This might have something to do with it....
Net: We believe that risk to VCLK earnings in 2007/2008 remains, as the lead-
generation industry responds to federal probes into aggressive tactics.
Heightened advertiser awareness of aggressive marketing tactics has translated
to caution and advertiser attrition for VCLK's WebClients unit, we believe,
for small and large advertisers alike. We have reduced estimates for 2Q07 and
FY07 accordingly. Finally, VCLK's heightened concern on the disclosure of
facts relating to their lead-generation practices has culminated in their
filing a lawsuit in LA County Court against unnamed current and former VCLK
employees (attached herein) alleging damages due to breaches of
confidentiality agreements. Reiterate Underperform rating and $24 target.
* Lead Gen Unit Scrambles, Margins At Risk: The FTC inquiry has fostered
greater awareness of aggressive tactics and poor lead quality of highly-
incentivized lead-generation. We believe VCLK's lead-gen arm has attempted
to stem advertiser attrition by inserting third-party offers in the
Webclients incentivized paths, sharing revenue it hadn't shared
historically. We have reduced our 2Q07 media division revenue and margin due
to these pressures, now anticipating an incremental $3mm drag on revenue
during a seasonally slow quarter. Our estimate assumes 18.5% growth in media
revenue vs. consensus 25%.
* MeziMedia Acquired To Diversify Away from Lead-Gen: VCLK announced the
acquisition of MeziMedia, fortifying its position in comparison-shopping for
$100mm-$352mm, depending on earn-outs. The deal should allow VCLK to
modestly raise guidance for revenue/EBITDA once the transaction closes,
potentially offsetting some of the underperforming businesses, although the
acquisition should be dilutive in the near-term. Longer-term, we believe any
efforts to move away from incentivized lead-gen should increase shareholder
value.
* Lawsuit Filed Against Former VCLK Employees: On July 3rd, VCLK filed a
lawsuit against unnamed current and former employees, alleging that breaches
of confidentiality led to "lost revenues and profits, damaged relations with
prospective customers, decreased ability to raise capital, deflated stock
price, decreased ability to engage in merger and acquisition activity,
losses of personnel and related costs, and material and continuing loss of
value of its trade secrets." We have attached a copy of the lawsuit for
review.
* Shares Overvalued Until Estimate Revisions Fully Understood: Changes in VCLK
business practices are under way. We believe estimates remain at-risk.
Details
Summary and Investment Conclusion: Uphill Battle With Shaky Business Model
It comes as no surprise to us that VCLK's lead gen units have been struggling
this quarter. The FTC's inquiry into lead gen business practices, industry-
wide, not just at ValueClick, has increased advertiser awareness of the
shortfalls of the lead generation business units. We remind investors that
the problem is not the FTC's investigation of VCLK " the problem, in our
view, is that the aggressive tactics used by many lead generation companies
may be deemed deceptive to consumers and likely correlates with low lead
quality. In a recent lawsuit filed by the company against current and former
VCLK employees, the company alleges it has "lost revenues and profits,
damaged relations with prospective customers, decreased ability to raise
capital, deflated stock price, decreased ability to engage in merger and
acquisition activity, losses of personnel and related costs, and material and
continuing loss of value of its trade secrets." The company is suing
unidentified employees who may have disclosed information to "competitors and
financial analysts."
Estimate Reductions, Possibly the First of Many
In what we believe may be the first of many estimate cuts, we have reduced
the year-over-year growth estimate for the media division from 22% to 18.5%
in the second quarter, essentially a reduction of $3mm in revenues.
* Our revised revenue estimates fall slightly below the guided range. We
believe the company did its best to backfill advertiser demand by
cooperating with third parties to insert offers into its incentivized path.
Those tactics are increasingly difficult as advertisers have started to
turn away from incentivized lead gen.
* That additional sharing of revenue may have impacted margins
disproportionately. Due to the high margin nature of lead gen, we have
reduced our EBITDA margin estimate for the media division from 23.1% to
22.3%, a reduction of $1.5mm in EBITDA. Our estimate for total company
EBITDA in 2Q has fallen to $40mm, at the low end of the guided range of
$40-$42mm.
* We note that the company offered 2Q07 guidance a few weeks before
announcing that it received an inquiry letter from the FTC. If our
estimates prove correct, this would be the first quarter in recent memory
that VCLK has not hit at least the middle of the guided range.
Finally, we note that eBay, the largest commission junction merchant,
restricted how it pays its affiliates that drive traffic to eBay's
properties. On May 15th, eBay announced it would no longer pay affiliates who
drove traffic to eBay using paid search, effectively reducing its
"advertising competition." We believe this may have had an impact on
Commission Junction, ValueClick's affiliate marketing division, but
estimating the magnitude of that impact is very difficult at this point. We
also note that the changes to its lead gen business and to eBay's policies
addressing search-driven customer signups were intra-quarter events, and may
cause the company to guide lower for 3Q07 and FY07.
What to Make of the Lawsuit?
We believe investors should review the lawsuit and arrive at their own
conclusions.
Hence, our views on this suit are limited to the following:
* We believe most companies would not have chosen to file this kind of
lawsuit against current and/or former employees.
* In its complaint, ValueClick alleges lost revenues and profits, as well as
a decreased ability to raise capital and engage in merger and acquisition
activity. We do not believe these allegations are in line with the
consensus view on the stock.
* The suit was filed on July 3rd, 2007. In our view, this timing raises
questions about whether fundamentals have deteriorated recently.
How Much Exposure is There?
The company stated in a recent 8-K dated 5/22/07 that overall lead generation
accounted for more than 60% of media revenue and that promotional lead gen
accounted for less than 30% of media revenue. If we assume overall lead gen
was 61% of media revenue and promotional lead gen was 29%, that would place
promotional lead gen in the $31m range in 1Q07, or around 20% of total
company revenue. However, it is also possible that some of the revenue in
VCLK's affiliate marketing business (Commission Junction) may be generated by
lead gen affiliates. Separately, Google's recent changes to landing page
quality score and eBay's refusal to pay affiliates for search-derived sign-
ups have made it more difficult for affiliates, including those working with
Commission Junction, to make money.
Based on our discussions with industry executives, as well as on VCLK's
public comments, we believe promotional (incentivized) lead generation may
generate EBITDA margins in the 50% range. If that assumption were accurate,
promotional lead generation could represent as much as $15m in EBITDA in
1Q07, which would equate to 37% of total company EBITDA.
Other Industry Data Points
We have learned that some advertisers have recently pulled budgets from the
incentivized space as a result of the now-public FTC investigation, and that
volumes for some companies are trending down 15%-20% from the time period
before the VCLK 8-K. A 20% cut to high-margin lead generation revenue for
half of a quarter could result in a $3m-$5m reduction to 2Q EBITDA, but a
greater impact to 2H07 estimates.
To offset the decline, we have heard specific instances of VCLK looking to
place advertiser offers from other lead gen companies in the VCLK
incentivized paths, presumably to make up for the attrition of its own
advertiser base. The FTC inquiry has fostered greater awareness of the
aggressive tactics and poor lead quality on heavily-incentivized leads.
Advertisers Pulling Away From Incentivized Lead Gen
We have learned that a number of advertisers have decided to pull marketing
budgets out of the incentivized lead generation area, including:
* BMG Music
* Blockbuster Online
* Classmates.com
* Gevalia Coffee
* People PC
* And many others...
We believe that the driving force behind these decisions is a greater
awareness and focus on lead quality vs. the prior mindset of focusing on lead
quantity. The FTC's involvement in the incentivized lead generation space
could also be spooking some advertisers, as the advertiser can ultimately be
held liable (and penalized) for receiving an economic benefit from a lead
generated via unacceptable tactics.
2Q RBC vs. Consensus
Our estimates now call for 18.5% growth in the media business, down from 37%
and 43% over the past two quarters. We are watching the media segment margin,
which we estimate at 22.3% in 2Q, down 150 bps sequentially. Our 2Q estimates
are below consensus and at the low end of the guided range, with revenue and
EBITDA of $154m and $40m, respectively. The company has guided 2Q revenue and
EBITDA to $157m-$159m and $40m-$42m, respectively.
Our estimates for 2007 and 2008 remain below consensus
We estimate revenue of $627m and $659m in 2007 and 2008 respectively, well
below consensus of $665m and $771m. Our estimates assume modest (2%) y/
y growth in media revenue in 2008, as the lead generation industry is
reformed. Consensus revenue growth of 16% in 2008 may prove aggressive, if
VCLK were to experience a downtick in lead gen revenue.
Our estimates had already assumed that a reset in the lead gen business would
happen in 3Q07 and beyond, so our estimate changes today are limited to the
second quarter. Full year estimates fall by an amount commensurate with our
2Q cuts. |
