The $2 Stock You Cannot Afford to Own

Pop quiz: If I tell you that Stock A costs two bucks and change, while Stock B costs $28, which stock is cheaper?

You knew that was a trick question, didn't you? You simply cannot answer without three additional pieces of information:

• How many shares does each stock have outstanding? (To compute their market caps.)
• How much cash and debt does each company have? (To figure the enterprise values.)
• Last but not least: How much money are they making? (Which, when divided into enterprise value, tells you each company's valuation.)

The backstory
While reviewing Google's (NASDAQ:GOOG) latest downgrade last week, I mentioned that the reason for the downgrade -- a precipitous drop-off in the online advertising market -- boded ill for fellow media conglomerates like Time Warner (NYSE:TWX) and News Corp (NASDAQ:NWS). Well, surprise, Fools! I missed a couple names.

Last week, two other companies whose fortunes are tied in part to the media market reported their earnings. Both firms reported significant difficulties arising from depressed advertising sales (and an investing environment not much better). Both stocks look cheap to me -- but one's clearly a better bargain. Let's take 'em one at a time:

TheStreet.com (NASDAQ:TSCM)
The news out of TSC ranged from good, to bad, to not-quite-as-bad-as-it-could've-been:

• Revenue rose 10%.
• Profits plummeted 96% to just $0.04 per share.
• Free cash flow dropped "only" 65% to $3 million.

Summarizing the news, and forecasting the future, CFO Eric Ashman commented: 

We expect the difficult market environment to continue in 2009 ... Early indications suggest that the year-over-year decline in advertising revenue that we saw in the fourth quarter will increase in the first half of the year, while the pressure on the subscriber base is likely to continue as many investors are no longer market participants, and job reductions in the financial sector reduce the pool of interested consumers.

On a brighter note, Ashman added, "Despite the challenging conditions, we delivered $3.0 million in free cash flow in 2008." Ashman stated his "goal" was to maintain "at least a free cash flow neutral position for 2009."

Morningstar (NASDAQ:MORN)
Speaking of sunny, Morningstar also had a rough Q4, as "revenue growth slowed significantly in the fourth quarter." Yet despite a decline in asset-based revenue streams, "cutbacks on Internet advertising," and further "cutting back on ... renewals" of Morningstar subscription services, Morningstar still managed to report:

• Revenue up 15.5% to $502.5 million for the year.
• Profits up 23% to $1.88 per diluted share.
• And last but not least, free cash flow of $103.9 million -- up 3%.

The big story here, it seems, is the dangers lurking in years to come. Morningstar lost one major asset management client, and it has so far failed to reach an agreement for renewing another. This puts 3.3% of asset-management-based revenue at risk this year. Additionally, the expiry of the "Global Analyst Research Settlement" (GARS) that required investment banks like Goldman Sachs (NYSE:GS) and JPMorgan Chase (NYSE:JPM) to purchase stock research from Morningstar jeopardizes another 4% of revenue. Says Mansueto: "we expect this research revenue to decline significantly" after GARS expires in July 2009. In all, therefore, we're looking at perhaps 7% of Morningstar's revenue disappearing late this year.

Still, the key thing to note here is that while Mansueto focuses on obstacles to success, the headline numbers show Morningstar is overcoming them. At TSC, revenue dropped in Q4, and profits and free cash flow fell for the year. At Morningstar, we saw slower growth -- but still growth -- in Q4, and growth everywhere you look for the year as a whole.

Pop quiz
Now that you know what's going on at the two businesses, it's time to answer our pop quiz. TSC currently sells for $2 a share or so -- Morningstar, for 14 times that. But the way I look at it, Morningstar is nonetheless the better bargain. Here's why:

Right now, TSC has $72.4 million in cash and equivalents, and no long-term debt. Subtract this sum from its market cap, and you may believe you're looking at an enterprise valued at less than its cash in the bank. You're not.

TheStreet has a pothole
To learn why not, you need to remember that late in 2007, a pressed-for-cash TSC issued $55 million worth of preferred stock to private equity house Technology Crossover Ventures. This "quasi-debt" raises TSC's enterprise value back up to $49 million, and means the business is actually selling for about 16 times last year's free cash flow.

Morningstar shines
Now contrast that with Morningstar. While TSC is contracting and hoping to just break even in 2009, Morningstar keeps growing; it generated $104 million in cash profit last year, and it's priced at about 10 times this free cash flow.

So which stock is cheap? Since analysts posit double-digit long-term growth for both firms, I believe both stocks have adequate margins of safety, and can be bought at today's prices. But relatively speaking, Morningstar looks cheaper by far.