Citigroup Initiates Coverage of ValueClick With "Buy" (VCLK)

| About: Conversant, Inc. (CNVR)

Citigroup Internet analyst Mark Mahaney initiated coverage of ValueClick (ticker: VCLK) with a "Buy" rating. Excerpts from his 31 page report:

SUMMARY
* We are initiating coverage of VCLK with a 1H (Buy, High Risk) rating and a $24 price target. Key positives include: 1) Strong secular growth of Net advertising; 2) A sizeable $3B+ market for Internet Ad Networks; 3) A leading position among Ad Networks; and 4) A broad solution set for Net advertising.

* We believe the market has overly discounted competitive risks and underappreciated product breadth. We believe the complexity of VCLK -- due in part to acquisitions -- has also deterred investors. We believe these factors are more than reflected in VCLK's valuation. We see the 13X 2006 EV/EBITDA multiple as attractive vs. our estimated 61% 2006 EBITDA growth. Further, we believe Street estimates are overly conservative -- we are looking for $0.60 EPS in '06 vs. $0.57 consensus.

* Key risks: 1) Margin & EPS risk in key Media segment; 2) A fluid competitive landscape; 3) M&A integration risks; and 4) Limited international presence.

A leading position among Internet Ad Networks -- Post the acquisition of Fastclick, ValueClick now offers the 2nd largest Internet ad network after Advertising.com, measured in terms of monthly unique visitors. Per comScore Media Metrix, ValueClick (unduplicated combined visitors of ValueClick and Fastclick) had almost 118MM monthly unique visitors in the September quarter vs. 135MM for Advertising.com. The third largest ad network, Vendare Media, had 85MM uniques.

We note that all of the leading Internet ad networks above are privately held or are part of larger public companies – e.g. Advertising.com was acquired by AOL in 2004. This leading position allows ValueClick to offer online advertising to various marketers with varied needs in terms of target audience and demographics. The larger network allows ValueClick to have an access to higher online advertising inventory, and that translates into higher revenue. The size of ValueClick’s network is impressive even when compared to all Internet properties and not just ad networks. Specifically, ValueClick ranks as the third largest ad focused property after Advertising.com and Yahoo!, when measured by monthly unique visitors, although it would rank the 6th largest when measured by total pages viewed...

VCLK INVESTMENT NEGATIVES

Our High Risk rating on VCLK reflects a balance between the significant competitive and acquisition risks we detail below and the company’s strong balance sheet ($225MM or $2.57 per share in cash as of September), its solid free cash flow generation ($47MM estimated in 2005), its relatively substantial liquidity (1.9MM average daily trading volume) and its sizeable float (81MM). In terms of its liquidity, we would point out that VCLK’s average trading volume is larger than that of all the other mid-cap stocks we follow (CNET, EXPE, MNST). We acknowledge, though, that the specific risks detailed below may impede the stock from reaching our target price:

1. Margin and EPS risk in ValueClick’s Media segment
– The Media segment is far and away this company’s most important segment. Again, it accounts for approximately 77% of the company’s revenue and 67% of its gross profits.

In the September quarter, Media gross margin reached a record high 64%, up 1,000 bps Y/Y. Scale and the acquisition of very high gross margin businesses like Pricerunner and Webclient have been the main drivers of this margin expansion. Following the Fastclick acquisition, this segment’s gross margin should decline as Fastclick had been reporting materially lower gross margins in the range of 35%. (Fastclick historically provided a much higher revenue share with Website publishers than ValueClick.) But our model does assume that ValueClick attains and maintains 60% gross margins in its Media segment going forward...

The risk here is that competition from other Internet Ad Networks and from leading Internet advertising companies like Google and Yahoo! could pressure these margins. Our take is that this potential pressure is a major Bear issue on VCLK shares. And given the sensitivity of ValueClick earnings to this segment’s gross margin trends, this is a very legitimate risk. We detail below the sensitivity of our 2007 GAAP EPS estimates to changes in Media segment gross margins. In short, every 100 bps decline in Media gross margins causes a $0.02-$0.03 hit to EPS.

We view the Media segment gross margin as essentially ValueClick’s revenue share or TAC (Traffic Acquisition Costs) with its Website publisher partners. So a 60% gross margin implies that for every $1 in ad revenue that ValueClick generates for its partner, $0.40 is shared with that partner. What are the comps here? Fastclick, before it was acquired by ValueClick, had 35% gross margins. So by buying Fastclick, ValueClick took out one of its low price competitors. Nice move.

But Google with its AdSense for Search and Adsense for Content programs and Yahoo! with its Overture Affiliates program and its Yahoo! Publisher Network are also increasingly competing in the ad network business. Google’s publicly disclosed TAC is currently 78%. While we believe that Google’s Adsense for Content programs with smaller Websites likely has a materially lower TAC, it is still very likely to be higher than ValueClick’s 40% TAC. We note that Google recently launched a new service called Onsite Advertiser Sign-Up, which allows Websites to connect with a wider range of small advertisers using Google’s advertising network. If this program is successfully executed, if Google makes a major push behind this, and if it offers an aggressive TAC to entice Websites, then here’s where the gross margin boom could be lowered on ValueClick.

We have attempted to capture this risk by flat-lining ValueClick’s Media gross margins at 60% in the out years. The 1,000 bps in Media gross margin expansion over the past year indicates the potential impact of more scale on this segment’s margins. (It also highlights the positive margin impact of the Media segment revenues that are not Ad Network based.) So we are implicitly assuming that ValueClick’s scale-driven gross margin expansion going forward is offset by competitive gross margin pressures. We may not be conservative enough here – hence, we are providing more of a downside than an upside case in our EPS sensitivity analysis. This is clearly a major investment risk for VCLK. But as one final hedge here, we would note that to date ValueClick has consistently competed against lower margin companies (like Fastclick) and not experienced margin degradation.

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