ValueClick : quality business run by mediocre management (VCLK)

ValueClick runs the second largest ad network on the internet, second only to the Google Adsense network. In an increasingly fragmented Internet, advertisers cannot contact each publisher individually to place advertisements, and turn to ad networks which aggregate content from many publishers. These ad networks are an excellent business, because they are semi-monopolistic toll booths on the highway of Internet commerce. ValueClick has 3 major lines of business. The largest division, Affiliate Marketing, consists of the Commission Junction Marketplace business. In the CJ marketplace, advertisers place products and services they would like to sell for a fixed commission, and publishers can incorporate these affiliate links into their content. When a product is sold through the affiliate link, the publisher and ValueClick split the commission. The second division, the Media segment, consists mainly of display advertising and email marketing performed on behalf of advertisers on its network of allied publishers who place excess advertisement slots they cannot sell with ValueClick. The last major division, Owned Content, consists of websites directly owned by ValueClick. These websites are mainly shopping/coupon-based websites (pricerunner.com, couponmountain.com), although the company has recently acquired Investopedia from Forbes in February 2010. Revenue from the Owned division derives mainly from advertising on the owned sites, much of it from Google and Yahoo.

Pluses

• While Internet commerce is longer growing dramatically, most analysts still expect a minimum growth rate of 10% per year.
• The Internet advertising space is dominated by Google, a situation which makes many advertisers nervous. Advertisers are likely to continue to use ValueClick, if simply to avoid giving too much market power to Google.
• ValueClick has a history of making significant share repurchases. The share count has shrunk consistently every year.
• Recent insider purchases suggest that management is expecting a turnaround in operations.

Minuses

• Anecdotally, Google has the highest click-through rate of the industry, due to its superior semantics technology which analyzes web content and places ads only on relevant webpages, where they are most likely to convert into click-throughs. ValueClick has no such technology, is inferior to Google in ad placement, and accordingly achieves a much lower click-through rate and a lower cost per click.
• As stated in ValueClick’s own 10K, there are “no significant barriers” to entrance to the industry. Indeed, many startups and new business models (e.g. Chikita, Amazon Affiliates etc.) have begun to encroach on the industry.
• ValueClick’s management has a history of sinking large amounts of cash in acquisitions at elevated multiples, and then taking large impairments.

Management strategy

In recent years, rather than improving its core business of affiliate and ad placement, management has sunk more than $300M into acquiring web content, in effect competing with its publishers. This strategy is presumably one of synergy with its ad network. If ValueClick owns the content, it no longer has to split the advertising fees with publishers. However, I consider this to be an ill-advised strategy. Firstly, ValueClick competes at a disadvantage with content publishers in this space, as it has neither the infrastructure nor the tradition of producing quality content regularly. And web content does depreciate quickly with age, so constant updating of the content is required. Secondly, while synergies are indeed achievable with its other lines of businesses, this is very modest, and not scalable. In contrast, any improvements in its ad and affiliate network technology can be leveraged across its entire business at once. Thirdly, the content business is very sensitive to policies at Google and Yahoo. In fact, ValueClick itself reports that its Owned division took a hit to revenue in 2009 due to a change in revenue policies at Yahoo. Sadly, while management continues with its suboptimal use of cash, it is protected by shareholder rights provisions, and a buyout followed by management change seems unlikely.

Earnings

Below is a table of VCLK earnings over the last 3 years. I evaluate businesses based on Buffett’s concept of “owner’s earnings” which is the cash left over for the owners of the business after deducting cash needed for operations. In practice, I add back non-cash charges in order to arrive at “owner’s earnings”. Figures are rounded to the nearest million.

Valuation

VCLK’s annual revenues have changed with every new 10K, due to its divestments and acquisitions, making it difficult to make comparisons across years. However, its core Affiliate division’s earnings are quite stable and comparable, and I estimate that the business in its entirety should generate at least $100M annually in earnings. There is also about $200M of tangible excess assets on the balance sheet. What is the appropriate valuation for an excellent business whose management has an unfortunate tendency to burn large amounts of cash in mediocre investments, while still returning significant amounts of cash to shareholders via buybacks? I will err on the conservative side, and attach a PE of 10. This means my price target for ValueClick is $1.2B, or over a share base of 81.81M, a PPS of $14.67. Given the strong bounce in advertising and the strong operating results recently reported by Google, I expect the stock will do well in the short term. I will however look to divest my position if it surges above $14.50, since there are many other well-managed and more profitable stocks.

Disclosure : I have a long position in VCLK