Valueclick: Great Business with Tough Competition

ValueClick (VCLK) is one of the largest pure internet advertising agencies. The company has 4 primary operating segments. The largest is the Media business (more than 60% of sales), which creates internet only ad campaigns for it's customers, and distributes the ads through search, e-mail, and a network of over 16 thousand web sites that reach over 75% of all U.S. internet users, a reach second only to Yahoo!. The Affiliate Marketing business (20-25% of sales) allows advertisers to use their own ad creatives to build an affiliate network using publishers that receive commissions through ValueClick.

The company probably runs the largest affiliate marketing program in the world through their Commission Junction subsidiary. The third unit is Comparison Shopping (28% of sales), which runs the Smarter.com and Pricerunner.com comparison shopping sites allowing consumers to research and compare products and prices. Last and least is the Technology unit (6-7% of sales), which provides software tools for both advertisers and publishers to track the efficiency of ad campaigns.

I really like ValueClick's business and it just missed making it as a Top Buy. Internet marketing is a great business, and ValueClick's MFI return on capital figures illustrate this. Over the last 5 years the company has averaged nearly 150% MFI return on capital, and even in weakening conditions over the past year it still sits at 128%. These numbers probably put it in the top 1% of all public companies. Very little capital investment is needed to grow revenues, and low fixed costs make it easier to pare down expenses when revenues are weak, a nice attribute with a revenue stream as heavily cyclical as ad spending.

ValueClick has an outstanding balance sheet too, with 161 million dollars and no debt. This, plus a very healthy free cash flow margin of 15%, allow management to provide shareholder value in numerous ways, from acquiring new businesses to buying back shares.

And there is plenty of growth potential. Some estimates have the internet ad market growing at a 20% annual clip through 2012. ValueClick has shrewdly used acquisitions to build out a wide breadth of services, and will likely continue that strategy. Continued roll-out of services in Europe is just the beginning of geographic expansion. Growth should not be a problem, although it will slow down from the trailing 5-year revenue CAGR of 40%.

Of course, since it's a Magic Formula stock, the price is right too - earnings yield of 10.5%, free cash flow yield of 8.2% are both very attractive numbers for this kind of growth. This price will likely be a bargain in the short term, as a poor macro-economic outlook is causing advertisers to cut down on spending. This is not a ValueClick specific problem. Its competitors are seeing the squeeze as well. As I've said many times before, uncontrollable macro-economic reasons for a cheap stock price is a good time to consider buying. Also, with the consolidation going on in the industry, there is a good possibility that a larger competitor may place a generous bid to acquire ValueClick's varied businesses and large affiliate network.

My biggest concerns with ValueClick, and the reason it does not make the Top Buy cut, is tough competition and no built-in moat characteristics. On the former, ValueClick currently competes with some heavyweights in internet marketing, including Yahoo!, Google, Microsoft, and AOL. Although ValueClick is holding it's own, it is likely that traditional ad agencies will soon move into internet marketing. This is a bigger problem, because these agencies already have relationships with big-spending advertisers, and can also offer newspaper, radio, and television services as well (Google is already moving in this direction with their Adwords program).

Also, there are no switching costs that provide a durable competitive edge. Any advertiser can easily drop ValueClick in a heartbeat if a better deal comes along from a competitor. A lot of competition, low switching costs, and low barriers to entry will eventually lead to major price competition, which severely limits potential profits, regardless of how big the overall market grows.

In summary, ValueClick is a great business, at a good price, and is a fine pick for your MFI portfolio. But tough competition and low switching costs prevent it from building a long-term moat, and thus prevent it from being a Top Buy.

Disclosure: Steve owns no position in any stocks discussed in this article.

Comments

[User 38309:]

New trends and patents in behavioral targeting will help VCLK maintain competitive edge.

2008 Sep 11 08:45 PM

[Sean H.:]

Great article! Some interesting additional info on VCLK and their seemingly very valuable patents in another article here yesterday.

Back in June, I wrote an article titled Why AOL’s “Platform A” May Not Make the Grade. The article discussed a series of changes being made by AOL to position itself as the world’s largest and most effective advertising network, building on its industry-leading Advertising.com network and the recent acquisitions of TACODA, Third Screen Media, Lightningcast, Adtech, Quigo and Bebo, collectively purchased for about $1.5 billion dollars (according to a recent interview with Lynda Clarizio, President of Platform A.) This realignment marked the final stage in AOL's transition from an access business to a global, ad-supported web company.

This new entity, Platform A, says it is offering advertisers access to the most sophisticated targeting and measurement tools available in the marketplace across Platform A's unmatched network of third-party sites, as well as AOL's owned and operated sites. According to comScore Media Metrix, Platform A is said to already reach more than 90% of the domestic online audience. Platform A builds on the success of Advertising.com, which operates the largest third-party display network, and integrates behavioral targeting leader TACODA, Third Screen Media, which operates the largest mobile media network, market leading video ad serving platform Lightningcast, and ADTECH's global ad serving platform.

Previously, I pointed out that I believed a possible material weakness existed in Platform A, one that had the potential to impact its entire structural integrity. That weakness is a lawsuit in which Modavox, (MDVX.OB) a small Phoenix Arizona based company, is suing Tacoda for patent infringement. I believe these patents were issued in 2002 (an interesting date as you will note below in relation to Be Free’s purchase by ValueClick (VCLK)) and 2007 respectively. Their issuance calls into question just who owns the behavioral targeting technology Platform A is both leveraging and dependent on for the monetization of its entire business plan.

Despite the suit having been filed prior to the actual closing of the Tacoda acquisition, AOL management apparently dismissed its relevance and proceeded to close the acquisition for a reported $275 million. Could this prove to have been a costly mistake for Time Warner (TWX) shareholders? If it’s proven that this little company does in fact own the patented technology that AOL thought they were buying with the purchase of Tacoda, then one must certainly wonder if this costly mistake could serve as cause for a potential shareholder action? Interestingly enough, in the legal section of Time Warner’s last filing, I saw little to no mention of this issue disclosed within.

Perhaps AOL’s management and Lynda Clarizio aren’t concerned about Modavox’s patent infringement suit? In my last articlem I posed the question “what happens if they lose this suit and can’t use Tacoda technology anymore?” Perhaps they view this as just one isolated suit by a little guy trying to cash in? Don’t be so sure. Enter ValueClick.

According to MediaPost, ValueClick has previously filed and settled lawsuits against Blue Lithium and Revenue Science for patent infringement on the general principles of behavioral targeting. Now, ValueClick has filed a similar infringement lawsuit against Tacoda. The patents at issue, one issued in 1998 and the other 1999, both deal with creating behavioral profiles of web users.

Ian Lee wrote a nice article containing some interesting commentary called “The End of Behavioral Targeting as we know it” Interestingly, he comments that in 2002, ValueClick acquired Be Free in a deal valued at $128 million. Many had long wondered why the high price tag was paid for Be Free hot on the heals of the Internet bust. Six years later, the real reason for the high price tag has become very clear. The real value in Be Free wasn’t its affiliate platform but the two behavioral targeting patents that it holds, the same two patents they are now leveraging against Tacoda.

One must assume ValueClick views these patents as far more valuable today than the $128 million they paid for them six years ago. It’s likely anyone seeking to acquire those same patents now could expect to pay a multiple of their original sales price. Perhaps AOL’s purchase of Tacoda for $275 million might be a good starting point, or the $300 million Yahoo (YHOO) paid for Blue Lithium. Wait, does either of those companies even own any patented technology for behavioral marketing or targeting? Based on ValueClick’s already settling with Blue Lithium and Revenue Science, and both Modavox and ValueClick going after Tacoda, it would appear not.

So ValueClick owns two patents and Modavox owns two patents (with a couple more rumored to be pending), all seemingly critical to the process of behavioral targeting and marketing. According to David Morgan, Founder of Tacoda, behavioral marketing could jump from $700 million last year to about $10 billion in 2013 making the stakes very high. Both companies are currently suing Tacoda, owned by AOL, for patent infringement through the alleged use of their respective patented technology. Are these patents enforceable, they certainly appear to be. Are they valuable, again they appear to be. But what is the difference between the ValueClicks and the Modavox patents? Ah yes, the million dollar question!

To the best of my understanding, ValueClicks patents acquired for $128 million in 2002 are again related to creating behavioral profiles of web users. It would appear they involve the process of gathering data which then may be used to better target the consumer via online advertising. Modavox’s patents on the other hand relate to the customization of content or what you do with the data once acquired.

In other words, when companies like Tacoda and perhaps even ValueClick procure the information, it appears that it’s Modavox’s patented technology which allows the actual advertisement to be tailored to the consumer based on that data. So perhaps ValueClick owns the front end of the behavioral marketing process while Modavox appears to own the back end. This begs the question “what is the all the behavioral data in the world worth if you can’t monetize it through custom tailoring of advertisements?”

It also begs the question if AOL acquired Modavox, would this potentially help them in their suit with ValueClick? Just a few of the question I’d love to ask Mr. Falco and Ms. Clarizio.

As we see a continued proliferation of advertisers shifting their ad spend online, advertisers will continue to seek and demand that their message has a reasonable chance of reaching their intended target audience. Gone are the days when advertisers will accept the old “Spray and Prey” methodology of online advertising. It is valuable patented behavioral technologies like those owned by both Modavox and ValueClick, which facilitate this all important process.

Again, until this important question of just who the rightful owner of this important technology is. I expect Platform A will continue to fail to make the grade.

2008 Sep 25 08:14 AM