Larsen Kusick is a research associate for the Stocks Under $10 service at TheStreet.com . For a more information about Stocks Under $10 and a free trial, click here .


Those who don't follow the small-cap sector are probably unfamiliar with Vasco Data Security ( VDSI), one of the top-performing stocks in the group since the beginning of the year. Investors in Vasco have been rewarded nicely in 2007 as the company posted better-than-expected financial results in both of its quarterly announcements this year, first in February and again last week, helping shares log a hefty 82% gain in just over four months.

Vasco is currently a Two-rated holding in the Stocks Under $10 model portfolio, meaning that we believe there's still enough upside to continue holding the stock, but that the risk/reward profile is not good enough to recommend additional purchases at the current price level. Nevertheless, investors can learn a number of valuable lessons by taking a look back at the company's progress in the almost two years since it became part of the model portfolio.

Lesson No. 1: Products and services meet a growing need.

Early on, Vasco positioned itself as one of the leading providers of security products -- both hardware and software -- aimed at preventing identity theft through user authentication.

Companies across the financial industry use Vasco's tokens and software to defend against sophisticated criminals trying to gain access to their databases and their customers' personal information. The growing need for security measures beyond simple passwords has helped Vasco post revenue growth of 83% in 2005 and 39% in 2006, with analysts' expectations pointing to a 55% gain in 2007.

Lesson No. 2: Tailoring product lines to a variety of customer demands enhances a company's appeal.

One of the many attractive qualities of Vasco's business has always been the large range of products it offers in order to meet a variety of customer demands. Companies in any industry can tailor their product lines and services to specific customer groups, but when looking to drive sales in an emerging market like online security, it's often the best policy to offer an array of choices that can serve the widest possible audience.

Banks and other financial institutions looking for a basic level of online security can start with Vasco's software called Digipass for Web, which provides simple protection using passwords. Customers seeking a higher level of security can step up to Vasco's token-based systems or invest in the highest level of protection -- Vasco's biometrics solutions, which include fingerprint, iris scan and voice-recognition technologies.

Lesson No. 3: Revenue and earnings are important, but margins can be a better indicator of future growth.

The popularity of Vasco's products has helped drive strong revenue growth over the past year, with the company's recently announced first-quarter results showing a 93% increase in sales vs. the same period a year ago. However, over the past year Vasco has also delivered surprisingly strong gross margins and operating margins, which are bullish indicators for investors.

Gross margins represent the percentage of income a company keeps from its sales after subtracting the cost of the goods sold. Operating margins represent what percentage of original revenue a company keeps after subtracting the costs of the goods as well as the significant costs associated with operating the business.

The first sign that Vasco was really hitting its stride came in late October, when the company's third-quarter results included gross margins of 68%, which were well ahead of management's 60% to 65% target. Operating margins of 26.6% were equally surprising, considering management's stated goal of a number between 18% and 23%.

Although companies often provide fairly conservative guidance to reduce the chance of a miss, these numbers were a real eye-opener for anyone following Vasco.

Lesson No. 4: Pay attention to the expectations of the investment community.

Although the company's growth rate also remained healthy, there was still a significant amount of skepticism about whether Vasco's results were sustainable. In addition, some analysts who had been bullish cautioned that the stock was unlikely to outperform the market because of its rising valuation after the October earnings report.

However, the post-earnings rally repeated itself following the company's fourth-quarter results in late February, and again a week ago when Vasco beat estimates and reported a growing backlog, indicating that sales will remain healthy throughout 2007.

To date, Vasco has proved that it deserves a significant premium, posting quarterly results that were even better than investors had hoped. In addition to the strong revenue growth, Vasco's most recent earnings and margins have all come in above analysts' estimates, indicating that management has been successful in keeping costs down while nearly doubling sales over the past year.

Lesson No. 5: But follow a disciplined approach with each investment.

As mentioned above, we currently have a Two rating on Vasco in the Stocks Under $10 model portfolio. Although we're still bullish on the stock's potential, we're likely to take profits in the coming months in order to put money to work in new ideas in the under-$10 sector that we believe offer more potential upside for investors.

The key to making distinctions about whether to buy more of a stock or hold on while looking for further gains is to take a disciplined approach to each investment. For Vasco, we initiated the position almost two years ago with a concise thesis centered on the increasing demand for online security at financial institutions.

At that time, both Citibank ( C) and Bank of America ( BAC) had made negative headlines after some of their customers fell victim to identity theft.

We also saw other catalysts, such as Vasco's ability to compete with its main rival, RSA Security -- which was later acquired by EMC ( EMC), in continuing to penetrate the U.S. banking industry. We alerted readers that we believed Vasco had a leg up on the competition because of its more-favorable pricing points for its products, which were up to 50% lower than RSA's prices.

In this case, our long-term thesis worked out as planned. And while it may seem odd to have a stock trading above $20 in a portfolio for stocks under $10, there is no rush to sell as long as the thesis in a position is working. After all, the ultimate reason for investing in low-priced stocks is to profit as they ride back up to higher levels.
In keeping with TSC's editorial policy, Larsen Kusick doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Kusick is a research associate at TheStreet.com, where he works closely with Jim Cramer and works on TheStreet.com Stocks Under $10. Prior to joining TheStreet.com, he worked in options trading and management consulting. He appreciates your feedback; click here to send him an email.

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