In contrast to beep889’s viewpoint and write-up on KITD, I believe that KITD is a short worth perhaps $4 where it would be valued on a similar EV/Revenue 0.7-0.8x multiple as Limelight Networks and other comps. In a worst case scenario for a short position, I value the company at the combined value of its’ acquisitions which implies approximately 15% upside. I do not expect the company to generate any meaningful FCF thus I avoid using that as a basis for valuation. Even ignoring cash used in AR growth (benefit of the doubt on growth), KIT has had “cash flow from ops margins” (ex-change in AR) of -5.7%, -6.0% and -7.6% in the TTM, CY2010 and CY2009 periods respectively.
Background on OTT delivery can be found in beep889’s write-up, so I will get to why I come to a different end conclusion on the value of the shares.
I believe that it will ultimately prove to be a good short for the following reasons:
1. The firm’s roll-up strategy should prove to be destructive to shareholder value.
First, KIT’s acquisitions have significantly diluted the per share claim on revenues. Revenue per share has progressed from CY2007to CY2010 in the following fashion: $13.98, $9.31, $7.19, $4.94 and lower on a TTM basis. It would be beneficial to shareholders if this were a higher margin revenue source. This does not appear to be the case as KIT has had incremental EBIT margins of 10.1% and 10.8% on a TTM and CY2010 basis and incremental EBITDA margins of 13.3% and 17.9% on a TTM and CY 2010 basis. These margins are well below long term Street forecasts for the firm. Admittedly, there could be some legitimate one time costs associated with the acquisitions which will go away.
Second, integrating acquisitions can be a difficult process especially at a firm that has been as acquisitive as KIT.
Third, we have seen this movie before. Kaleil Tuzman sunk a previous firm, govWorks, by having a wildly aggressively land grab mentality against the advice of several VCs. The previous episode has even been turned into an HBS case and HBR article (http://hbswk.hbs.edu/item/2978.html). Here is an excerpt:
Soon after Herman and Tuzman set up shop, they approached a venture capitalist for additional funding and for advice. He suggested that the company test and refine its business model by initially focusing on one payment operation, for parking tickets, in one U.S. city. The entrepreneurs almost bit off his head. "The leader in this market space is going to be a multibillion-dollar company," Tuzman declared. He believed that by winning the support of umbrella organizations that represent many municipalities, such as the U.S. Conference of Mayors, govWorks could quickly go nationwide.
2. The business should prove to be much less defensible and of a lower quality than management would have you believe. I do not believe this will prove to be an “Oracle-like business” as I have heard stated by Mr. Tuzman in justifying his aggressive acquisition strategy.
First, evidence (both direct and anecdotal) suggests that there are limited barriers to entry and many of KIT’s customers do not view their service as mission critical. Several customers and competitors left me with this impression. Anecdotally, I think looking at The Feedroom, which KIT purchased in 2009, is instructive. KIT purchased The Feedroom for $16 million after the company had received $68 million in funding. Although the Company went in many different strategic directions, wasting money, this does not leave me with the impression that capital deployed into this business gets a great return. Additionally, The Feedroom had some fairly high profile clients such as Barnes & Noble, Bausch & Lomb, Hewlett-Packard and Intel among others. This leads me to believe that either it is not mission critical or not that hard to do.
Second, the Company has no patented IP and does not actively pursue patents.
3. Management is questionable and has already begun to cash out. Kaleil does not have a particularly great reputation with many believing him to be overly aggressive in business with govWorks being a perfect historical example. The management team and acquisition targets are and have been chock full of former pals from JumpTV. Stories about his professional behavior are some of the craziest that I have encountered. Although it doesn’t make him a bad manager or this a bad business, I do think that some if true are egregious enough to give cause for concern. In a meeting with Kaleil, a contact who works for a software focused L/S fund asked to follow-up with the CFO to clarify numbers multiple times. He was told that he could call Kaleil. Finally, Kaleil pointed at him and said, “I see what you are trying to do. I know your game...” As told, my contact was asking about some of the acquisition accounting. Several sellside sales people have relayed some colorful stories. Kaleil apparently likes to bring his small dog (chihuahua, I believe) to sales meetings. In one instance, the dog relieved himself/herself in the entryway of a buyside client. Kaleil suggested that the sales person clean it up because “..my shoes are way too nice.” Again, I think that these stories say very little about his management capability or the business quality, but it does make me question whether his roll-up strategy is for sound business logic or a vanity project.
As far as implementation, I believe that there could be better entry points give the recent pullback, decent quarterly numbers and the high short interest.
Catalyst
Failure to generate FCF now that the Company has shifted from acquisitions to profitability.
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