InterActive Is Slowing Down

| About: IAC/InterActiveCorp (IAC)
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Shares of InterActive Corp (IACI) plunged on their quarterly results, falling over 10%. Investors are now faced with the question of whether they should sell at a significantly lower price or take advantage of this drop to buy shares. I believe this quarter is a sign of continued weakness and deterioration of IACI's business and am not a buyer at current levels. I will first go over quarterly data and then show why IACI is comparatively overvalued.

IACI reported EPS of $1.29 on $757 million in revenue. EPS was a big beat versus expectations of $0.95 while revenue was very disappointing with analysts looking for a bit more than $805 million. It is important to note that IACI recorded about $14 million in gains from the sale of Newsweek and Rezbook, making continuing EPS closer to $1.13, still a notable beat. However, I believe that there are core issues that make these EPS not-representative of the broader picture.

First, while revenue grew 6% on the year, operating expenses fell by 0.3%, which resulted in significantly higher operating margins. While quarterly revenue rose by $42 million, operating income grew by $44 million. While companies can certainly grow operating margins, rarely does operating income grow more nominally than revenues when a company is growing, and almost universally, such operating income growth is unsustainable. In fact, this decrease in expenses is really an aberration. In the first nine months of this year, operating expenses have actually grown by 10%, in-line with YTD revenue growth. There were likely transitory factors in the general and administrative account, and there was also a benefit from seasonally lower traffic acquisition costs. On the whole, I believe these lower costs are not permanent, rather they were an anomaly from recent results, helped by traditionally lower summer expenses. Transitory expenses account for about $0.20 of EPS, leave the company with sustainable EPS of $0.93 in my estimation, slightly below analyst expectations.

Further, most internet companies have been reporting significant revenue growth in excess of 10%. Many social networking sites like Facebook (NASDAQ:FB) and LinkedIn (LNKD) have been able to grow revenue by over 40%. Even Google (NASDAQ:GOOG) expanded revenue by 12% despite continued weakness at its Motorola unit. InterActive has only been able to muster 6% growth, and it is decelerating. Year-to-date revenue growth stands at 10% with a deceleration over the past three months. In the internet sector, decelerating growth can quickly lead to negative growth. In fact, 6% growth suggests a loss of market share with internet usage expanding faster than that. Consumers are losing interest in IACI's products like Ask.com and About.com.

There are data points within this quarterly report that suggest their diminishing perceived value in IACI's offering. Their search and applications segment, the driver of their business, saw a 17% increase in traffic, but revenue only rose by 10%. IACI is generating less revenue per eyeball, which is amazing in the current environment. Looking to sites like Facebook and LinkedIn, revenue is growing dramatically faster than users as they learn how to better monetize their consumer base to advertisers. The exact opposite is happening in InterActive's business. I was honestly stunned by this development given the explosive growth in more lucrative targeted advertising. There are two reasons why I expect this trend to continue.

First, competitors have been able to expand revenue per user by monetizing mobile better. InterActive's websites, in particular About.com, are simply not built for mobile viewing like a Twitter or Facebook is. Attempts to monetize our sites, like dictionary.com, via applications has also been a struggle with a mere 3% growth, thanks to the rabid competition within the App stores. As more internet traffic is done via mobile rather than desktops, I expect IACI's revenue per pageview to continue to deteriorate.

Second, much of IACI's business is dependent on Google with users going to about.com after searching on Google and seeing the site at or near the top of the results. Google this year has been updating its search algorithm to reflect shifts in how people search with a bigger focus on underlying concepts within each query. These changes have negatively impacted the prevalence of IACI in search results, cutting traffic. Essentially, few web users start on about.com when they have a question, instead going to Google to find the best answers. Fewer and fewer of these users are ending up on an IACI site, which will negatively impact revenue growth going forward. For these reasons, I expect revenue growth to continue to decelerate.

With 6% revenue growth in this most recent quarter and websites facing deceleration, IACI still trades at 25x trailing earnings. For comparison, Google, with twice the revenue growth, is trading at 28x. For me, I would rather pay that mild premium for a company with faster and accelerating growth. Moreover if you take out net cash, these firms have an identical multiple, at roughly 23.5x. With a struggling business, IACI is relatively expensive at current levels.

I also expect 2014 estimates to come down significantly for IACI. Analysts had been looking for 19% EPS growth to 4.62 (a forward multiple of 12x) on 12.5% sales growth before the release of this surprisingly weak quarter. Given this last quarter, where revenue growth dropped dramatically to 6%, less than half of expectations, I believe 12.5% growth is extremely unrealistic. I believe IACI will be able to grow revenue between 0-6% next year as headwinds from mobile and a less-friendly search algorithm continue. As such, revenue of between $3.05 and $3.23 billion in 2014 is a more reasonable estimate. I consequently expect sustainable EPS of between $3.85 and $4.05, for a forward multiple of 13.5x.

Investors need to ask whether they want to pay 13.5-14x earnings for a company facing decline that is overly reliant on desktop usage and Google searches. As seen by lower revenue per user, there is no economic moat to about.com or its other sites. Consumers have been perfectly content going to the different sites that Google now leads them to. The dramatic deceleration in this quarter gives investors no reason to believe otherwise. In a space where so many companies are accelerating revenue growth and taking advantage of the switch to mobile, I simply see no reason to invest in IACI. With a forward-ex cash multiple of 15.5-16x, Google trades at a relatively small premium to IACI given its much better growth prospects, especially as there is a significant chance IACI revenue growth turns negative in late 2014 to 2015.

Yes, given the sharp drop in IACI, I can see investors wanting to buy shares on the cheap, but I do not believe this is a good strategy as the business is in decline and is not that inexpensive. Given the massive headwinds and declining performance, I would be uncomfortable paying more than 10x earnings, or roughly $40 per share. The risk in IACI is to the downside. Google is a far safer bet.

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.