ValueClick Inc.

ValueClick is one of the largest pure Internet advertising agencies. The company has 4 primary operating segments. The largest is the Media business (more than 50% of sales), which creates Internet-only ad campaigns for its customers, and distributes the ads through search, e-mail, and a network of over 15 thousand web sites, reaching over 80% of all U.S. internet users, a reach second only to Yahoo! (YHOO). The Affiliate Marketing business (~20% 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 (25% 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 (Mediaplex) unit (5% of sales), which provides software tools for both advertisers and publishers to track the efficiency of ad campaigns.

Internet marketing is a great business model, 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 140%. 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 159 million dollars in cash 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. Financially, there are zero concerns.

Growth potential is a bit of a wild card. The Internet ad market is still growing, with some estimates reaching 20% annual expansion for the next 3 years or so. Internet ads provide advertisers with performance data which helps in determining return on investment, a notoriously difficult task with the historical impression-based model. However, I'm concerned that ValueClick will not be able to capture its fair share of this growth. ValueClick currently competes with some heavyweights in internet marketing, including Yahoo!, Google (GOOG), Microsoft (MSFT), and newly-public AOL (AOL). Additionally, traditional integrated ad agencies like Omnicom (OMC) and WPP Group (WPPGY) have moved into the Internet advertising fray. All of these names have larger resources and often more established client relationships, and some of them can offer integrated marketing that spans not just the 'net, but also television, radio, and print.

This flows right into a discussion of ValueClick's competitive position. While the company is currently one of the top names in online advertising, the durability of that position is not very strong. For one, the FTC investigation into unfair trade practices in the lead generation portion of the Media division in 2007 caused several clients to leave, and they are not coming back. In the affiliate division, the company lost its largest client, eBay (EBAY), in 2008, as they decided to pursue their own program. These examples illustrate the low switching costs and overall lack of built-in competitive advantages in the business. Barriers to entry in affiliate marketing and technology are also low. There are dozens of technology platforms for affiliate marketers, from direct Commission Junction competitors like LinkShare to small, single-site programs. So, ValueClick earns a "D" for durability of competitive position, or moat.

Management is also less-than-stellar. For one, ValueClick has engaged in some poorly conceived and priced acquisitions, writing down over $300 million in goodwill last year from previous acquisitions. Also, large share repurchases were executed at prices 20% higher than current levels. The FTC investigation, while settled for about $3 million, really hurt client perceptions of the company. The company's governance also has numerous anti-takeover provisions, which are concerning as buyout potential is a clear positive in the stock's favor. In a highly competitive and no-moat business, management is critical to success and it is not that impressive here.

While the company is not close to MagicDiligence Top Buy material, I still rate the company as a second-tier buy. Internet marketing is still an organically expanding business, and ValueClick has been pushing into new geographies where it should be able to grab some market share. The price is certainly cheap at 13.8% of trailing operating earnings, and 13.1% of forward 2010 estimates (an average number is about 7%). Most intriguingly, the industry is experiencing consolidation, and there is a good possibility that a larger competitor may place a generous bid to acquire ValueClick's varied businesses and large affiliate network. AOL and Yahoo! both look to be good fits given their focus on display ads.

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