I recently sold my position in ValueClick (NASDAQ:VCLK), an Internet advertising company I wrote about and described as a bargain in April and August of last year. After a 65% runup since August -- fueled by bullish fervor across the entire Internet sector -- ValueClick now looks to have gotten a bit too big for its valuation britches.

By way of review, when I last wrote about the company in August, I liked ValueClick's investment potential, not because its Internet advertising solutions were about to set the world on fire, but because the stock was cheap. At a price of around $2.45, shares of ValueClick traded at a 17% discount to net cash in the bank -- a situation I likened to buying dollar bills for 83 cents. This proposition was made all the more appealing by virtue of the company's positive (albeit modest) free cash flow (FCF) and management's enthusiastic willingness to buy back stock.

Since then, the market has more than recognized this company's value. After a fantastic run to $4.03, where it last closed, ValueClick shares now trade at a 33% premium to cash. This price is beginning to look awfully steep for a company that only in the most recent quarter generated its first GAAP profit. Even when you annualize fourth-quarter sales and FCF, the valuation multiples are on the pricey side:

  Market Cap (a):                  $305.3MNet Cash (b):                    $233.0MEnterprise Value (EV) (a - b):   $ 74.5MAnnualized Q4 Revenue:           $ 75.2MAnnualized Q4 FCF:               $  2.8MEV/Revenue:                         1.0x EV/FCF:                            26.6x

That last metric, EV/FCF, bears some explanation, especially how I calculated FCF. In Q4 '02, ValueClick generated cash flow from operations of $3.2 million. Out of that, I subtracted interest income of $1.5 million and maintenance capital expenditures (capex) of $1.0 million, which nets to FCF from operations of $0.7 million ($0.7 x 4 = $2.8 million annualized). Enterprise value of $74.5 million divided by $2.8 million yields the EV/FCF multiple of 26.6.

And, oh, by the way, this is really giving ValueClick every benefit of the doubt for two reasons: First, ValueClick currently isn't paying taxes due to credits from past losses, so the EV/FCF multiple is artificially low based on untaxed FCF. Second, total capex for Q4 was actually much higher at $2.4 million. Had I used total capex rather than maintenance capex, FCF from operations would've been negative. I'll take management's word, however, that maintenance capex is closer to $1 million per quarter.

So, even under the best-case scenario, ValueClick trades at 26.6 times FCF, or a 49% premium to the S&P 500's comparable multiple of 17.9, according to Barra. In sum, whereas in August of last year ValueClick was a conservative play on liquid assets, now it's a speculative bet on a richly valued business.

And this business, as I said in August, is frankly not the best under the sun. ValueClick is the product of six major acquisitions in the past two-and-a-half years, so it's more or less a cobbled-together collection of advertising-related services and technology products. Management is to be highly commended for acquiring cheap assets and keeping costs under control, but there's yet to be any proof that the combined company will be able to drive profits significantly higher in the coming years.

In fact, the company's 2002 10-K, filed last month provides evidence to the contrary. In reading it, I found a number of reasons to be skeptical of ValueClick's ability to grow future per-share profits and thereby live up to its premium valuation:

1. No barriers to entry
By ValueClick's own admission in the risks section of the 10-K, competition in the Internet advertising business is intense and only likely to increase because "there are no significant barriers to entry." ValueClick's only real competitive advantage is its ability to offer clients a single source for a diversity of online marketing services. As far as competitive advantages go, I'd say that's a pretty weak one.

2. Struggling media business
ValueClick's original pay-for-clicks media business has been hemorrhaging revenue at massive rates for the past several years. In 2002, media revenue declined by 28.2% and was less than half that generated in 2000. Even after all the technology-related acquisitions over the past two years, the media business still accounted for 47.6% of revenue last year. By the fourth quarter, revenue had stabilized, but management reported that there was gross margin deterioration.

It's not a pretty picture, and the 10-K offers some detail as to why:

This [media] business model may not continue to be effective in the future for a number of reasons, including the following: Click rates have always been low and may decline as the number of banner advertisements on the Web increases; Internet users can install "filter" software programs, which allow them to prevent advertisements from appearing on their screens;. and direct marketing companies may prefer other forms of Internet advertising we do not offer, including search engine placements.

Ouch. And if that's not enough, consider this specific example of how changing technology standards can represent a constant threat to ValueClick's media business:

[A]dvertisers are increasingly requiring Internet advertising networks to have the ability to deliver advertisements utilizing new formats that surpass stationary images and incorporate rich media, such as video and audio, interactivity, and more precise consumer targeting techniques. Our system does not support some types of advertising formats, such as certain video and audio formats, and a number of the websites in our network have not implemented systems to allow rich media advertisements.

3. Customer concentration risk
The risk section of the 10-K reveals that one customer (unnamed) accounted for 14.5% of ValueClick's overall 2002 revenue and 27.7% of the technology segment's revenue. That's a great client, to be sure, but there are a couple of pretty obvious problems with this. For one, this client has the potential to wield some pretty powerful leverage, in negotiating terms, with ValueClick. And second, if this client ever walked away, ValueClick's revenue would take a massive hit, and earnings would be hurt even worse because its expenses are largely fixed in the short term.

4. Egregious stock options
Last, but in no way least, ValueClick's stock option program is one of the worst I've come across. In each of the past three years, option grants (net of cancellations/forfeitures) have exceeded 10% of diluted shares outstanding. At this rate of shareholder dilution, ValueClick would have to grow FCF by 10% annually just to tread water on a per-share basis. That's a loser deal for shareholders.

My decision: sell
For all these reasons, I sold my ValueClick shares a few weeks ago at $3.30. I unfortunately missed some of the gains that have come along since then, but I still got exactly what I was hoping for when I purchased at $2.39 last September. If ValueClick ever gets back down to around cash value, or if the business proves more profitable than I'm expecting, then I might give it another look some day. Until then, on to greener pastures.

Next Monday, I plan to share some observations from LendingTree's (NASDAQ:TREE) 10-K.

Matt Richey (MattR@fool.com) is a senior analyst for The Motley Fool. At the time of publication, he held shares of LendingTree. For Matt's best stock ideas and exclusive in-depth analysis each month, check out our newsletter, The Motley Fool Select . The Motley Fool is investors writing for investors.