VitalStream Post-MySpace: A 'Black Diamond' Buy?

| About: VitalStream Holdings (VSTH)

In the diamond industry there are many types of diamonds you can buy. Each offers its own risks and its own profit potential. You can save up three months' salary and buy a sparkling diamond ring for your fiancee, you can buy a freshly cut diamond and have it mounted yourself, or you can buy a black diamond that looks more like a rock then a precious gem. Each level of quality offers greater opportunities to profit, but also greater risks that you must take in order to achieve those higher profits. Such is the case for VitalStream (VSTH).

After announcing that they had lost a major partnership with Myspace on Monday, the company looks more like a black piece of coal then a diamond in the rough, but for investors who don’t mind taking chances on an uncut stone, a real opportunity may be presenting itself after the stock has sold off by over 25%.

There is little doubt that online video is hot. Everybody wants a piece of the action and if you could compare the VOD industry to the diamond industry, you could argue that Akamai Technologies represents the most expensive engagement ring in this space. They have the most compelling technology, but at a valuation of $7.8 billion this little kept secret has very limited upside for jewelers willing to invest in their technology. YouTube and DivX may represent a cut diamond waiting to be mounted, but at a price of $1.6 billion and $700 million respectively, these developing diamonds aren’t exactly cheap either. However, with a market cap of only $155 million Vitalstream could be a diamond in the rough when it comes to VOD technology. Like black diamonds it doesn’t come without a high degree of risk, but for jewelers who understand what they are doing, there may be a real profit opportunity.

VitalStream’s technology is all about streaming video. They have the technology to do downloads, but streaming is their bread and butter and over the last few years, the company has done an impressive job of demonstrating that their technology deserves a place in the VOD market. Along the way, they’ve moved from being an over the counter penny stock to a small cap Nasdaq play and while definetely risky, the company represents a rare value opportunity in the hot VOD market. Over the last few years the company’s focus on streaming technology has managed to win them contracts with ABC, Comcast and up until September 30th of this year, MySpace. Unfortunately for VitalStream, after MySpace moved from being just 11% of their revenues in 2005, to 33% of the company’s revenues last quarter, MySpace decided to take their business in house and has put the company on notice that they intend to end their business relationship at the end of the 3rd quarter. When the news leaked out last Friday, Wall Street punished the stock by selling it off over 20% and when they actually announced this development on Monday morning, the markets gave VitalStream another 3.5% haircut to boot.

Losing the MySpace’s business has undoubtably been a huge setback for the company, but even without the 4th quarter MySpace business, VitalStream still expects to generate $25 - $27 million in revenue this year and assuming that they can replace the lost MySpace business with their new advertising inititives, they are predicting that they should achieve $38 - $42 million in revenue for 2007. Central to VitalStream’s approach has been their focus on being a revenue center instead of a cost center for their business partners.

When it comes to VOD, most companies think servers, bandwidth and IT expenses, but VitalStream provides these hosting services for content owners and instead of making their partners buy new technology, they instead use the content to sell advertising so that all content owners need to worry about is cashing their checks in exchange for cutting VitalStream in on a piece of the action. Because the company is focused on providing multiple VOD solutions for their customers, they’ve taken a format agnostic approach and are able to use either flash or WMA based VOD technology. The company has recently expanded to international markets and earlier this year, they acquired a company named EonStream that will be crucial to the company’s success or failure.

From a consumer standpoint, EonStream is a real pariah. They deliver pre-roll, mid-roll and post-roll advertising that you can’t fast forward through. While YouTube has resisted implementing this technology, VitalStream has been more then happy to fill this void for content owners who want to capitalize on the high CPM opportunities that online video ads offer. From an investor standpoint however, the pre-roll ad is the future of VOD and with the company positioned in the middle of this market, they may be one of the largest beneficiaries from the challenges that the PVR is placing on the ad industry.

Historically, content has been paid for either on a subscription basis or on an advertising basis, but as the PVR has eliminated advertisers ability to reach live audiences, advertisers have struggled to deal with the loss of the live audience. Through their acquistion of EonStream, VitalStream has created a solution for advertisers who still cling to the forced 30 second ads. Unlike time shifted content, streaming content is always viewed live. Because VitalStream can dynamically update their ad inventory, they can ensure that people who stream their content on a Thursday night are able to see trailers for movies coming out the next day. They can also require viewers to enter demographic information and can target those viewers with geographic or demographic sensitive advertisments in a way that broadcast television can only dream about.

As the company has moved their VOD technology forward, they’ve wholeheartedly embraced this ad platform and have begun integrating it into their core VOD services over the last few months. With this year being the first year that internet usuage has actually surpassed television usuage when it comes to competing for our leisure time, more and more consumers are adopting VOD and streaming video as an entertainment solution and VitalStream is well positioned to take advantage of this trend. With over $20 million in cash and a balance sheet close to $50 million dollars, the company trades at slightly more then three times their book value and in an industry that just saw Google pay over $1.6 billion for YouTube, this number seems awful cheap to me even with their loss of the MySpace account.

Investing in a stock like VitalStream contains a high degree of risk. The company still isn’t profitable and it will take at least 6 months for them to recover from the loss of the MySpace revenue. They’ve authorized a ridiculous 290 million shares and have already announced their intention to price another 8.95 million shares in a secondary offering.

If the company moves forward with their underwriting at these valuations, I would be very cautious with this stock, but on the plus side, the MySpace account was a real drag on the company’s gross margins and with the loss of the account, VitalStream is expecting to exceed the 65% gross margins that they had previously predicted for 2007. While their technology isn’t necessarily unique and their contracts are always at risk as companies become more reliant on VOD technology, VitalStream has still done an excellent job of carving their way into this niche market. With strong organic growth amoung their own customers and the potential to partner with other studios and media companies in the future, VitalStream may be worth considering for those who don’t mind investing in a black diamond. Only time will tell whether it ends up being cubic zirconia or whether a diamond really exists beneath the surface, but after seeing the beating that their stock has taken, it could end up being a real gem, if the company can continue to execute on their business plan.

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