You're Underestimating This E-Commerce Stock

I'm a believer in growth stocks. As an analyst for our Motley Fool Rule Breakers service, I think you should be a believer, too. But some growth stories are inevitably better than others, hence this regular series. My goal? Out the Fakers, elevate the Breakers, and examine the growth stories stuck in between.

Next up: Digital River (Nasdaq: DRIV  ) . Is this e-commerce specialist growing sustainably enough for your portfolio? Let's get right to the numbers.

Foolish facts

Metric

Digital River

CAPS stars (5 max) **
Total ratings 329
Percent bulls 91.8%
Percent bears 8.2%
Bullish pitches 45 out 49
Highest-rated peers Spark Networks, Photochannel Networks, Chordiant Software

Data current as of March 27.

Conceptually, there's a lot to like about Digital River. The company's tools and services are the backbone of online storefronts for many of the Web's largest e-tailers, including Adobe Systems (Nasdaq: ADBE  ) and Western Digital (NYSE: WDC  ) . All told, servicing its clients' e-commerce needs netted Digital River $363 million in revenue and $15 million in profit last year.

The bad news? Those numbers are done substantially from earlier years, mostly because of the loss of Symantec (Nasdaq: SYMC  ) as its largest client. The security specialist accounted for 21.5% of 2009 revenue, with another 6.9% derived from Digital River products sold directly to Symantec's customers. The final tally: $115 million.

Revenue dipped $40.6 million last year, or a little more than one-third of the value of the Symantec contract. Worth celebrating, right? Not exactly. According to Digital River's financial filings, the agreement ended on June 30. The company still enjoyed half a year's worth of payments from its top client. Not so this year.

Bullish investors counter that e-commerce is one of the best businesses to be in right now. They're right. According to Commerce Department data, U.S. e-commerce sales rose 14.8% to $165.4 billion last year. That's a serious wave for Digital River to surf.

Don't expect the bears to care. Shares of Digital River sold off mightily in January, after the company issued predictably lean fourth-quarter results and a surprisingly scant outlook for 2011. The stock is up slightly year to date, but not enough to outperform the S&P 500 index.

The elements of growth

Metric

2010

2009

2008

Normalized net income growth (75.0%) (28.4%) (16.3%)
Revenue growth (10.0%) 2.4% 12.9%
Gross margin 82.2% 84.2% 85.4%
Receivables growth 0.5% (4.8%) (18.0%)
Shares outstanding (millions) 39 38.7 37

Source: Capital IQ, a division of Standard & Poor's.

A little more than a year ago, CEO Joel Ronning pledged to replace Symantec's revenue contribution. Judging from this table, I'd say he still has a way to go.

Let's review:

  • Growth investors like me love straight-line accelerating revenue growth leading to accelerating profit growth. Not surprisingly we have neither here. Call it the downside of betting big on a client with a big wallet, as Symantec was.
  • Pricing power is also something we like to see. Or, in lieu of that, excellent cost management leading to higher margins. Thankfully, losing Symantec hasn't cost Digital River much in the way of pricing power. That's a positive sign. Extreme discounting almost always does more harm than good.
  • We also like businesses that collect quickly. Revenue isn't growing, so there isn't much in the way of good news here. But Ronning and his team did manage to keep a lid on receivables growth, which again suggests that the company is pursuing responsible growth rather than booking deals it can't collect on.
  • Finally, Digital River is experiencing only modest dilution. A history of stock buybacks also suggests that management is sensitive to the need to return value to shareholders. Both are good signs.

Competitor and peer checkup

Company

Normalized Net Income Growth (3 Years)

Accenture (NYSE: ACN  ) 3.7%
Digital River (46.9%)
GSI Commerce (Nasdaq: GSIC  ) (33.4%)
ValueClick (Nasdaq: VCLK  ) 12.5%

Source: Capital IQ, a division of Standard & Poor's. Data current as of March 27.

No doubt because of the Symantec snafu, Digital River is by far the worst performer in this table. But that also might not mean much. More important is Ronning's commitment to get growth back on track. A lighter-than-expected outlook for 2011 could mean he's having trouble making good.

Grade: Sustainable
But it could also mean he and his team would rather remain conservative. After all, they've been burned once before. And it wouldn't be out of character. Digital River maintains more than $374 million in cash and investments on its balance sheet after accounting for debt. That's quite a stash for a company worth $1.4 billion in market cap. 

I'm siding with Fool co-founder David Gardner on this one. He singled out Digital River in the December issue of Motley Fool Rule Breakers as a long-term growth story worth buying. After having reviewed management's performance in the wake of Symantec's devastating defection, I think he's right.

Do you agree? Disagree? Let us know what you think about Digital River's products, strategy, and valuation using the comments box below. You can also ask me to evaluate a favorite growth story by sending me an email, or replying to me on Twitter.

And in the meantime, keep tabs on Digital River or any of other stocks mentioned here by adding them to your watchlist for free, personalized stock tracking.

ValueClick is a Motley Fool Short short-sale selection. Accenture is a Motley Fool Inside Value pick. Digital River is a Motley Fool Rule Breakers recommendation. Adobe Systems is a Motley Fool Stock Advisor selection. Motley Fool Options has recommended a diagonal call position in Adobe Systems. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is a member of the Rule Breakers stock-picking team. He didn't own shares in any of the companies mentioned in this article at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool owns shares of Western Digital and is also on Twitter as @TheMotleyFool. Its disclosure policy thinks Monty Python is sustainably funny.


Read/Post Comments (2) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 28, 2011, at 9:38 PM, truthseeker789 wrote:

    Tim,

    Did you take the Microsoft online store into account in your analysis?

    (see Ronning Says Holiday Internet Retail Sales May Rise 15%: Video at Bloomberg (Mon, Nov 22))

  • Report this Comment On March 29, 2011, at 2:11 PM, buffalonate wrote:

    It has a 30% expected growth rate and a p/e ratio of 80. That tells me it is overvalued by at least a factor of 2. Stay away from this stock if your smart. At least wait for the peg to come down to a reasonable number before you enter this stock.

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