FOOL ON THE HILL
Value at ValueClick

Online advertising is a fickle but still lucrative market. As the economy slowly rebounds over the next few years, the advertising industry should be a prime beneficiary. Investors have the opportunity to play this thesis without significant risk through pay-for-performance leader ValueClick.

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By Matt Richey (TMF Matt)
April 16, 2002

One of the great ways to make money in the stock market is to look beyond the market's time horizon of 6 to 12 months and place your bets accordingly. Right now, for example, the market loves the retailers, restaurateurs, and defense companies because of their relatively shining prospects for the coming year -- at a time when there are few other sectors poised for profitable growth. Making money in the stock market, however, is not about chasing the market, but rather trying to position yourself one step ahead.

I believe the next market theme may include a gravitation toward industries that will get a strong boost to earnings as the economy improves. Advertising is an industry that fills that bill, and one company with an attractive risk/reward profile is online advertiser and digital marketing solutions provider ValueClick (Nasdaq: VCLK). Now that online advertising bellwether DoubleClick (Nasdaq: DCLK) has reported first-quarter results that were a little light on the revenue line, ValueClick shares have drifted down in sympathy and are offering a potentially attractive entry point for new investors.

Though a small company ($140 million in market cap), ValueClick is the leader in pay-for-performance online advertising, offering both digital marketing solutions and advertising technology tools. Sales in 2001 were $44.9 million, down 30% from the dot-com heyday of 2000, but now stabilizing on a quarter-to-quarter basis.

The company's core business is selling online ad inventory on a cost-per-click basis to advertisers. ValueClick is a middleman in these transactions, with its ad inventory made available by a network of over 30,000 participating small- to medium-size Web publishers.

Here's how the value proposition works: The Web publishers sign up for inclusion in ValueClick's network because of the convenience and cost advantages of outsourcing their ad sales. ValueClick, for its part, gets the benefit of selling ad inventory across a vast network of sites, which it can slice and dice into a variety of targeted categories -- thereby creating a more appealing value proposition to advertisers.

Across the board, the model is performance-based: Advertisers only pay ValueClick, and ValueClick in turn only pays a publisher when an Internet user clicks on an advertiser's banner. This low-risk advertising model has attracted a blue-chip roster of clients including General Motors, eBay, Coca-Cola, Heineken, Sara Lee, GlaxoSmithKline, Citigroup, American Express, British Airways, Dell Computer, Expedia, and Microsoft.  

Granted, pay-for-performance online banner advertising is not a stellar business, but it does fill a useful niche and generates sustainable revenues. Plus, my attraction to ValueClick is not its amazing business but rather its ultra-low valuation, which I believe more than compensates for the mediocrity of its business.

Last month, I introduced a valuation metric called Net Net Working Capital (NNWC), which attempts to conservatively calculate the liquidation value of a company's working capital (cash, inventory, and receivables). As of December 31, 2001, ValueClick had $163.4 million in cash, $9 million in receivables, and no inventory (its inventory is digital). Net of $13.7 million in total liabilities, this equates to NNWC of $156.5 million or $3.17 per diluted share, versus a current stock price of around $2.58.

So ValueClick is trading at a price-to-NNWC multiple of 0.81x, or a 19% discount to estimated liquidation value. In other words, if ValueClick shut its doors today and closed up shop, the stock probably has 19% upside. That's what I call dirt cheap. Clearly, the market is valuing ValueClick not on the future profits of its business but on the liquidation value of its assets.

I mentioned at the outset that I consider this stock to offer an attractive risk/reward profile, and here's why: With liquid assets in excess of the current market cap, the downside is almost nil as long as the company doesn't burn cash. ValueClick has been pretty good in this department thanks to very conservative financial management. Operating cash burn in the most recent quarter was only $2.2 million, and that was largely because of the integration of an acquisition. Prior to that acquisition, in the third quarter of 2001, the company was operating cash-flow positive. As for the reward side of the equation, it could be quite good if ValueClick can grow its revenue and turn a profit.

To that end, ValueClick's management has been on a shopping spree for the past two years, taking advantage of dirt-cheap prices across the sector in an attempt to gain scale and build a comprehensive suite of digital marketing services. An acquisition-based growth strategy such as this is not without risk, but ValueClick management has demonstrated skill in rapidly integrating and trimming the costs of its acquired targets.

The latest and biggest acquisition came on March 11, when ValueClick announced that it would purchase Be Free (Nasdaq: BFRE) in an all-stock transaction. You might wonder why ValueClick would issue its seemingly undervalued stock, rather than use its large cash hoard. I'd have preferred a cash transaction that would've avoided the dilution to shareholders, but apparently ValueClick sees the opportunity to preserve its cash while issuing its own shares for equally undervalued shares of Be Free. Like ValueClick, Be Free has a ton of cash and consequently trades for a discount to its NNWC. At the stated transaction ratio, ValueClick will be buying Be Free for a price-to-NNWC multiple of 0.90x, only a slight premium to ValueClick's own NNWC multiple of 0.81x.

ValueClick is getting a bargain price on what appears to be a decent business. Be Free's performance-based partner marketing programs will fit in nicely with ValueClick's pay-for-performance suite of offerings. Be Free achieved 2001 sales of $23.4 million, up nearly 19% from the prior year. Additionally, Be Free broke even on an operating cash flow basis in the fourth quarter of 2001. Going into 2002, Be Free's business was experiencing some softness, thus resulting in a forecast of approximately flat revenue growth for 2002.

When you put the two businesses together, the ValueClick-Be Free combination has annual revenue potential of $83 million, based on ValueClick's 2002 revenue guidance for $60 million and Be Free's guidance for $23 million. When the transaction closes at the end of the second quarter, the combined company is expected to have $270 million in cash. Assuming that receivables and total liabilities are the same as current, NNWC would total about $255 million. Divided by an expected diluted share count of 92.7 million, NNWC per share would be $2.75.

Looking farther ahead, ValueClick management anticipates break-even results on a cash basis by the fourth quarter of this year. If, in 2003, the combined company can generate a modest 5% net profit margin on its $83 million in sales (which assumes no revenue growth), that would be a profit of $4.15 million, or about $0.045 per share. Capitalized at a conservative 10x multiple, that would represent business value of $0.45 per share. Adding cash of $260 million (which assumes $10 million in cash burn during the second half of 2002), or cash per share of $2.80, and that's a total per-share value of $3.25. Compared to the recent price of $2.58, the upside potential is a bit over 25% over the next 12 to 18 months.

While there are many execution risks for management in successfully pulling off a turnaround play like this, I think the investment risk is low based on the bargain price. At the same time, the reward could be high, especially given the potential catalysts of an improving economy, possible acquisition by a larger online advertising player such as DoubleClick (which already owns 14.7% of ValueClick), and sheer value which should begin to prove interesting to other investors.

Matt Richey is a senior investment analyst for The Motley Fool. Matt doesn't like pop-up ads any more than you do, but he knows they're annoying enough to work. At the time of publication, he was long ValueClick. Matt welcomes your feedback at MattR@Fool.com.