Blucora Should Still Have Room To Run

| About: Blucora, Inc. (BCOR)
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After yet another earnings beat -- its third in the last five quarters -- shares of Blucora (NASDAQ:BCOR) are trading near their highest levels in some five years, closing Tuesday at $17.65. The stock has fallen over 6 percent in the first two sessions this week; that drop may be due to some profit-taking after a 21% gain following the release of first quarter earnings on May 2.

Still, Blucora shares have outperformed recently, with shares better than double their levels of late 2011. But even with the improved valuation, the company's fundamentals still look impressive. Trailing non-GAAP earnings are $1.90 per share, putting the trailing P/E below 10, while the company's net cash balance of $126 million represents nearly $3 per share on the books. (Trailing earnings of 81 cents on a GAAP basis offer a much higher multiple, but include substantial acquisition-related costs.) Trailing twelve-month free cash flow is $56.4 million, nearly 10 percent of the company's enterprise value, which sits around $580 million.

And yet, Blucora has posted outstanding growth rates of late; total revenue grew 78 percent year-over-year in 2012, and 43 percent in the first quarter of 2013. Revenue growth is projected to slow in the second quarter, according to the company's guidance, due in large part to stronger comparables; but net sales for the quarter are still guided for roughly 15% growth at the midpoint of guidance, though non-GAAP and GAAP earnings are expected to be flat year-over-year.

Some of that growth was purchased through the company's early 2012 acquisition of do-it-yourself tax provider TaxACT; but much of it has come organically, from the company's legacy search business. The search segment -- which still operates under the InfoSpace name; Blucora changed its corporate name nearly a year ago -- grew revenue by 51 percent and earnings by 35 percent in 2012, according to the company's fourth quarter release.

To be fair, few expect that level of growth to continue going forward. Even the company guided in its second quarter conference call for full-year search segment revenue growth of "approximately 10%," which would appear to project low single-digit growth in the last three quarters of 2013. Tougher comps from a year ago explain part of the slowdown in top-line growth; but another key factor appears to be new policies for advertising partners instituted by Google (NASDAQ:GOOG) last month. These policies were meant to target purveyors of downloadable software that include search toolbars, additional pop-ups, and other online advertising tactics, such as AVG Technologies (NYSE:AVG) and Perion Networks (NASDAQ:PERI) (among many others).

Blucora's search business partners with many distributors of such content, and it expects the effect of Google's policy changes to trickle down to its business. In its most recent 10-Q the company wrote that:

We expect revenue growth in our distribution partner network to slow, possibly significantly, in the second half of 2013, as the impact of the policy changes implemented in the current quarter by...Google..take effect...Revenue from these distribution partners [those who acquire end users through downloadable programs] currently and historically represents less than 50% of total search segment revenue.

On the conference call, CEO Bill Ruckelshaus attempted to mollify some concerns about the change, noting in his remarks that "these changes, while introducing transitions and tough comparisons for us this year, are long-term positive for the market and for InfoSpace." In the Q&A section of the call, he elaborated in response to an analyst question:

[I]t is our expectation, and it has been our experience in the past, that as we move through rules changes, we move through implementation changes, there's a transition period. Some partners are able to make that transition, others struggle, others stop becoming really present and ultimately stop becoming partners of ours. And so, at this point, it continues to be our view that a number of our stronger partners will make this transition, not without some degree of interim impact, but ultimately will figure it out.

There are also longer-term concerns about the move to mobile and its potential impact on online advertisers. Even leaders in the online space such as Google, Facebook (NASDAQ:FB), and Pandora (NYSE:P) are seeing challenges from the smaller real estate and lower cost-per-click rates received from mobile usage versus the legacy desktop platform. As I noted last year, Blucora is certainly not immune to the danger; on the second quarter conference call last year, Ruckelshaus admitted that "revenue models, as they evolve from desktop to mobile, will lag."

In short, it appears that Blucora's recent, explosive, revenue growth in the search segment is unlikely to be sustained going forward. As for TaxACT, the company is expecting pro forma growth for the first half of 9 percent on the top line and 7-8 percent on the bottom line compared to the first two quarters of 2012. (The segment operates at minimal revenue and an operating loss in the second half, given the obvious seasonality of the tax preparation business.) Q1 revenue was about 60/40 in favor of the search business; on an annual basis, the tax preparation segment seems likely to post about 20 percent of total revenue. The tax segment did provide roughly 32 percent of income in 2012, despite its first month's results being excluded from calculations (as the TaxACT acquisition did not close until January 31, 2012.) With the TaxACT business posting single-digit growth while accounting for just one-fifth of sales and less than one-third of profits, it's unlikely the tax preparation segment will able to, on its own, boost top- or bottom-line growth for Blucora back to recent rates. Even given the tax preparation segment's higher margins, the search segment has been the driver of the company's recent torrid growth, and will be largely responsible for its organic growth rates going forward.

Given the near-term headwinds in search, and the ever-present fears of competition and concentration -- Google provided 77% of search revenue in 2012, according to the Blucora 10-K -- the company's valuation appears to make more sense. While the recent growth rates look like they should support a higher cash flow and earnings multiple, it's clear that the next two years for Blucora will not see the growth of the last two. As such, the roughly 10x multiple on earnings and cash flow seems cheap -- particularly given the company's net cash balance -- but perhaps not as compelling as its trailing fundamentals might suggest.

But there is one more key reason for a long-term bullish stance: the aforementioned cash balance and its potential use. The company's cash and investments total some $400 million, with roughly half of the cash coming from a convertible debt offering in March. The stock actually sold off on the news, likely due to fears of the bonds' dilutive impact on equity holders. But that cash now represents a war chest for another acquisition.

Blucora's interest in acquisitions -- which include two smaller purchases in 2010 and 2011, of Make the Web Better and Mercantilia, respectively -- is driven in large part by its balance of net operating loss carryforwards. According to the 2012 10-K, the company's NOL balance at the federal level is still a staggering $723 million, with the majority of the assets not expiring until 2020-2024. The NOL balance was a key rationale for the TaxACT acquisition; the tax business offered little, if any, synergies with the legacy InfoSpace business. Yet the profitable nature of TaxACT provided a clear use for Blucora's carryforwards; after a proposed acquisition of TaxACT by H&R Block (NYSE:HRB) was scuttled due to antitrust concerns, Blucora (then still known as InfoSpace) stepped up and bought the company for the exact price originally offered by H&R Block.

On the most recent call, CEO Ruckelshaus noted that the company "continue[s] to focus on acquisitions as a way to build value." The company has noted in the past that any potential targets do not necessarily need to be complementary to either the search or tax businesses; profitable companies whose tax burdens can be lessened or erased by Blucora NOLs will be considered.

This strategy has clearly worked in the case of the TaxACT purchase; BCOR stock is up roughly 50 percent in the sixteen months since that acquisition. Free cash flow went from less than $17 million in 2011 to $45 million in 2012; while the growth in search created some of that improvement, the addition of the tax segment surely boosted cash generation, given that its segment income was $30 million for the eleven months following the close of its purchase.

So with that $400 million available for yet another purchase, Blucora management has a clear path to substantially increase its earnings and cash flow. And with the substantial NOL balance, it does not need to find a takeover candidate whose business complements the company's existing franchises or even one with compelling top- or bottom-line growth. It simply needs to find a profitable company with a compelling niche somewhere in the Internet space (most likely; it's hard to imagine the company buying, say, a bricks-and-mortar retailer).

Using that $400 million -- or a portion of it -- on a profitable acquisition at a reasonable valuation could provide a significant boost to the company's bottom line. A $350 million acquisition at even 17x net income -- an admittedly substantial multiple -- could add roughly $20 million of net income to Blucora. Add in the tax benefits of the NOLs, and such a purchase could add as much $30 million of profit to Blucora annually.

That type of acquisition could add as much as 65 cents per share to the bottom line, moving Blucora's corporate earnings to the $2.50 per share range and its free cash flow to the $85-90 million level. Even if the near- and mid-term headwinds facing search cause its revenue and earnings to plateau, the modest growth from TaxACT and any potential growth from the acquisition would likely give the company a reasonable earnings multiple. And at a current price of $17.65 per share, a 10x earnings and cash flow multiple would move the stock to a range of $20-$25 per share, representing appreciation of roughly 15 to 40 percent.

A cheaper acquisition multiple would only improve Blucora's earnings power, and it's worth noting that TaxACT was purchased at just 7.6x trailing adjusted EBITDA. A similar purchase -- in size and valuation -- could easily add $30-$40 million to cash flow; with the company's tiny capital expenditure requirements (just $3.8 million company-wide in 2012), nearly all of those operating earnings will come back to Blucora, and its shareholders.

So if Blucora can execute another acquisition similar to that of TaxACT, its earnings seem likely to move over $2 per share and its free cash flow could approach $100 million annually. Given the current share price of $17.65 and its current enterprise value below $600 million, that type of earnings power would almost certainly boost Blucora's valuation.

The opportunity for such a purchase may not come up immediately; Blucora's acquisition strategy has been in place for years, yet TaxACT remains the company's only substantial purchase. (The Make The Web Better and Mercantilia acquisitions totaled $29 million, including liabilities assumed in the Mercantilia deal. That deal turned out to be a flop; the business was sold thirteen months later for $250,000 after being bought for $16 million in May 2010.) In a 2010 conference call, former CEO William Lansing argued that "the big opportunity for growth remains on [the] acquisition front." Indeed, the current CEO Ruckelshaus appears to have been recruited in large part because of his M&A experience at Credit Suisse First Boston and Expedia (NASDAQ:EXPE). In the press release announcing Ruckelshaus's permanent hiring as CEO in April 2011 (he took over on an acting basis in late 2010), chairman John Cunningham emphasized the new chief's "significant experience in mergers and acquisitions" and named Ruckelshaus as "the right person out the right strategic opportunities."

Ruckelshaus' experience and the company's patience with its long-running balances of both cash and carryforwards should give investors confidence that an acquisition, if and when executed, will be smart, targeted, and shareholder-friendly. Blucora is not going to chase growth at any cost, or enter uncertain or immature business segments. The company is looking for a stable, profitable, cash-generating business whose earnings can be shielded from taxes through Blucora's substantial NOLs. If it can find such a purchase, its fundamentals may look different than they do today -- but they will look just as tempting. The only difference will be that Blucora's future fundamentals -- strong earnings and strong cash flow -- will be far more sustainable than the current impressive, but faltering, revenue in search.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.