Description

Digital River Inc. (Nasdaq: DRIV) represents a contrarian opportunity to invest in a leading e-commerce and fast-growing payments company at a significantly discounted price, with the opportunity for an event catalyst through a possible take-private transaction by the company’s largest shareholder, Vista Equity Partners, a $6 billion private equity firm focused on software and technology companies, or numerous other financial or strategic buyers.  In the last week of April, Vista increased its ownership position to 9.9% of shares outstanding (weighted average purchase price of $16.28).

DRIV is a widely disliked name by both the sellside and buyside, as the stock has fallen from $37 in Q2 2011 and sits at $16.58 today, driven by poor execution by the prior CEO, loss of several customers including Kodak via bankruptcy.  That said, the business has stabilized, 2013 revenue is guided to grow low to mid-single digits and payments revenues (est. ~15% of run-rate revenues) are growing organically at a 60%+ rate.  Further, owing to DRIV’s inordinately large cash balance, the stock screens poorly on a P/E basis, which tends to be the primary (if not sole) focus of sellside analysts.

In summary, we believe the company is misunderstood and unappreciated, causing the stock to trade at a significant discount to its private market value.  We believe shares of DRIV are currently worth $20 to $28 on a standalone basis using current metrics, and $23-$30 in a sale to a strategic buyer (eliminating corporate overhead), with upside to these numbers as management executes, the payments business expands and non-core business units are sold.  Currently, shares trade at only 4.8x consensus 2014 EBITDA and 0.7x revenues (*using our conservatively estimated “Adjusted TEV” which assumes $100mm of “permanent cash” to account for the structurally negative NWC nature of the business).  There is also real lottery ticket potential in the payments business, which if it were to continue to grow at its current 60%+ organic rate could be worth more than 2x DRIV’s current Adjusted TEV based on precedent transactions.

Valuation, Segment Estimates and Sum-of-the-Parts analysis:

Keys to the thesis are as follows:

• Over $611,000 worth of open-market share purchases by key insiders last week (May 8-10)
  • New CEO David Dobson purchased 30k shares for $446,300
  • Chairman Thomas Madison purchased 9k shares for $135,063
  • CFO Stephan Schulz purchased 1k shares for $14,830
  • General Counsel Kevin Crudden purchased 1k shares for $14,980

• B2B payments business Digital River World Payments is growing organically at a 60% annual rate
  • Competes with Paymentech (Chase), GlobalCollect (Welsh Carson) and Cybersource (Visa)
  • DRIV acquired LML/Beanstream in Sept 2012 for $72mm TEV (~3x revenue)
  • DRIV payments segment currently generating ~$50-60mm total revenue (est.)
  • Management thinks payments can grow to 30% of total revenues
  • Visa paid $1.8bn for CyberSource in 2010 (6.6x revenue)
  • CyberSource paid $450mm for Authorize.net in 2007 (6.1x revenue)
  • DRIV’s Beanstream is a partner with MasterCard via its PayPass Wallet Services (press release here: http://www.mastercard.com/ca/company/en/press/2012/05_10_paypass_wallet.html)
  • If valued at similar multiple as CyberSource, unit could be worth majority of DRIV’s TEV
  • Huge option value, if payments business grows at the current 60% rate for the next 2 years, it could be a $130-140mm revenue business worth 5-6x sales ($650-840mm)

• Strong balance sheet, virtually no risk of acquisitions as company focuses on repurchasing common stock and convertible debt
  • $698mm of cash and investments
  • $299.8mm 2.0% convert puttable at par on 11/1/2015 (due 2030, conversion price $49.13); in Q1 2013 DRIV purchased $43.9mm at 98.5%
  • $8.8mm 1.25% convert puttable at par on 1/1/2014 (due 2024, conversion price $44.06)
  • Net cash per share of $11.03, book value per share of $12.70
  • We expect both converts to be retired opportunistically by DRIV at a modest discount to par
  • Former CEO on Q4 call:  “At this time, our capital deployment emphasis has shifted from acquisitions to common stock and convertible debt buybacks.”
  • New CEO on Q1 call:  “Second, we're going to be more disciplined and focused on how we allocate our resources in selected growth markets.  Over the years, we've acquired a number of assets and companies. And frankly, we have not done a good enough job of rationalizing and integrating them into the business. We have an incredible base to work from, and we will focus our energy and attention on a smaller number of high-impact growth initiatives going forward.”
  • Purchased 761,813 shares in Q1 for ~$11mm
  • $86mm remains authorized on the repurchase plan

• Likely sale of non-core marketing services businesses
  • We estimate that the company’s affiliate marketing and email marketing businesses generate $50-60mm of annual revenue and are likely to command 1.0-2.0x revenue when sold

• Re-energized core business
• Company will invest in additional R&D and sales & marketing over the next 4-6 quarters (~$20-25mm), driving revenue growth in core e-commerce and payments business, temporarily depressing reported earnings
• New CEO on Q1 call:  “Our system is dependable and secure, but now is the time to take it to a whole new level. The end result will be an even more robust, resilient and scalable platform that will position us to be more responsive to customers' requirements and drive more efficiency across our business. We're investing in the latest technology to take full advantage of cloud computing. This includes further augmenting our infrastructure and opening up our platform-as-a-service capability.”
• 2014 Consensus EBITDA of $61mm is not far-fetched – DRIV had $83mm of Adjusted EBITDA in FY 2011; 2014 EBITDA estimates are as low as $51mm (First Analysis) and as high as $79mm (Piper Jaffray)

Keys risks to the thesis include:

• Customer concentration with MSFT:  DRIV runs Microsoft’s online store on a global basis (>230 geographies worldwide, with >140 new geographies launched in Q4 2012 and >50 new geographies in Q1 2013) and MSFT represents ~29% of revenuesPoor operational execution, competitive pressures
  • New CEO on Q1 call:  “In addition, we continue to strengthen our relationship with Microsoft. Since our last earnings call, we helped them expand their business into more than 50 additional geographies. We are now supporting microsoftstore.com in more than 230 geographies around the world and are looking forward to continuing to help this strategic client grow their global business. During the quarter, as you'd all expect, I visited Microsoft in Redmond and have personally started that relationship with Microsoft and look forward to going forward with them in a very strategic way.  As you know, during the quarter, we also supported Microsoft's launch of Office 2013 and their new versions of Surface Pro.”
  • MSFT relationship has grown over time:  3.5% of total revenue (2007), 7.1% (2008), 11.8% (2009), 24.7% (2010), 27.7% (2011), 29.6% (2012)
  • In 2009, DRIV lost Norton as a customer, which was temporarily quite painful as the company’s TEV fell to $560mm before recovering; noteworthy that today’s TEV is 65% lower than that level despite current revenues and gross profits that are 10% higher than the 2010 low point
• Poor operational execution, competitive pressures
• Software market weakness (McKinsey study in 2012 for DRIV confirmed this market is actually stable)
• Exit by largest shareholder, software private equity fund Vista Equity Partners (we view as unlikely given that they just ramped their stake to the 10% threshold in last week of April, after new CEO came onboard in February – it’s rational to assume Vista had spoken with him at least once by late April)

Business Overview (via Capital IQ)

Digital River, Inc. provides end-to-end cloud-commerce, payments, and marketing solutions to various companies in the United States, Europe, and the Asia Pacific. Its solution combines a cloud-commerce technology platform and a suite of services to help businesses to avoid running an integrated global commerce operation in-house. The company offers an e-commerce solution that operates as part of a client's website. Its services include design, development, and hosting of online stores and shopping carts; store merchandising and optimization; order management; denied parties screening; export controls and management; tax compliance and management; fraud management; digital product delivery through download; physical product fulfillment; subscription management; online marketing, including e-mail marketing; management of affiliate programs; paid search programs; payment processing services; Website optimization; Web analytics and reporting; and CD production and delivery services. The company also provides paid search advertising, search engine optimization, affiliate marketing, store optimization, multi-variant testing, web analytic, and e-mail optimization services; and a range of payment processing services, such as multiple payment methods, fraud management, tax management, cloud-based billing, and other payment optimization services. It serves software, consumer electronics, and computer and video game product manufacturers; and online channel partners, including retailers. The company sells its products and services to consumers through the Internet, as well as through direct sales force. Digital River, Inc. was founded in 1994 and is headquartered in Minnetonka, Minnesota.

Disclaimer:  The author of this idea presently has a long position in securities of this issuer and may trade in and out of these positions without notice.  The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein.

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