I am advocating Alloy, Inc. (ALOY) as a long based on numerous catalysts this year (including upcoming earnings), thereby raising visibility of the company (and its cheap valuation) to both public market investors and ultimately to strategic buyers. ALOY trades at 3.4-4.1x 2008E EBITDA, based on management’s range of guidance which was provided on December 5, 2007 (among the catalysts is my expectation that guidance will be reiterated in the next couple of weeks when earnings are announced).  This valuation doesn’t account for NOLs (over $35M as of July 2007).  If one adjusts for NOLs, ALOY is trading for 2.9-3.5x management’s EBITDA guidance.  Based on EBITDA guidance and $8M of anticipated capital spending, the implied FCF yield at the current stock price is ~15-20%. 

 

Valuation provides reasonable downside protection.  If  the company were to miss the low-end of guidance ($20-24M EBITDA on $225-240M Revenue) by 25%, this implies a current valuation of 5.4x EBITDA (unadjusted for NOLs) for a company strongly positioned with marketers/advertisers seeking to penetrate the Gen Y community through non-traditional approaches.

 

Based on the company achieving the mid-point of guidance (which I try to validate in some detail below) and trading at just 6x EBITDA, the company could soon trade to ~$12 (over 65% upside) as visibility from results improves that supports management’s guidance.  More importantly though is greater upside that could materialize over the next two years, based on successful execution of the Channel One strategy coupled with the on-line ad network business growing (both described below).  In the case that both of these businesses grow as management envisions, it’s likely that EBITDA will be $35M in 2010.  At just 6x, this implies a stock price of $17 (over 135% upside).  However, if management does achieve $35M of EBITDA in 2010, the valuation multiple is more likely to be above 6x (each multiple point, with no change to current shares outstanding, is ~$2.50 of change to share price).  The company has a strong balance sheet and continues to buyback shares.

 

ALOY is almost exclusively focused on marketing to the Gen-Y demographic (specifically 10-24 year old) and is primarily engaged in the fastest growing sectors of marketing/advertising to reach the Gen-Y demographic for its clients.  Alloy is a beneficiary of advertising/marketing growth/mix shift to non-traditional media/approaches.

 

The company serves over half the Fortune 500 and nearly every major advertising agency.  ALOY’s clients have recently included McDonald’s, Wal-Mart, Proctor & Gamble, Heineken, Unilever, Cadbury Schweppes, Burger King, Burt’s Bees, Clinique, Ford, Paramount, Verizon Wireless, AT&T, and Sprint. 

 

ALOY’s businesses are segmented across three reported segments:  Media, Promotion, and Placement.

 

The Media segment (~30% of 2007 revenue) provides the most potential upside given fixed cost leverage, undermanaged assets (sellout of out-of-home billboard inventory is less than 50%) and from its recent acquisitions (including Channel One, which is described more thoroughly below). 

 

The Promotion segment (~45% of 2007 revenue) conducts sampling, event and field marketing, consumer research, and on-campus marketing (approximately one-third of segment revenue and includes residence linen, care packages, and diploma frames).  On the recent earnings call in December, management highlighted 83% of the revenue generated by Alloy in 2007, from its main promotion business, is already pre-booked for 2008 two months prior to the start of fiscal year 2008.  Moreover, the typical pattern for Alloy’s promotion business is that another 50% is usually booked during the year; this is among the reasons Alloy’s management team conveyed their guidance for 2008 with confidence. 

 

The Placement segment (~25% of 2007 revenue) is strictly an agency business (generating a margin of 11-12%) representing third party media properties that cater to the Gen-Y community.  For example, if a client wants to advertise to reach the college demographic and the client’s advertising campaign is being directed through newspapers, that client will reach out to Alloy as the placement agency; this is by far more efficient than a client like McDonald’s conducting a national advertising campaign and contacting all the major universities on their own.  Alloy estimates its market share for placing national advertising in college newspapers is 85%.  The company also serves as a placement agent in multicultural and military newspapers, and is also a buyer of radio/other media on college/high school campuses for its clients. 

 

Based on guidance, ALOY is cheap.  The valuation coupled with numerous catalysts is both a source of downside and upside.  Therefore, the key question is whether guidance is reasonable.  The company doesn’t frame their guidance specifically by segment but I attempt to do so below in an effort to validate my perspective that guidance appears reasonable. 

 

In FY 2007 (i.e., CY 2006 since FY ended January 31, 2007), ALOY generated the following Revenue and EBIT by segment:

 

                        Promotion                  Media             Placement                  Corporate                  Total

Revenue         $96.0                          $46.3              $53.8                          NA                               $196.1

EBIT                $11.1                          $6.6                $5.6                            ($10.7)                        $12.7

D&A                $0.8                            $1.8                $0.0                            $0.8                            $3.4

Stock-based  $0.5                            $1.0                $0.1                            $1.1                            $2.8

EBITDA          $12.4                          $9.4                $5.7                            ($8.8)                          $18.9

% Margin        12.9%                         20.3%             10.6%                         NA                               9.6%

 

Because of two acquisitions completed in 2007, including Channel One which creates a host of accounting issues (described below) that clouds the transparency of recent CY 2007 results, and also because 2007 results have yet to be announced, I use CY 2006 as my baseline from which to describe how the company is likely to achieve 2008 guidance of $20-24M in EBITDA.  The summary of my estimates for 2008 is shown immediately below; the rationale for these estimates is described in more detail below this summary.

 

                        Promotion                  Media             Placement                  Corporate                  Total

Revenue         $90.5                          $89.4              $50.0                          NA                               $229.9           

EBITDA          $11.8                          $13.0              $5.0                            ($9.8)                          $20.0

% Margin        13.0%                         14.5%             10.0%                         NA                               8.7%

 

As described above, management highlighted in December that the visibility of bookings was strong at 83%.  The promotion business is inherently lumpy but also inherently attractive as marketers / advertisers seek non-traditional channels to penetrate targeted demographics.  For the nine months ended October 31, 2007, although promotion segment revenue was down 14% yoy, the company’s operating income was down just 3.5% as management pruned some less profitable business activity.  For 2008, given the comments regarding strong visibility, I assume ALOY’s promotion segment grows 7% yoy from 2007 and a 13% EBITDA margin is generated (consistent with 2006).  I assume the promotion segment will generate $84.6M in revenue in 2007 (this is derived from the nine months ended October 31^st adjusted to account for the seasonality of the business such that the first nine months is roughly 80% of the annual segment revenue).  Based on 7% yoy top-line growth and EBITDA margin of 13%, the revenue and EBITDA for promotion segment is assumed as $90.5M and $11.8M, respectively.  During the call in December, management said that the visibility of the pipeline provided confidence that promotions would return to the level achieved in 2006 (i.e., $12.4M).

 

Since there were two acquisitions made in this segment last year and since the internet part of Alloy’s business is growing very quickly, I will address the “legacy” media segments first.  I view 2006 as a good baseline for such in light of Alloy having virtually no internet business then.  In 2006, the media segment generated $9.4M EBITDA on $46.3M of revenue.  I think this business has been flat at best but I am going to assume revenue is down 5% to $44M and EBITDA declines by $1.2M (assumes 50% contribution) such that the “legacy” media segment is $8.2M. 

 

During April 2007, Alloy acquired Frontline Marketing, a national in-store advertising and display network comprising displays located in ~7,000 grocery/other stores.  The company paid ~$6.0M for the business plus agreed to pay a potential earn-out of up to $7.2M based on EBITDA performance over the next three years.  Although no figures were disclosed, it is estimated that Frontline was generating $1.2M of EBITDA.  I assume EBITDA grows 5% and EBITDA margin is 15% (i.e., $8.4M Revenue, $1.3M EBITDA).

 

Also during April 2007, Alloy acquired the operating assets of Channel One Communications.  The transaction was with PRIMEDIA by which Alloy received $8.6M of working capital, of which $5.0M was cash, by assuming certain liabilities of Channel One, with ~$8.6M value.  Subsequent to the transaction announcement/closing, the actual value of certain assumed contract obligations and severance agreements was determined to be just $3.1M.  Therefore, Alloy recently recognized an extraordinary gain of $5.5M.  Because of the acquisition of Channel One, the media segment’s results are difficult to analyze without isolating Channel One.  

 

Channel One’s business model is relatively simple.  The business debuted in 1989 as the first news program beamed directly into schools.  In exchange for TV equipment for each school, Channel One provided a 10-minute daily news program with two minutes of ads.

 

Although historically controversial, the advertisements are age appropriate and not the junk food-type.  School principals have the authority to preview/block ads.  Advertisers include the Armed Forces, Gatorade, New Line Cinema, and Verizon Wireless. 

 

Alloy was prudent to recognize its core competency did not include originating video content on a daily basis but rather its strong relationships to thousands of marketers seeking to reach the Gen Y community through non-traditional media.  Therefore, shortly after the Channel One acquisition, Alloy entered into an arrangement with NBC whereby NBC would program the ten minutes in exchange for some inventory that NBC gets to sell.

 

Since ~$10M of capital was spent last year (of the total company $14.6M in capx) to upgrade Channel One technology to digital, Alloy’s Channel One now has two-way communication, better compliance and participation.  Management reported in December that Nielsen ratings were up 15-20%, on average.

 

I am not asserting anything by the following except it’s interesting for context to note that KKR’s PRIMEDIA bought Channel One in 1994 for $300M.  My research evidences Lazard was interested in buying the business for $750M in 2000.  Channel One complements Alloy strategically and Alloy’s arrangement with NBC reduces Alloy’s break-even to ~$20M (i.e., Alloy needs to sell $20M of Channel One inventory).  According to the CEO, the sales capacity for Channel One is ~$70M and he envisions ultimately selling $30-35M but I am not comfortable ascribing probability to that potential outcome in advance of visible traction.  I am confident, however, asserting that Channel One is a valuable asset because of the captive audience marketers seek to reach but is notably hard to do through traditional media.

 

During the call in December, management said Channel One would contribute to profitability this year and was already breakeven in the last quarter.  I assume that revenue in 2008 is $22M and EBITDA is $2M.  I don’t think it’s a stretch for this business to ultimately generate $10M of EBITDA by 2010 if the business plan is successfully executed.

The next critical incremental contributor to the media segment is the online ad network called TEEN.com.  If you didn’t see the WSJ article on page B3 on February 25^th, I encourage you to review such for context.  According to the article, Glam Media is being valued at $500M by a variety of VCs.  The article reinforces the secular growth trend among online advertising networks.  Such networks sell ads that appear on an array of other Web sites and sometimes their own sites.  These networks have gained traction recently as advertisers seek to reach groups (e.g., teens) of consumers beyond the main portal properties.  According to the WSJ article, Glam is targeting $100M of revenue this year.  As a value investor, I am not quick to embrace that Glam is “worth” 5x revenue but I share it for context because it highlights enormous potential upside at Alloy from improved visibility of the growth expected from its on-line ad network.  Alloy’s network is now ~20 million in unique users compared to Glam at 25 million.

 

I don’t know the magnitude of revenue being generated from Alloy’s internet businesses but there is much traction in executing its strategy in this secular growth opportunity as evidenced by the unique users among its owned and publisher sites having grown by over 5x in less than a year.  There is increasing evidence of advertiser, publisher, and investor interest for on-line ad networks.  Alloy was strongly positioned to launch their business because of the thousands of relationships it has with marketers who know Alloy as a platform through which to target the teen community. 

 

Without the internet segment, I’ve described media in aggregate summing to an estimated $11.5M of EBITDA in 2008 ($8.2M for “legacy”, $1.3M for Frontline, $2.0M for Channel One).  To achieve management’s guidance of $20-24M of EBITDA this year, there is an implied (based on the other segments described above and below) $1.5-5.5M required from Alloy’s internet businesses (i.e., primarily the on-line ad network).  I will use the reported Glam Media $100M of revenue on 25 million uniques for context and assume that Alloy’s TEEN.com is therefore likely to generate $15-30M of revenue at 10-20% margin on 20 million uniques.  I think I am being conservative based on my research of other on-line ad network activity.  I assume the low-end of the range in the summary I shared above (i.e., $1.5M from Alloy’s internet business). 

 

Although Alloy’s position in this market is dominant, we can probably all agree that it’s a niche market in decline given the increasing importance (and area of focus by Alloy) of alternative / new media.  For the nine months ended October 31, 2007, the placement segment revenue was up 2.8% yoy and operating income was up 3.6%.  Although EBITDA for placement was $5.0M through October 31^st and will likely finish the year at ~$5.8M, I assume EBITDA for placement in 2008 is lower, at $5M, on lower revenue (assume $50M) because of further displacement of newspaper advertising.

 

As a small public company, Alloy has a substantial fixed corporate cost structure as a percentage of revenue.  I believe (and I know some major shareholders agree) the company’s corporate expenses are unreasonably high.  It is possible that major shareholders agitate for change in such regard.  I also think that the ultimate upside will materialize from a strategic takeout which will presumably ascribe some value to the elimination of corporate redundancies, including public company costs which amount to $1-2M.

 

For 2008, I assume $9.8M of corporate expense (in line with run-rate as of October 31^st) when adding back stock-based compensation and D&A.

 

 

There are a variety of reasons the opportunity exists and some require patience among investors to monitor the improved visibility from execution and results.  A key reason the stock is so cheap is simply because it’s a micro-cap (i.e., there are many cheap micro-caps nowadays).  Another reason is because there is no meaningful research coverage to elevate the company’s profile with the investor community.  Another reason is because the guidance seems like a leap of faith without spending time with some of the details to understand the reasonableness (I hope I’ve assisted you in this regard) and especially since last year’s numbers are clouded by the acquisitions and the absence of the on-line ad network growth.