FOOL ON THE HILL
FTD.com's Rosy Ending?

FTD.com was on a serious roll until the company's parent, IOS Brands, announced that it would be re-combining the two companies in a stock swap. The news sent FTD.com shareholders to the exits. While FTD.com is clearly a much more attractive business than IOS Brands, investors in the combined company may be getting a real deal at the current price.

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By Zeke Ashton
April 24, 2002

The stock of online floral retailer FTD.com (Nasdaq: EFTD) had been on a tremendous run since hitting a low of $3.99 in mid-October of 2001, shooting up as high as $9. The stock has been a longtime favorite of mine, ever since I first researched it (but, alas, didn't buy) way back in December of 2000. The business (and the stock) have been going great guns ever since -- until March 4, that is.

That's when the parent of FTD.com, the privately held IOS Brands, announced that it was re-combining with FTD.com. I didn't read the news until the next day, and by then it was already apparent that EFTD investors weren't having any of it -- the stock had already lost more than a third of its value, dropping from $9 on the day the deal was announced to under $6 in the course of one trading session. Suffice it to say, this wasn't the ending to the story that most investors envisioned when they bought the stock. But maybe the story isn't entirely over.

But let's start at the beginning. FTD.com went public on October 4, 1999, with four and a half million shares at an initial offering price of $8 per share, raising $31 million for the company net of expenses. The company was able to get out of the IPO gate just months before a giant invisible pin would swoop in with a resounding pop to deflate virtually every Internet stock on the market. FTD.com, despite excellent business momentum, was still unprofitable, and the stock was tossed into the stock market trash bin alongside all the other unprofitable, unworkable dot-com businesses that were masquerading as public companies at the time. The stock eventually sank as low us $1.06 during December of 2000.

Despite the depressed stock, business at FTD.com was anything but depressing. The company announced its first profitable quarter in September of 2000, though the company needed an assist from its interest income to get there. The December quarter, though, brought true operating profitability, and it only got better from there. The quarter ending in March of 2001 brought 38% revenue growth and a profit of a nickel a share. The June quarter was even better -- revenues hit $43.5 million and the company reported an $0.08 profit. By this time, the stock had run up into the $6 range. With the stock trading at $5.77 on Mother's Day of 2001, Motley Fool writer and well-known flora connoisseur Matt Richey extolled the company's virtues in nominating EFTD for our annual Stocks for Mom special feature. 

In the wake of 9/11, EFTD, along with just about every other stock that wasn't involved in defense contracting, security, or Web conferencing got hammered down to the $4 range. The stock recovered nicely as FTD.com turned in two quarters of fabulous performance. We gave EFTD the thumbs up again at a price of $6.50 in the January issue of The Motley Fool Select, and the stock had run up to a new all-time high of $9.21 in early trading on March 4. The stock actually was initially up on the day, at least until the terms of the deal were announced. Today the stock sits in the mid-$5 range, even after EFTD's announcement of another excellent quarter yesterday.

Most acquisitions are done in such a way as to ensure that shareholders in the acquired company get at least a small premium to what the stock was trading for when the deal is announced -- it's rare to see a company get acquired, even by its own parent, and watch the stock plummet by more than 40% immediately thereafter. So, why did FTD.com shareholders drop their stock like a hot rock? And if you are still holding, should you do the same?

Maybe now we'll get research coverage
I wasn't able to listen in on the conference call announcing the deal, but I did find a transcript of management's prepared statements from the company's recent SEC filings. In reading the transcript, I found myself laughing out loud at some of the really lame reasons that the managers put forth for re-combining the two companies. Here's a two-part quote from Michael Soenen, the president and chief executive officer of EFTD.

"Certainly we've had six consecutive quarters of revenue growth and profitability. We have continued to consistently increase our margins versus our prior year quarters, and we're just coming off our record Valentine's Day results. Despite these successes, though, we have been unable to achieve certain things." 

Oh, sure, just six consecutive quarters of revenue growth and profitability, rising margins, and all that boring stuff that great businesses accomplish. But despite all these positives, FTD.com wasn't going to succeed as a separate entity because.....

"We have been unable to increase liquidity or the trading volume of our stock. We've worked very diligently to generate sell side research coverage, but have been unable to date to do so. And generally, we've just had to realize that we're just too small of a company to be able to move forward without some type of a transaction that would get us into a larger earnings and revenue base, a more diversified earnings and revenue base, and one that will allow us to have greater flexibility with the capital market."

Now this is really lame, and I doubt that even Michael Soenen believes this stuff. You'd expect management to have some good reasons to justify a transaction of this nature. What, are the shareholders of FTD.com expected to jump for joy because now maybe the combined company is big enough for a junior research analyst at Merrill Lynch to write up a fancy report with a "strong buy" rating? Because clearly, without Wall Street research coverage, the stock wasn't doing well enough on its own -- it was only up 800% in 15 months! 

And of course, what good is fantastic revenue growth and rising profit margins when your stock doesn't have liquidity or trading volume? The argument that FTD.com was too small of a company is just as ridiculous. It's not the size of the company's revenue base that matters, it's how well that company can increase shareholder value -- and FTD.com was doing that just fine on its own, as reflected by the increasing share price.

OK, I've ranted enough. Suffice it to say, I think the fact that the managers didn't offer much in the way of solid economic rationale for the deal didn't help matters. But the real reason why most investors probably sold is that FTD.com alone is a wonderful, growing business with rising profit margins, outstanding cash flow generation, and the free use of the parent company's strong FTD brand. By lumping EFTD back into the slower-growing parent company, whose businesses are nowhere near as economically attractive as EFTD, the stock simply loses all of its appeal to investors who bought EFTD for its unique qualities. Nevertheless, investors are overlooking one important factor: the price.

Why I'm holding my shares
According to the terms of the deal, EFTD shareholders will receive 0.26 shares of the newly public combined company, IOS Brands. IOS will be buying back the 17% of EFTD that was held by the public, and in return, those shareholders will now own 12.7% of IOS.  Let's play with the math a little bit, and see where this leads us.

At the time of the announcement, EFTD was trading at $9, for a market cap of $449 million. The public shareholders owned 17% of EFTD, which would have been worth $76 million, which translates into 12.7% of IOS. This implies a valuation of the new company to be $598 million, which implies that EFTD shareholders would have been getting the parent company for only about $149 million (that is, $598M - $449M). The terms of this deal also imply that 75% of the value of the combined company is allocated to EFTD. Considering that IOS Brands accounted for about 60% of revenues and about half the operating cash flow of the combined company (for the six months ended in December), this deal strikes me as relatively fair.

But let's look at those same terms now that FTD.com is trading at $5.60, or a market cap of $270 million. At this price, 17% of EFTD (which, remember, is 12.7% of the combined company), comes to $46 million. This implies that buyers of EFTD at the current price are getting the new combined company for only $360 million, or about $90 million less than the market was previously willing to pay for EFTD alone.

The combined company generated $138.2 million in revenues in the six-month period ended December 31, 2001. This figure is down slightly, from $141.3 million in the same period the previous year. Income from operations, however, improved to $14.3 million, up from $8.5 million, and, most importantly, free cash flow jumped to $17.2 million, up from $10.5 million. Remember that the six months ending in December represent the two weakest quarters for the company; seasonally, the biggest floral gift-giving holidays generally come in the March and June quarters -- and EFTD just turned in strong results for the March quarter. Nevertheless, if we annualize that $17.2 million in free cash flow, we come up with $35.4 million. With the combined value of the company at $360 million, the combined company is now selling at just over 10 times free cash flow.

For a company with a great brand and a still-improving FTD.com business, I think that at the current price, the EFTD/IOS Brands combination is exceptionally cheap. That being the case, I'm not only holding my EFTD shares, but I've added to my position. Hopefully, the FTD.com story will have a happy ending.

At the time of publication, Zeke Ashton owned shares of FTD.com. The Motley Fool is investors writing for investors.