year growth estimates) = 1.34 PEG

Hmm…doesn’t look like such a screaming bargain now does it?

This gives us more information to look at to better understand valuation, and when to pull the trigger on a trade to minimize downside risk and maximize upside potential, otherwise known as the RISK/REWARD, and something I look at very carefully and take very seriously here at PeakStocks.com

The Bottom Line

So now what?

Here I have brought you a cutting edge technology company that is growing like wildfire, is profitable, has no debt, has expanding margins, a defensible moat around it’s business and is a small enough company that we can still get in now, and reap very nice rewards in the next few years.

Yep, that’s the easy part. But the hard part of being a disciplined investor is also being patient with the Risk/Reward parameters on a stock if they don’t favor you in the short term.

Like I outlined in my Investing Style page, part of the way we will mitigate our risk is by NOT chasing stocks that have risen.

Now, that being said, sometimes it so happens that some stocks NEVER get “cheap” or offer a “fair” risk/reward proposition because they just keep rising and prove over and over again that they are great companies that blow away analysts earnings estimates, keep improving their businesses, defend their territory and always command a higher valuation and premium vs. their peers because they are the best-in-breed or the best in their class.

I am certainly aware that stocks such as Starbucks, Microsoft, Apple, and others were never “cheap” by traditional valuation standards, and the people that waited for the gates of Heaven to open up and give them a good entry point, waited and waited and waited for years and sometimes decades, and watched while sitting on their hands (and money I might add), while these stocks became some of the largest and most well-known companies on earth.

I am also aware of the opposite: Good companies at bad prices (to high) that always seem to give you another shot at getting into them if you are patient and disciplined enough to be firm on what you will pay.

Needless to say, I love AuthenTec, what they do, how they do it, and how they are managed, so that being said, when the time comes to enter the stock, my trigger finger will be ready to pounce.

For now, take some time, learn more about what they do and how they do it, and become comfortable with AuthenTec so that when you do receive the inevitable “Buy Alert” from me, you will feel comfortable with your own research and the time you have spent reading this posting, and doing your own due dilligence.

In the mean time hang tight, and stay tuned.