Why You Should Be Cautious About Tying The Knot

| About: XO Group (XOXO)

It's June and the weather is shaping up, flowers are in full bloom, and wedding bells are ringing. This time of year usually brings good tidings to investors in The Knot (KNOT), as the second quarter often is the busiest for brides planning their wedding. The company's flagship website helps brides plan for the big day with helpful articles, links to florists, photographers, and caterers; and other helpful content. Revenues for the company come primarily through its advertising partners who find the website to be frequented by motivated buyers in a very specific demographic.

Although its a key time of year for the company, executives are spending more time trying to control damage than lauding the company's great success. That is because many of the advertisers have recently pulled their business from KNOT or simply decided not to renew contracts. The problem stems from one of the other company's websites, The Wedding Channel, which has not lived up to promises the company made to advertisers. The problem caused concern for the customers many of whom have pulled back not only from wedding channel but also from theknot.com and other sites the company runs.

Analysts have touched on the issue recently saying the company is getting things back in line and expect ad revenues to pick up next year and bring the company back into growth status. Apparently investors are drinking the cool aid because the stock is trading at nearly 40 times expectations for 2008. Assuming the company is able to right the ship and earn $0.55 cents next year (62% above this year) there will still be an incredible premium on the shares. This seems a bit aggressive considering the barriers to entry are very low in this type of business - especially when you know the major potential customers are unhappy with the performance of the industry leader!

Traders may be tempted to think this is a good spot to add shares as the stock has dropped well over 30%. I would caution against this type of thinking, as there is a firm reason why this drop has occurred. The stock was even more expensive at one time but that was because everyone believed the company had the potential to ramp earnings at these accelerated rates for the foreseeable future. While I don't think the company is going to quit making money, I think investors who are pricing in a continued geometric earnings increase will be disappointed.

This recent rise to test the 50 day average may be just the chance holders of the stock need to turn out shares. If the stock drops below this level I would treat any holdings very carefully as it will probably send the last weak holders scurrying for the exits and invite short players to take another stab at the name. Remember, capital preservation is the name of the game so know the risk you are taking and have an exit plan if things don't turn out as you expected (long or short).

Disclosure: The author has a short position in KNOT.

KNOT 1-yr chart