In our first article entitled "Bazaarvoice's Valuation is Utterly Bizarre" we detailed our concerns that the shares of Bazaarvoice (Nasdaq: BV) had become significantly overvalued in the face of rising competition from the likes of Google (GOOG), Oracle (ORCL), Salesforce.com (CRM), Jive Software (JIVE) and Demand Media (DMD). Moreover, we illustrated that BV has a struggling financial model with years of projected losses, and that the expensive new acquisition of PowerReviews posed significant integration risks. We also detailed that management was already making plans to sell their shares, and that both BV and PowerReviews's lock-up expirations would put significant pressure on the share price.
Therefore, it came as no surprise when late last week the company filed an S-1 for the sale of 8.5 million shares. The share sale is comprised of 1.7 million shares issued by the company and 6.8 million shares by existing investors. A closer look into the transaction reveals numerous concerns with the PowerReviews acquisition.
S-1 Insights Confirming PowerReviews a Bad Deal
The S-1 filing offers new insights into BV's acquisition of PowerReviews, which closed recently on June 12th and cost shareholders a staggering $169 million, or 14.6x LTM revenues. This figure included $39.2 million of cash, 6.4 million BV shares, and the assumption of 1.7 million options. What exactly did BV shareholders get for this costly transaction, what is the financial profile of PowerReviews, and what should BV shareholders' expect going forward?
According to BV, the deal added approximately 300 network clients, approximately 800 express clients and 81 new employees to their business. They believe that the acquisition will establish them with small and medium-size businesses and further expand the reach and value of their network. They also claim to expect significant cost synergies by combining the operations of PowerReviews with their own.
On the surface, this story sounds nice, but a closer look at the numbers paints a different picture. To illustrate, the 1,100 customers of PowerReviews only generated $11.9 million of revenue in the LTM 3/31/12 period. On a per client basis, this equates to a paltry $10,400 per customer. On the other hand, BV's average revenue per client is approximately $144,000. For BV to extract any value from this acquisition, they are going to have to convince the PowerReviews customers to spend significantly more money for a higher service. Yet, since there are essentially only two companies in the industry that provide this service, it's likely the case that PowerReviews attracted its customers precisely because they offered a lower price point solution. The notion that they will now want to spend more money for BV's services is an overly optimistic assumption.
BV warns exactly about this issue in the S-1:
Customers of Bazaarvoice and PowerReviews may not continue to use Bazaarvoice or PowerReviews to the same extent as they would have if PowerReviews had remained an independent company, or they may cancel existing agreements.
Furthermore, the assertion that BV will extract cost synergies by combining operations will also be challenging. According to the pro forma financial statements filed in the S-1 and illustrated below, PowerReviews is losing significant amounts of money in its business, at even a faster rate than BV. The company will have to eliminate a minimum of $5 million of expenses to even come close to achieving an EBITDA neutral position on a pro forma basis. Yet, this seems unlikely because BV admits elsewhere in the S-1 the following:
Expenses associated with the purchase of PowerReviews and the integration of PowerReviews' customers, employees and operations into our business could further delay our profitability. We anticipate that our operating expenses will increase substantially in the foreseeable future as we continue to invest to grow our business and acquire clients, develop our platform and develop new products and solutions.
For example, the company noted that they have recently initiated a search for a senior executive to join their management team as a president and have undertaken a plan to upgrade and expand their sales organization. The board also gave a generous raise to senior executives and a nice cash bonus plan tied to sales, EBITDA and bookings. Shareholders would be better rewarded if the bonuses were tied to cash flow enhancement.
Adding insult to injury, BV quietly disclosed in the S-1 a very material piece of information that the company is under investigation by the Department of Justice.
According to the disclosure:
After the completion of our acquisition of PowerReviews, the Department of Justice, Antitrust Division, or DOJ, notified us that it has opened a preliminary investigation to determine whether the acquisition violated Section 7 of the Clayton Act, 15 U.S.C. Section 18. The DOJ's investigation could be lengthy, and we may be required to produce documents and data and offer to the DOJ other written and oral testimony, which could result in material legal fees and associated costs and require considerable time and attention of our management. Further, if the DOJ determines our acquisition of PowerReviews violates the Section 7 of the Clayton Act, we could be required to divest part, or all, of PowerReview's operations and assets. As a result, this investigation could have a material adverse effect on our operating results and could materially impact our business strategy going forward.
Given that BV believes they are a monopoly in their industry, it is surprising they didn't take the necessary steps to clear this issue prior to announcing the deal. It could prove to be a very costly mistake, and as the company suggests, may have a material effect on cash costs.
From a balance sheet perspective, the preliminary purchase price indicates a substantial allocation to goodwill for the transaction at $114 million. Including indentifiable intangible asset of another $40 million, a total of 97% of the total assets are goodwill and intangibles. The intangible estimate only includes $5.4 million and $33.9 million for developed technology and customer relationships, respectively. Clearly, the success of this deal depends heavily on BV's ability to harness PowerReviews customer relationships to drive value creation.
Overall, the deal puts a material strain on the financial profile of the company absent significant revenue growth. The costs are set to rise from further internal investment, increases in wages, and legal costs associated with the DOJ investigation. The bottom line result for shareholders appears to dilute earnings potential as well from the added share dilution.
At today's share price of $18.00 investors continue to price in a substantial premium to BV's future. The additional information provided in the S-1 about the acquisition of PowerReviews still does not provide greater clarity into the future of the combined company. The PowerReviews deal came at a significant cost to BV shareholders of 14.6x revenues. Absent a significant synergies from acquiring this business, each $1 of additional revenue will result in $1.20 in additional losses. The notion that the combined companies will create significant revenue synergies is not guaranteed given the company's different client segments and vastly different revenue per client profile.
Furthermore, cost synergies do not appear to be significant enough in the near term to be accretive to the company's earnings. In fact, costs are anticipated to grow over the course of the integration. In light of the recently disclosed DOJ investigation, there is a very material risk of added legal costs to justify the transactions. The consequences of terminating the transactions could also put a significant dent in the company's future growth trajectory. BV's valuation is still at a significant premium to marketing and digital service peers, and a healthy premium to other social media stocks. As a result of all these concerns, the risk / reward of owning BV's shares appear slanted toward the downside, particularly as insider selling is poised to vastly increase the float of shares on the market.
We reiterate our belief that BV's shares are more appropriately valued in the $5 range. We arrive at this $5 target using a 2x revenue multiple, which is closer aligned to digital and marketing service trading multiples, and also comparable with other social media businesses that have struggled to achieve positive EBITDA such as Groupon (GRPN) and Zynga (ZNGA).