The Internet’s Toll Road

In yesterday’s DailyWealth, you read my ‘How-To Guide’ for hyper-growth investing.

Now for the prize... the most promising hyper-growth stock I’ve found in a long time.

This business is even more scalable than Digital Insight (DGIN). Remember what scalability means? It’s the ability of a business to take on many additional customers at no additional cost.

This company’s major cost is telecommunications bandwidth, the price of which continues to drop about 80% a year. So, in addition to the company’s profit margins growing wider because of huge increases in sales volume, its costs are also falling in absolute terms. The result, I think, will be an avalanche of cash.

Early in 2005, this company merged with its top competitor. With 80% market share now (and no one undercutting it on price), everything that could go right for this business did go right last year.

It's one of my top three recommendation for 2006 because, while 100% of the development risk is now gone, the shares are still priced like they were when it looked like the whole thing would end up in chapter 7 bankruptcy.

I call this business the “Internet’s Toll Road” because it’s a privately owned and managed global Internet network that’s used by large corporations to deliver content and mission-critical information around the world.

The company was founded in 1998 by M.I.T. graduate students who believed corporations would need (and be willing to pay for) secure network connections that are more reliable and much faster than the connections available on the public Internet.

They developed a whole set of proprietary technologies and systems to distribute digital content around the world on their own network. It's an essentially a global, private Internet, or a global, digital toll road for large companies and governments.

As you would imagine, building a global toll road is extremely expensive. And for a long time, it looked as though the company might go bankrupt – mostly because it was spending so much money on bandwidth. The company was connecting the 15,000 or so computers they'd set up in 69 different countries with expensive bandwidth contracts they'd signed back in 1999.

But then something amazing happened -- something that could only happen with digital technologies powered by Moore's Law: the cost of provisioning bandwidth began to fall steadily every year, by about 80% each year.

Although the company doesn't disclose precisely how much it spends on bandwidth, it does have to disclose all of its material financial obligations. So we can see what its minimum spending on bandwidth will be for the next three years:

The decline of these commitments gives you a sense of how much costs have fallen at this company. Without these efficiencies, the Toll Road would have surely gone bankrupt... but with these efficiencies, the company has become a moneymaking machine.

So, let's go back to our growth stock criteria.

1. Sustainable sales growth

In the most recent quarter, the Internet’s Toll Road had sales of $75.7 million. That's a 42% increase over last year. But, remember, it made a big acquisition this year, at the end of the first quarter. Most of those revenue gains are a result of that acquisition. The better comparison is to measure against the second quarter of this year: revenues grew by 17%. That's the apples-to-apples comparison. That’s solid growth – more than twice the average on the S&P 500.

Next year the Internet’s Toll Road revenues should grow by around 15%.

2. High operating margins

Margins on the Internet’s Toll Road are finally looking good. Yes, it certainly takes a lot of money to maintain and run a parallel global Internet. But with revenue of $75.7 million, these costs are covered. Last year, this company posted profit margins above 22% – and they’re still growing with each additional dollar of revenue. This is outstanding.

3. Low capital requirements

The Toll Road uses commercial computer equipment in its network -- essentially off-the-rack PCs. It buys its bandwidth at wholesale prices using long-term contracts. Aside from replacing PCs as they burn out, no further investments are required.

4. Scalability

Finally, the key criteria for making big money in growth stocks: scalability.

The Internet’s Toll Road is one of the most scalable businesses I've ever seen. To make more money, all it has to do is fill its network.

Looking at the apples-to-apples comparison of the third quarter over the second quarter, the Toll Road saw its sales increase 17% while its net income increased 29%... the company's profits are growing almost twice as fast as its revenues! That’s scalability at work.

This stock is a buy anywhere under $24. I think the shares could hit $40 by the end of the year. But remember the first rule of growth stock investing that we covered yesterday: never too much, never too long.

Good Investing,

Porter Stansberry