Artificial Intelligence company in the advertising space is approaching good value. I'd bet these shares are cheap at this price, considering their future growth rates.
Consider Buying Rocket Fuel
May. 9, 2014 7:48 AM ET
seekingalpha.com 
SummaryRocket Fuel shares fell 25% Thursday afternoon as the company offered very disappointing second quarter guidance.Second-quarter growth will decelerate to about 65% from 95% in the first quarter and 137% last year as customers spend less with Rocket Fuel amid tough competition.Still, shares are trading less than 2x sales, so the bad news is fully priced into shares.The major downside risk is the entrance of a large tech company into the space, though there is the possibility a larger firm simply buys Rocket Fuel.Given this context and the low valuation, the money has been made on the short side, and going long is the better trade from here.
Rocket Fuel ( FUEL) has been one of many "new tech" companies that promptly became a momentum stock, and has since fallen out of favor. After rallying past $60 when it IPO'd last fall, shares had dropped to $28 Thursday. On Thursday night, Rocket Fuel had a chance to regain some momentum when it reported quarterly earnings. Instead, the company offered deeply disappointing guidance, sending shares down 25% to $20 after-hours. With shares down 70% from their highs, is there some value in FUEL or should you still be a seller of shares? To find the answer, let's explore the quarterly figures.
Rocket Fuel is essentially an online ad platform company. Its software helps to better target advertising to increase the probability a consumer clicks on ads. The software is continually learning from each new interaction to fine-tune its algorithm and improve click rates, which is why Rocket Fuel classifies its software as artificial intelligence. Rocket Fuel can play a role in improving the efficiency of online advertising, which is obviously an area of tremendous growth. As a consequence, the company is growing very quickly, though growth has slowed down and substantial profitability remains far away. In the quarter, FUEL lost $0.18, while analysts were looking for a loss of $0.29 (financial and operating data available here). Revenue of $74.4 million missed by $1.2 million, though it was up 95% year-over-year. Interestingly, Rocket Fuel lost more money even though it nearly doubled revenue, with a net loss of $6.3 million versus $5.4 million a year earlier. Because the company is spending aggressively on sales, marketing and R&D, it actually moved further away from profitability.
Year-over-year, R&D spending rose a whopping 200%, while sales and marketing was up 83% compared to last year. The fact is many companies are aggressively moving into data analytics, which is essentially what Rocket Fuel does to improve online marketing. With many firms moving into the space, it is necessary to spend a significant amount of money on R&D to keep a technical edge. Otherwise, it is impossible to maintain and grow market share. I expect the company to continue to spend aggressively on R&D. As it works to accelerate sales growth in the second half of the year, it will likely be spending on expanding the sales force, which in turn, will elevate those expenses. On the positive side, gross margins improved by 364bp to 49.5%, which suggests the company has significant pricing power, thanks to its strong product offerings. 26% of revenue also came from mobile, which was a solid figure.
Now if FUEL can grow at a breakneck pace, spending is merited to foster this growth. Being a young, growth company necessitates aggressively increasing spending. Investors need to focus on two issues, then: whether the spending is financially possible and whether it will generate a sufficient return. On the first issue, there is no problem, because Rocket Fuel has a solid balance sheet. FUEL carries $218 million in cash against $27 million in debt. With this balance sheet, FUEL can afford to increase spending without threatening the financial integrity of the firm. Under even the worst-case scenario, increased spending would leave the firm generating about -$40 million in free cash flow in 2014. The cash burn will likely be closer to $25 million this year, so this spending does not threaten the firm in any way.
However, this quarter leaves me concerned about whether FUEL will generate sufficient growth to merit the spending on sales talent and R&D. Second-quarter guidance is undoubtedly horrendous, with the company forecasting $88-92 million in revenue, while most analysts were looking for $102 million. This translates to only 62-69% growth compared to last year. For perspective, in last year's second quarter, FUEL grew by about 137%. FUEL's growth rate is falling by half year-over-year.
65% growth would also be a significant slowdown compared to this quarter, when growth was 95%. That type of a slowdown makes me worry that customers are either moving their business elsewhere or using multiple platforms. During the first quarter, customer count grew by 123%, which is fantastic. However, that outpaced revenue growth by 28%, which means spending per customer was actually lower than last year. If customers are spending less with Rocket Fuel, that will put significant downward pressure on growth and raises the possibility that other platforms and services are gaining share.
Now, it is important to note that Rocket Fuel maintained its full-year guidance of $420-$435 million in revenue. Management is predicting a significant surge in the second half of the year, as this range is roughly in line with analyst consensus of $432 million. Frankly, this guidance seems way too optimistic. Basically, it expects to beat consensus by about $12 million in the second half of the year, after predicting a $10 million second-quarter miss on top of a $1 million first-quarter miss. There is no catalyst to propel this type of acceleration. Yes, the company is investing in its sales force, but this growth is slowing dramatically this quarter and the average customer is spending less with Rocket Fuel. I expect the company at some point to take down full-year guidance with sales of $400-$420 million as a more realistic estimate, which would translate to about 71% revenue growth and a loss of $0.30-$0.35.
Second-quarter guidance was weak, and shares took a major hit as a consequence. Now, shares are trading at about 1.75x revenue, which is not expensive compared to other profitless tech stocks. However, there is a constant threat that a bigger, better-funded company like Google ( GOOG, GOOGL) or even Facebook ( FB) decides to fully enter the online artificial intelligence data analytic space. Even IBM's Watson project could theoretically someday compete with Rocket Fuel. An entry from a big player like this could quickly lead to significant market share loss and halt the growth. Barring such a shift in the competitive landscape, Rocket Fuel will likely break even or even turn a small profit next year, which is better than some other falling-momentum stocks like FireEye ( FEYE), which will lose money for several more years.
In the $18-$20 range, FUEL is attractive at a price-to-sales multiple of about 1.7x. With a market cap of less than $800 million, it might even be a takeover candidate from a big tech company who finds it cheaper to buy the technology than build it from scratch. Conversely, the entrance of a big tech company could seriously imperil FUEL's growth, making $20 an unattractive entry point. At $20, I would not short FUEL even after this weak guidance. If you don't see a significant increase in competition coming, I would consider adding a small long position in the $18-20 range, as FUEL could easily merit a 2.5-3x sales multiple, which would push shares back towards $30. At this point, there is more risk to the upside than the downside. The stock is pricing in the bad news and an eventual reduction in full-year guidance. A major new entrant to the space if the major threat to shares from here, but there is also the potential a bigger tech firm acquires Rocket Fuel to get exposure to this space. The money has been made on the short side, and it is wise to cover or consider adding a very small long position in FUEL. |
