The Case For InterClick: Impressive Growth, Increasing Leverage

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InterClick’s (ICLK) recent pull-back to under $6/share represents a very attractive entry point. InterClick’s internet advertising network utilizes behavioral, demographic, contextual, geographic, and retargeting strategies to maximize display advertising ROI for internet advertisers. The company recently grew Q2 revenue 34% over the prior year. Revenue growth rates were 83%, 146%, and 237% for 2010, 2009, and 2008 respectively. The company generated EBITDA margin of 12.9% in 2010 and 8.3% in 2009. Based on company guidance of $142 million sales and EBITDA of $19-$20 million for FY11, EBITDA margin should approach 13.7% in FY11. Please note that this also includes approximately $1.2-$1.5 million in one-time legal costs associated with a recently dismissed lawsuit. Several factors suggest that the company’s impressive growth and increasing leverage is sustainable. Additionally, based on several industry acquisitions in 2011, the stock appears undervalued.

1) Strong Secular Industry Trends

The diagram above depicts the “purchasing funnel” often quoted in internet advertising vernacular. The wide end of the funnel is the point at which product awareness begins with the pointed end representing the consumer purchase. “DR” represents direct response. InterClick’s technology platform improves the effectiveness of display advertising, or ROI, for its advertising clients. The company’s prime differentiator vs. other advertising networks is its utilization of third party data. The relative richness of depth of this data enables more intelligent decisions regarding advertising campaigns. The evolution of internet advertising and its accompanying mass of consumer data has facilitated a paradigm shift in how advertisers spend their ad dollars. Previous advertising mediums e.g. newspaper, radio, etc. which employed more “spray and pray” tactics are now utilized less often in favor of the precise and audience-centric strategies afforded by internet advertising. The graph below depicts the continued expected growth of display advertising over the next five years. It is expected to overtake “search” in 2015. Google (NASDAQ:GOOG) has recently extolled the future of display advertising. The tech giant, known obviously for its expertise in “search” advertising, made a pronounced leap into “display” advertising with its 2007 acquisition of DoubleClick for $3.2 billion, or 10x sales.

It is important to recognize that the growth of display advertising and internet advertising in general has shown little correlation to general consumer spending patterns due to the paradigm shift previously mentioned. This macro immunity is demonstrated quite poignantly by InterClick's 2009 topline growth of 146% during the Great Financial Crisis. It could be argued that internet advertising is somewhat counter-cyclical as advertisers look to pinch pennies in the most efficient manner during uncertain economic conditions. Anecdotally we acknowledge public announcements regarding office space expansions and staff hiring’s within the internet advertising industry which attests to the strength of the industry.

While the internet advertising network has received some negative publicity due to the use of tracking cookies and speculated privacy infringement, the technology employed is fairly innocuous as sensitive data such as social security numbers, etc., is never used. In fact, consumer tolerance for such tracking methods is higher than expected. A 2007 survey by Deloitte revealed that 66% of internet users approve of “relevant advertising” methods on the internet.

2) Highly Leverageable Business Model

As is common with IT companies, the company’s business cost structure is a tightly coiled spring with significant earnings power as fixed costs are relatively low. Management continually preaches building “scale” in its conference calls. The leverage occurs primarily at the operating expense level vs. at the gross margin level. Gross margin fluctuates based on seasonality, advertising inventory pricing, and company technology investments. It is expected to hover in the low 40% range. The table below demonstrates an improving EBITDA margin based on lower operating expenses as a percentage of sales. As mentioned previously, the FY11 EBITDA margin is forecasted at approximately 13.7% which includes $1.2-$1.5 million of one-time legal expenses. The company has publicly stated a long-term EBITDA margin goal of 20% which is common within the industry. Whereas prior expense growth was related more to the hiring of new sales reps and geographical expansion, recent expense growth is focused on technology platform investments and the hiring of technology personnel. Leverage has occurred despite the hyper sales growth.

3) New Growth Initiatives in Place

While the company’s previous prodigious topline growth rates have subsequently subsided due to an increasing comparison base, growth still remains robust at 30%. It is also important to note that the company cites recent market share gains in the form of returning clients due to the recent lawsuit dismissal. Additionally, the company reports that approximately 75% of the revenue in Q2 was derived from current customers suggesting strong organic growth.

The company has recently laid the foundation for two new revenue streams in the form of its video product and its SAS (Software-as-service) product Genome. Video internet advertising is classified under display advertising. As the table below demonstrates, video is still a small percentage of displaying advertising but is forecasted to grow the most significantly in future years. The company reports that its video revenue grew 250% sequentially in Q2, albeit from a small base. The company believes that video could potentially comprise 10% of overall revenue on a long-term basis. Meanwhile, the Genome product is a SAS product to be used directly by marketers akin to Bloomberg. Marketers will have access to raw marketing data and can develop campaign strategies more autonomously if so desired. The Beta launch of the product has been received very favorably. The company has not guided for potential revenue on the product yet.

4) Attractive Valuation

Acquisition activity within the internet advertising industry has been quite robust in 2011 as companies acquire needed technology pieces and seek accelerated scale. The list below highlights the more prominent and relevant acquisitions relative to InterClick. We believe InterClick’s historical sales growth rate and future sales growth potential justify the use of a sales multiple in valuing the company. The median sales multiple of the acquisition sample is 1.9. InterClick presently trades at a TTM EV/Sales multiple of 1x, suggesting the company could be significantly undervalued. The TTM EV/EBITDA exclusive of $.9 million in one-time legal expenses is 8 xs, not unreasonable for a tech company, and the prognosis for continued margin expansion appears strong. Of the listed acquisitions, the only publicly disclosed EBITDA figure was for Greystripe. Projected EBITDA for 2011 is approximately $4.5 million indicating an EBITDA multiple of 15x estimated 2011 EBITDA. Debt and cash balances for Greystripe were not disclosed.

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The consensus revenue estimate from 6 analysts for InterClick’s 2012 revenue is $173 million. Applying the 1.9 sales multiple and factoring in a diluted share count of 33 million yields a price target of $10.

The primary risk factor to the InterClick story is working capital pressure as the company operates with elevated DSO’s of 100+ days. However, the current net cash (cash-debt) balance is $8.7 million with a borrowing capacity of $11 million so the next 12 months appear secure.

In summary, InterClick’s “secret sauce” of multiple algorithms and richer raw data combined with a highly levered platform within a growing secular industry that has demonstrated macro resiliency, represents a compelling investment opportunity especially given the recent pull back in the stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.