Liquidity Services (LQDT) became the latest hot web property to reach the billion dollar market cap threshold Wednesday, (though they ended the day just under that level), as shares surged 11% higher on the back of Stifel Nicolaus' initiation of research with a buy rating and $41/price target. However, the enthusiasm appears to be reaching an excessive level, and Liquidity Services' shares are becoming vulnerable to a significant pullback.
For those unfamiliar with the Liquidity Services story, the company has developed a profitable niche within the online auction space. Dubbed by Forbes 'The Government Ebay,' Liquidity Services creates markets for surplus and salvage items. Thus far, Liquidity Services has focused on the government, and has relied on contracts with government agencies such as the US Department of Defense and the UK Ministry of Defence to provide a good deal of merchandise for its various websites, which include liquidation.com, govliquidation.com, govdeals.com, truckcenter.com, and others. In recent months, the company has been branching out, though, most recently with the announcement of the acquistion of privately-held Jacobs Trading, which will deepen Liquidity Services' relationship with Wal-Mart (WMT).
While the company has been growing nicely in recent years, its valuation has grown much more rapidly, with investors now slapping a nearly billion dollar market cap and a triple-digit trailing P/E on the company. Since the beginning of 2009, Liquidity Services' shares have more than quadrupled while net income has risen by roughly a third (excluding non-recurring losses).
Based on analysts' estimates, the company has a forward P/E of 35 and a PEG ratio 1.3, both of which are pricey but not stratospheric. The bigger valuation question comes from looking at the company's balance sheet. While the company has no debt, its book value is just $5/share (mostly cash but also $1/share of goodwill). Much of the ~$4/share of existing cash will be spent on the upcoming Jacobs Trading acquisition. The company's valuation is almost entirely tied to its future prospects, with no dividend, little book value, and a fairly weak moat to protect it from competition.
And unlike many other hot internet properties, Liquidity Services has not had an unblemished track record of growth in recent years. The company was significantly impacted by the Great Recession, with revenue dropping from $263 million to $236 million from FY '08 to FY '09, and net income dropping from $18.6 million to $13.2 million over the same time period. Though the company's revenue has rebounded nicely from the 2009 trough, the company has failed to prove that it can produce the sort of torrid revenue growth that helped lift other momentum stocks such as Chipotle (CMG), Opentable (OPEN), and Netflix (NFLX) into the realm of triple-digit P/E companies for extended periods of time.
With the upcoming addition of Jacobs Trading to Liquidity Services' earning power, 2012's earnings will be significantly better than this year's. Still, it is hard to see enough sustained revenue and earnings growth to support the company's present valuation. Over the past 5 years, according to Yahoo Finance, Liquidity Services has grown 18% a year. Analysts are predicting that this growth rate will accelerate to 27% a year over the next 5 years.
While the company's management team has done a fine job of running the business, there is still little reason to believe they will be able to achieve accelerating revenue growth. As companies mature, their revenue growth rates typically decline, rather than accelerate. And remember that Liquidity Services' revenue actually shrank in 2009 -- the company has not shown itself to be recession proof, and the economy appears to be heading straight into a double-dip recession now.
Also, a quick glance at insider transactions shows that management has been consistently taking profits over the past two years, according to Secform4.com.
With a forward P/E of 35 and a low book value, investors are betting on future results remaining extremely good. And over the last few weeks, trading has gotten particularly frothy, with the stock up 45% month-to-date. In my view, this is just too much too fast, and the company is quite vulnerable to downside in the near term, creating a decent short-selling opportunity.
In the longer-run, while the company has been run solidly and is nicely generating cash flow and revenue, there is a significant amount of execution risk. As shareholders of eBay (EBAY) are aware, there are many ways to destroy value in the online auction space, including bad acquisitions and offending customers and resellers, and disappointing investors with numerous lofty but unachievable plans. For those wanting to play the auction trade, a cheaper alternative is auto part salvager and online auctioneer Copart (CPRT), which trades at a reasonable 19 P/E, a forward P/E of 13, a PEG ratio under 1, and which sports a stronger balance sheet. Copart also weathered the Great Recession more easily than Liquidity Services, suffering a much smaller 4% decline in net income between FY '08 and FY '09.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in LQDT over the next 72 hours.