Summary

We focus on smaller companies with Ft. Knox balance sheets and large & sustainable free cash flow yields and we are typically seeking a mid-teens FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation, through share buybacks, debt reductions, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.  We also focus on small and micro-cap stocks because there is a much better chance to find an attractive investment opportunity which is under-followed or undiscovered.

One larger company we believe is under-valued is Conversant Inc. (CNVR), which provides digital marketing services in the U.S. and internationally.  CNVR operates through two segments, Affiliate Marketing and Media.  The Affiliate Marketing segment provides technology, network, and customer services that enable advertisers to create their own online sales force comprising third party website publishers.  The Media segment provides a suite of digital marketing services and tailored programs that help marketers create and increase awareness for their products and brands, attract visitors, and generate leads and sales through the internet and mobile applications.  The company sells its products to advertisers and advertising agencies.  The company was formerly known as Value Click, Inc. (VCLK) and changed its name to Conversant, Inc. in February 2014.  Affiliate Marketing’s segment revenues and segment operating income for LTM were $171m and $107m, respectively.  Media’s segment revenues and segment operating income for LTM were $422m and $129m, respectively.

CNVR offers a comprehensive range of digital marketing services across its Affiliate Marketing and Media business segments.  CNVR  believes the unique combination of its: scale and breadth of services; vast amounts of proprietary data spanning online and offline channels; cross device capabilities; and industry leading approach to personalized communication, all combine together to position it to be the digital marketing services provider of choice for major marketers and the advertising agencies that service them.  CNVR believes its services help marketers achieve a variety of strategic objectives, including customer relationship management (CRM), new customer acquisition, and branding.

CNVR has an attractive, asset-light business model with high margins (EBITDA margins of mid 30’s or higher), limited capital expenditures, and limited working capital needs.  CNVR is generating strong free cash flows.  In 2013, CNVR generated free cash flow (we define as cash from operations less capital expenditures) of about $165m and, for LTM (June 2014), FCF is about $175m.   CEO John Guiliani, who took over in late 2012, is implementing a strategy to consolidate CNVR’s various digital advertising businesses together onto a single platform (see Conversant Personalization Platform below).  CNVR has about 67m shares outstanding at about $26.50 per share for a market cap of about $1.75b.  CNVR has a strong balance sheet with a net cash position of about $20m at Q2 of 2014.  CNVR has an enterprise value (EV) of about $1.73b.  CNVR is trading at a 10% unleveraged FCF yield with good prospects for stronger growth in revenues and adjusted EBITDA in 2015 and 2016.  CNVR is making significant investments in increased operating expenses in order to drive revenue, especially in the Media segment, and this has (we believe) temporarily depressed adjusted EBITDA margins.  By 2016, we believe CNVR could generate $250m in adjusted EBITDA and FCF of $180m to $200m. 

We believe with stronger revenue growth and adjusted EBITDA margins, CNVR could trade for 10x adjusted EBITDA, with a debt- free balance sheet, or a market cap of about $2.5b by 2016.  CNVR has about 67m total shares outstanding today and has been aggressively repurchasing shares over the past five years (for example, at year-end 2008, there were about 92m total shares outstanding).  We believe CNVR’s total share count could be near 55m by year-end 2016.  Based on a $2.5b market cap and 55m shares outstanding, CNVR would have a share price of about $45 per share or 65% higher than the current price of $26.50 per share.

CNVR’s highly cash generative business model enables it to concurrently make organic growth investments, complete strategic acquisitions, and repurchase large amount of common stock.  The combination of these shareholder-driven activities, concurrently executed, likely represents a very powerful driver of long-term shareholder value creation.

Background

CNVR went public in March 2000 as ValueClick (VCLK) and has completed 18 acquisitions (8 of which were subsequently divested) since its inception, including three acquisitions in the past three years.  In April 2011, CNVR acquired Greystripe, a brand-focused mobile advertising network with expertise in ads delivered on smartphone applications for about $71m.  Greystripe provided CNVR with immediate scale in the U.S. mobile advertising market.  In August 2011, CNVR acquired Dotomi, a leading provider of data-driven (customer relationship management or CRM), intelligent display media for major retailers, for total consideration of $288m.  Dotomi enables advertisers to re-market to their existing customers through customized display ad campaigns.  Dotomi provided CNVR with a unique set of data-driven targeting capabilities combined with expertise in brand strategy and creative development.  In February 2014, CNVR acquired SET Media, a digital video technology company, for cash consideration of $26m and assumption of $4m in employee obligations.  SET Media strengthens CNVR’s technology offerings and adds unique video targeting and brand safety capabilities to its platform.

Importantly, these acquisitions were completed for almost $380m over the past three years yet CNVR has still maintained a net cash balance sheet as of Q2 of 2014.  This highlights the Company’s strong cash generating ability and management’s opportunity to make selective acquisitions to add important product features or services or geographies to continue to build its overall value-proposition.  We believe CNVR can continue to selectively fit gaps to meet customer demand through these tuck-in type acquisitions over time.  We believe CNVR’s vision of an integrated solution to customers’ advertising requirements which is highly focused, analytical, and efficient will be a compelling alternative to both direct advertising customers and advertising agencies (see Conversant Personalization Platform below).

We believe advertisers and ad agencies are increasingly using technology to become more surgical about how they are spending the vast of dollars they invest in sales and marketing.  CNVR is well-positioned to benefit from this trend.  CNVR should also benefit from continued strong growth in the ecommerce industry (through its Affiliate Marketing segment) and continued strong growth in digital advertising (through its Media segment). 

Affiliate Marketing Segment

Affiliate marketing has become a key part of marketing for leading brands.  CNVR says advertisers in its affiliate network report that the affiliate channel delivers return on advertising spend performance that is among the highest across all marketing channels.  CNVR’s Affiliate Marketing segment is the dominant player in its industry with a market share estimated at more than 50%, with a strong network of advertisers and website publishers, both benefiting significantly from CNVR’s value-added services.  Affiliate Marketing’s network includes thousands of advertisers and over 60,000 publishers.  Affiliate Marketing enables advertisers to expand their reach and grow their businesses through a “pay-for-performance” approach, through their own fully-commissioned online sales force comprised of third-party website publishers, also known as affiliates.  During 2013, Affiliate Marketing generated more than $8b of transactions for its advertising clients and paid more than $700m in commissions to affiliates.  Advertisers upload their offers onto CNVR’s system, making them available for placement by affiliates.  Affiliates apply to join the advertisers program and upon acceptance, affiliates select and place the advertisers’ offers on their websites or mobile websites, in email campaigns, or in search listings.  Affiliate Marketing serves as a trusted clearinghouse which collects commissions due from advertisers and disperses them to thousands of affiliate each month.   Affiliate Marketing primarily generates revenue from variable commissions paid by advertiser customers, based on a percentage of commissions advertisers pay to affiliates.  In 2014, CNVR plans to introduce Affiliate Personalization, which will leverage the Conversant Personalization Platform to identify and customize promotional offers for select target segments, for both new and existing customers.  Affiliate Marketing’s competitive strengths include: 1) leading scale and reach; 2) industry-leading expertise; 3) innovative tracking technology; 4) analytics and insights; and 5) strong network quality.  For LTM ended June 2014, Affiliate Marketing generated segment revenues and operating income of $171m and $107m, respectively.

Media Segment

CNVR’s Media segment is positioned to benefit from the secular shift towards digital advertising, which is expected to increase at about 11% per annum through 2016.  During this period, digital advertising is expected to increase from 25% of the total U.S. advertising market to about 30%.  Media’s solutions enable marketers to deliver personalized communications and are designed for flexibility based upon each brand’s specific needs.  The level of personalization, data integration, creative development, cross channel delivery, and measurement sophistication is tailored for each individual client.  Media is led by its customer relationship management or CRM business, which has a proprietary database of over 260m anonymous profiles of consumer purchasing behavior.  These profiles are highly valuable to major advertising clients, who can focus and monitor their advertising investments more effectively.  The CRM database is continuously updated as consumers take actions online and interact with marketers in offline channels.  Media’s competitive strengths include: 1) exclusive data sources which enable precise user identification; 2) seamless ability to reach individual consumers across channels and devices; 3) real-time decisions and execution; and 4) ability to provide unique ROI measurement.  For LTM ended June 2014, Media generated segment revenues and operating income of $422m and $129m, respectively.

Conversant Personalization Platform

The Conversant Personalization Platform enables leading brands to engage their customers on a personal level.  Based upon each marketer’s specific needs, they can determine the level of personalization, data integration, creative development, cross channel delivery, and measurement sophistication that is appropriate for them.  CNVR management has talked about a common ID in the past and this common ID allows the Company to link up individual profiles across its many businesses, so CNVR can identify people on different devices as the same person.  Management indicated that, after the common ID was put together, the Company’s online presence or reach was second only to Google’s.  This is all part of CEO Giuliani’s One Conversant integration strategy which management believes further differentiates the Company in a highly competitive market.  CNVR continues to work on its personal calibration engine, which is an initiative that will further help clients make decisions on where to best spend their money.  There is the potential for a model which may allow clients to have more control in the decision process, which is something they want.  Overall, CNVR’s investments in this area are creating a stronger value proposition for its clients and are where the Company believes the overall market is likely heading.  We agree.

Customers

CNVR sells its products and services to a variety of advertisers and advertising agencies.  Its revenues are generated from thousands of customers and there is no significant customer concentration in either of its business segments.

Seasonality

CNVR’s business is subject to seasonal fluctuations, with the calendar fourth quarter generally being its strongest.

Financial Results for 6mos of 2014

Six month revenues were $283m or up 7% versus $263m in prior year, and six month adjusted EBITDA was $90m versus $97m in prior year as CNVR increased operating expenses to drive higher revenue growth and adjusted EBITDA in 2015 and 2016.  Operating expenses increased by about $10m in Q2 alone.  These higher operating expenses are related to one-time corporate rebrand costs (fron ValueClick to Conversant in early 2014), operating losses at SET Media, and investments in video and other areas.  Total employees have increased by about 9% in H1 of 2014.  For Q3, management guided to 8% revenue growth and revenue in the range of $142m to $148m and adjusted EBITDA of $44m to $47m or a margin of 31.4% at the midpoints.  Management expects EBITDA margins to rebound in seasonally strong Q4 of 2014 and into 2015 due significantly to stronger revenue growth from Media due to video and other investments being leveraged and starting to generate revenue. 

Strong cash generative business model and attractive FCF yield

CNVR has a highly cash generative business model which is asset-light with limited capital expenditures and working capital needs and a high ROIC.  CNVR currently trades at an attractive 10% unleveraged FCF yield, with strong prospects for growth in adjusted EBITDA and FCF in 2015 and 2016.  CNVR has a high ROIC business model (over 100%) based on adjusted operating to the investment in net working capital plus net PPE.  Consequently, with even modest revenue growth, we think CNVR can generate significant incremental FCF from current levels.

CNVR’s highly cash generative business model enables it to concurrently make organic growth investments, complete strategic acquisitions, and repurchase large amount of common stock.  The combination of these shareholder-driven activities, concurrently executed, likely represents a very powerful driver of long-term shareholder value creation.

Potential Benefit from Growth in Ecommerce, Digital Advertising, and Digital Video Advertising

Both of CNVR’s business segments are in growing markets.  Affiliate Marketing should benefit from the continued strong growth in the ecommerce industry over the next several years.  Ecommerce is expected to grow about 11% per year through 2016, according to industry sources.  Media should benefit from the continuing trend towards increased digital marketing expenditures over the next few years.  Digital advertising expenditures currently represent about 25% of total advertising expenditures in the U.S. and this share is expected to increase to about 30% by 2016.  The digital advertising industry is expected to grow about 12% per annum in the U.S. over the next couple of years.  As Cuyler1903 has noted in his excellent write up of YuMe (YUME), there is tremendous growth potential, in particular, in digital video advertising, as consumers increasingly shift their media consumption to a digital format, and video commercials which might have been seen on television, are instead viewed on a desktop or mobile environment.  CNVR’s recent purchase of SET Media is meant to position the Company to participate in this strong growth in digital video over the next few years.  CNVR management has made several optimistic comments about the potential for digital video and SET Media in particular, but we will have to see how this plays out. Overall, both of CNVR’s segments should benefit from their strong positions in growing digital markets.

Strong Competitive Position In Affilate Marketing and Media Segments

We believe the Company has a very strong competitive position in digital marketing services.  CNVR is the largest player in the Affiliated Marketing segment business, with close to a 50% market share, a well-established leadership position, and a highly attractive “pay-for-performance” business model for customers.    Its network of thousands of advertising customers and over 60,000 digital publishers is not easily replicated.  Affiliate Marketing provides important value-added services such as monitoring transactions and collecting and disbursing fees to its advertising and affiliate customers.  About $8b of transactions were completed through the Affiliate Marketing segment network in 2013.  Advertiser customers find this business model very attractive since it is basically a pay-for-performance model, where they only pay for transactions.  The Media segment’s CRM business includes approximately 260m anonymous customer profiles with important and proprietary information on purchasing patterns.  CNVR acquired Dotomi’s CRM business in 2012 and this has formed a strong foundation for its Media segment. The Media segment is rapidly expanding its capabilities in mobile (via acquisition of Greystripe) and video (via acquisition of SET Media) as these become higher growth opportunities in today’s digital advertising industry.

Strategic Investments in 2014 Should Drive Stronger Revenue Growth and EBITDA Margins in 2015-6

The Company is making substantial investments in additional operating expenses (mostly people) in order to drive stronger revenue growth and better EBITDA margins going forward.  These incremental expenses are significantly focused on the digital video opportunity which is quite significant over the next few years.  These increased operating expenses have resulted from additional sales people and additional product capabilities, including SET Media’s video capabilities, which enhance CNVR’s value proposition to advertising customers.  We do not believe the Company has seen the benefit resulting from these investments in sales and marketing and product development (video and SET Media).  The Company expects these investments to drive stronger revenue growth in H2 of 2014 and 2015.  (For six months of 2014, Affiliate Marketing revenues grew about 11% and Media segment revenues grew about 7%).  The Company also expects its adjusted EBITDA margins to improve in H2 of 2014 and into 2015 as stronger revenues get leveraged over more stable operating expense levels.  We believe the result of these factors could be stronger revenue growth in 2015 and higher adjusted EBITDA margins, which together should drive meaningful improvement in adjusted EBITDA in 2015.  We believe CNVR’s adjusted EBITDA could be roughly $225m in 2015 and $250m in 2016.

CEO Giuliani Consolidating Businesses into Unified Platform

John Giuliani became CEO of CNVR in late 2012 and has refocused the Company on a unified approach to its traditionally separate digital marketing businesses.  His objective is to simplify and integrate CNVR’s various capabilities onto one platform that is easy for advertiser customers to use (see Conversant Personalized Platform).  We believe this approach makes sense and will increase the value-proposition to customers and tighten their relationship with the Company.  Advertising customers will be able to reach customers across various platforms on whatever device (desktop, smartphone, etc.) they are using to access digital content (display, video, or mobile).  We believe this integrated approach is what advertisers want and is where the market is likely heading over time.  CNVR’s unified platform approach will also make it easier for advertiser customers to utilize and benefit from its substantial CRM information database, with over 260m anonymous customer profiles.

Trends Towards More Focused Advertising Spend

We believe the huge advertising and marketing dollars which are being spent by major marketers are becoming increasingly focused and ROI-driven.  We believe CNVR is well-positioned to benefit from these trends with its digitally focused and highly analytical approach to advertising spending by major marketers.  We believe these capabilities to track and monitor more specifically the marketing and ad dollars spent with continue to attract a greater share of total ad dollars towards digital marketing.

Attractive Upside Potential

In 2013, CNVR generated approximately $165m of FCF (cash from operations less capital expenditures).  We believe CNVR can grow revenues and adjusted EBITDA in 2015 and 2016 based on continued modest growth in Affiliate Marketing and increased growth in Media due to growth in mobile, video, and display areas, all over a more stable level of operating expenses.  EBITDA margins have been reduced to the low to mid 30s in 2014 due to investments which management is making in sales and marketing and product development, including video and SET Media.  We believe these investments will help CNVR improve its revenue growth rates in 2015 and 2016 and adjusted EBITDA margins will move closer to historical levels as these investments are leveraged against higher revenues.

We believe CNVR can achieve adjusted EBITDA of about $250m and free cash flow of $180m to $200m in 2016, and maintain a balance sheet with zero net debt.  Furthermore, we believe CNVR could concurrently repurchase up to 12m common shares to reduce total shares outstanding to about 55m by year-end 2016.  We believe CNVR could trade for $2.5b or 10x adjusted EBITDA in 2016 with zero net debt and about 55m total common shares outstanding or a share price of about $45 per share, 65% higher than current price of $26.50 per share.

Share Repurchases and Dividends

CNVR has repurchased over $1b of common stock since 2001, including about 15% of total shares outstanding in the latest 12 months.  CNVR recently initiated an additional $150m share repurchase program.  We believe CNVR’s management is acutely aware of the current depressed relative valuation of its stock and has confidence that its organic and inorganic investments will drive increased revenues and adjusted EBITDA in 2015 and 2016.  Consequently, we expect CNVR to continue to aggressively repurchase shares, spending $100m to $150m per year on share repurchases in 2015 and 2016.  CEO John Giluiani is a significant shareholder, with about a 4% ownership stake in CNVR.  We believe the entire management team is very focused on driving shareholder value over the next couple of years.

“Ft. Knox” Balance Sheet Enables Value Creation

CNVR has a “Ft. Knox” balance sheet with a net cash position of $20m at Q2 of 2014.  We believe management has positioned CNVR to generate $150m to $200m of FCF per year in 2014 through 2016.  Therefore, we think CNVR could end 2016 with total shares outstanding of about 55m or 18% lower than current 67m shares, as CNVR’s strong free cash flow is directed toward share repurchases.  We believe management is evaluating acquisitions but is likely to be careful in deploying its excess capital.  CNVR has completed multiple strategic acquisitions during 2010 to 2013 and divested non-core divisions which do not fit its integrated strategy.  CEO John Guiliani and his team have been focused on integrating and simplifying CNVR’s businesses which we believe will improve and highlight their value proposition to major advertiser customers.

Conclusion and Target Price

Based on 10x our estimated EBITDA of $250m for 2016 and zero net debt at year-end 2016, we believe CNVR could trade for an EV of close to $2.5b or $45 per share or more versus $26.50 per share today (+65%).  If CNVR continues to execute and its digital marketing business performs as we expect, we think our target price can be achieved.  Further, CNVR’s digital marketing business has a well-established competitive position in both its Affiliate Marketing and Media segments as well as important relationships with major advertisers and advertising agencies with a highly focused approach to advertising spending.  We believe CNVR could prove an attractive acquisition to a strategic or private equity acquirer.