ValueClick: Richly Valued, But Well Positioned

| About: Conversant, Inc. (CNVR)

ValueClick (VCLK) emerged from a split-up of the Internet advertising division of Web-Ignite in April 1998. This division pioneered performance based advertising on a cost-per-click [CPC] basis as a viable business model. Since then, the company has focused on creating an ecosystem around its performance based advertising model. ValueClick’s business caters to the long tail of the Internet. The CPC model was introduced at low rates to sell unsold inventory on publisher’s websites. This proved compelling for publishers as otherwise the inventory would remain unsold. Advertisers on their part appreciated the value in having to pay only if the user clicks (performance based model) as opposed to having to pay per the number of impressions served [CPM]. The company’s display ad network was born out of this harmonious concept.

A number of value-added initiatives were added to the company’s core expertise in display ad network over the years including Display Ad Media, Lead Generation (email & vertical sites), and Comparison Shopping sites. En masse they represent the ValueClick media business unit, which generates more than 70% of ValueClick’s revenue.

With sustainability as its goal, ValueClick steadily acquired several other companies. The table below represents the company’s growth over the years:

The revenue growth of ValueClick for the most part reflects the revenue of the companies acquired rather than organic growth. However 2006 and 2007 saw organic revenue growth as the company benefited from expanding into Europe. Also worth mention is the synergy achieved through the integration of display ad network and comparison-shopping products. Revenue and Earnings are expected to grow at around the 20% range going forward.

Number of unique users (reach) is the standard performance measure for this business niche. ValueClick is #2 behind Time Warner’s by this measure. The core display ad network business does have one major issue looming regarding the viability and sustainability of growth going forward. As individual publisher websites gain popularity, they tend to manage their own ads rather than continuing with the Display Ad Media product from ValueClick. Hence the business growth depends on an ever-expanding long tail. This limitation will cause the business to run into a brick wall sooner than later.

The current two-way split-up of the Internet ad inventory between the search engines and the display ad networks will see an overhaul with the arrival of the social media websites. Facebook and My Space along with other social media sites pose significant threats to the company’s display ad network business. Facebook’s flyer ads base behavioral targeting on the information volunteered by users as opposed to ValueClick’s model of concluding user interest based on online behavior. My Space also uses a similar strategy. Eventually, as the social media networks mature, the ad inventory will get split among search engines, social media, and display ad networks with the latter getting more headwinds. The fact that Social Media is only in infancy with ideas still being developed into viable business models should be a cause for concern. The competitive landscape still in the works makes it difficult to gauge the full extent of this risk. Nevertheless, the overall advertiser inventory and the long tail of the Internet should continue to grow. ValueClick’s niche in serving this segment should hold steady moving forward.

The FTC (Federal Trade Commission) investigation into ValueClick’s lead generation business is yet another risk factor. The immediate problem of declining revenue due to advertisers shying away from lead generation may already be factored in the share price. ValueClick did experience a precipitous price drop after 2nd quarter results came in below expectations. The investigation will help determine whether the company violated the CAN-SPAM act in its lead generation business. CAN-SPAM deals with rules that prohibit businesses from sending unwanted email messages to wireless devices. It has been noted that nearly one-third of ValueClick’s revenue may be tied to aggressive marketing that violates FTC guidelines. Regulation of the industry that results in negative growth in the lead generation business is the worst-case scenario.

A focus area in ValueClick’s acquisitions has been in expanding their presence in the Display Ad Serving value chain. The Webclients acquisition represents the company’s entry into the publishing space primarily to generate leads. A relatively small capital was also committed to garner an eCommerce retail presence through the acquisition of eBabylon. PriceRunner and the most recent Mezimedia acquisitions are efforts at expanding further into the publishing space and being able to provide retail advertisers with an in-house option for Ads. These new initiatives should drive growth going forward.

ValueClick is currently priced at close to 30 times next year’s projected earnings. With an expected earnings growth of 20% the PEG ratio comes in at well above 1, making it a rich valuation. The shares also experience volatility on constant rumors about ValueClick getting acquired.

Given the valuation, steady growth expectations in the company’s niche display ad market, and the prospects of developing the comparison-shopping sites into significant retail ad revenue drivers, ValueClick should provide average returns in the long term.

Disclosure: We sold out of ValueClick on 10/14/2007 at 28.28/share