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We recommended Digital River (NASDAQ:DRIV) for Investor Advisor’s undiscovered growth portfolio exactly one year ago. After a 50% gain, I now think the stock has shifted from value to growth at a reasonable price [GARP]. But I maintained a buy for our subscribers.

DRIV is my favorite way to participate directly in ecommerce. In 2005, U.S. ecommerce sales grew 25% to $86 billion but what’s remarkable is that $86 billion is less than 3% of total retail. We sometimes forget it’s still early for ecommerce adoption.

Here is a stacked chart of Digital River’s revenue and net income, by quarter:

The company notched down second quarter guidance, but that shouldn’t be relevant to the seasonally weakest quarter. Of greater concern ought to be the margin drop: down four points to 29% for the quarter. However, all of this can be attributed to a higher R&D and sales & marketing spend for the quarter.

Their full year guidance is a $300 million in sales and diluted EPS of $1.36. That gives a forward P/E ratio of about 33x. Or about 26x if use the non-GAAP EPS (I don’t think you should). Some analyst concern about the capital structure strikes me as overwrought. For their profile—high tech, rapid growth, very acquisitive—equity dilution and balance sheet are surprisingly healthy.

The chart below plots diluted shares and long term debt over the last five years:

The company didn’t carry any long-term debt until they issued a private $175 million note subsequent to their now successfully executed Element 5 acquisition. Over the five year period, the share base has grown at an compounded annual rate of about 14%. Taken together, the share accretion and the long-term debt, the capital structure is reasonable given their rapid growth. Further, stock option dilution is almost too conservative and contributes to an overall set of favorable governance practices. Their option overhang (i.e., shares available for future grant plus shares outstanding) at quarter’s end was only 15%. For their profile—high tech, rapid growth, acquisitive—that’s quite low and compares to an industry average of 20 to 25% (e.g., their distribution partner Ingram Micro runs 30% overhang). The pro forma FAS 123R EPS hit looks bad in 2006, but it’s really not. Their run-rate (annual grant as a percentage of shares outstanding) is very competitive at 2%, and 85% of that goes to non executives.

Finally, in comparing adjusted operating cash flow (adjusted = removing current balance sheet changes) to diluted EPS, I see high quality earnings:

In the negative column, we have low transparency into the different business segments. On the call, one analyst characterized the financials as “a black box.” Also, competition is formidable, including but hardly limited to: IBM (NYSE:IBM), Amazon.com (NASDAQ:AMZN), Akamai (NASDAQ:AKAM), Yahoo! (NASDAQ:YHOO), and eBay (NASDAQ:EBAY).

Since I’ve covered Digital River, Microsoft (NASDAQ:MSFT) has unduly spooked the stock on a regular basis at every announced, threatened entry into the anti-virus market. This concern is not competitive per se, but rather that Microsoft will hurt Digital River’s customer Symantec (NASDAQ:SYMC). Symantec is 30% of Digital River’s, so there is indeed concentration risk. The market fretted over this chimera for years and, ironically, this concern may be calming just when Microsoft is launching its first real threat in anti-virus. (After a few awkward starts, Microsoft has repackaged antivirus into Live OneCare, which to me looks finally like a promising security offering).

In the positive column, Digital River has proven is knows how to move up the value stack by acquiring technologies. The successful Element 5 acquisition was geographical expansion, but most of the others have been means to move beyond transactions into paid search, affiliate marketing, marketing analytics and outsourced enterprise ecommerce. There are wide open growth opportunities in international regions and enterprises; the Commerce5 acquisition helps because they were losing some key large account bids to Commerce5, that now become global brand-name clients.

Finally, our original themes still apply:

* Further room for domestic and international growth in ecommerce, where scale and experience (some countries are very complex to serve) are competitive advantages
* Inexorable shift from of-the-shelf (literally) packaged goods to downloadable digital goods
* Controlling the shopping cart (i.e., Digital River is PayPal for businesses) ought naturally to lead to other platform/network (B2B) opportunities

Source: Digital River: High Quality Earnings (DRIV)