One of the most difficult things to do as an investor is to accept that, despite one's thesis playing out, a company's shares may have a difficult time coming to reflect the estimate of its intrinsic value for any number of reasons (management, ongoing short-selling pressure, etc.). And while we have been quite forgiving of Ancestry.com's (ACOM) management in the past and have been very open to the "short" thesis on the company, the firm's investment in DNA has turned us off to the stock. We will be looking to trim our position in Ancestry.com in the portfolio of our Best Ideas Newsletter in coming trading sessions.
Our primary thesis on Ancestry.com is that the firm has tremendous subscriber growth ahead of it, and such growth will easily translate into significant bottom-line expansion. The company's cash-rich business model that benefits from one of the best competitive advantages out there-the network effect-will lay the fundamental groundwork for continued value-creation over time, while justifying an above-market multiple until it realizes peak subscriber potential many years from now.
So far, the firm's business model remains intact and the online genealogy company's earnings trajectory, to a large extent, has delivered, and well ahead of consensus expectations at times. Ancestry.com, for example, posted $0.40 in earnings per share in its most recently reported fourth quarter, trumping the Street's $0.34 per share forecast. So what gives?
Well, looking forward, a part of our thesis also centered on annualizing the earnings-per-share level achieved in the fourth quarter of 2011 (its most recently reported quarter) and building in modest sequential growth through the course of 2012 to arrive at about $1.62 to $1.65 in expected earnings per share for 2012 (consensus was at $1.53 per share pre-quarterly results). The firm's subscription-based business model allows for such a forecast of sequential growth, in our opinion. Our basic view was that consensus numbers would then have to come up considerably after the earnings beat (which we expected), and the shares would then continue to migrate higher to reflect the company's intrinsic value, which we measure at over $40 per share based on our DCF process. All good so far.
Unfortunately, management has thrown a wrench into our thesis with its investment in DNA (some $10 million to $15 million during fiscal 2012). And if this new endeavor wasn't an unnecessary headwind to earnings expansion, the headline net subscriber additions number of 1,000 in the fourth quarter, though pre-announced, will still feed the "short" thesis and put unsubstantiated pressure on the stock. Further, subscriber acquisition costs surged in the quarter and average monthly revenue per subscriber fell sequentially. It's hard to say that the quarterly results weren't disappointing; and unfortunately, a huge earnings beat doesn't matter much when internal fundamentals appear weak. But that's not all.
For some time, we had been predicting a run-up from the low $20s in Ancestry.com's stock, and we got that through the first several weeks of trading of 2012. However, we thought Ancestry.com would come out with higher revenue and subscriber guidance for 2012 than it did. In our view, this was the quarterly release for management to set the tone for its best year ever - to appropriately capture in its guidance the incremental subscriber revenue from the extra episodes of Who Do You Think You Are (now in its third season) and to better reflect the 1940 US Census as a stimulus for Ancestry.com members currently sitting on the sidelines to re-up (a huge part of the company's model). Management did no such thing and set revenue expectations as if 2012 is just another year. How can the longs win if management doesn't believe in its own story.
Simply put, management failed. And this isn't the first time. Just last year, CFO Howard Hochhauser completed upended the stock's investment base (its steady, stable shareholders) when he told the Street that ending subscribers would actually decline in the most-recently reported quarter (the fourth quarter). That the CFO came out and said such a comment (without it being absolutely 100% true) completely scared away the long-term fundamental holders, and the stock dropped considerably.
Perhaps needless to say, Ancestry.com actually ended up growing subscribers during the period that this decline had been predicted. Is management trying to scare away all of its steady-eddy, long-term shareholders by playing some sort of earnings game? Or was management just flat-out wrong, and didn't understand the consequences of its move at the time? Either way, management is not making it easy on themselves.
Frankly, we didn't like what happened then, and we don't like what management has set up for 2012. The shareholder base is now littered with technicians and short-sellers, especially now that the firm has broken through its uptrend (a few days before the report as a result of poor viewership on its television show). Management doesn't seem to understand that they are not managing a tried-and-true company like Coca-Cola (KO), but instead a relatively misunderstood business that faces as much skepticism regarding its sustainability than any other firm out there. Destroying investor confidence time and time again is the worst thing that could be done with such an unproven firm.
So, back to fourth-quarter results. Instead of prepping the Street for an excellent and significantly better-than-expected 2012 (which still may happen), management instead gave us a view that the company's earnings trajectory has been jeopardized (due to DNA), that growth in the UK will be challenging, and that NBC might not renew Who Do You Think You Are for the fourth season next year. Overall, we think management can do better.