Description

LookSmart (LOOK) - TREMENDOUSLY UNDERVALUED AT A 51%+ DISCOUNT BELOW NET CASH WITH CATALYSTS AND 400%+ UPSIDE POTENITAL

Conclusion: LOOK is a rare combination of an incredibly undervalued company which seems to be at a performance inflection with fundamentals starting to improve, but the stock has not reflected the improvement. LOOK's valuation is compelling with the stock trading 51% below net cash, at a price/book of 0.53x, an adjusted* P/E on my FY10 estimate of 6.4x. The company has a solid existing business with over $50 mil of annual revenues and substantial organic revenue and earnings growth potential. The company also has valuable proprietary technology in the growing market of on-line advertising. I think the risk/reward is compelling with my estimate of potential fundamental upside of 400%+, and limited downside due to the company's strong cash position, and the fact that if LOOK's fundamentals don't improve (or even if they do) the company could be acquired at any time.   

Company Description: LookSmart is a leader in certain segments of the online advertising market. The company generates the vast majority of its revenues through acting as a broker, by operating a software based search advertising platform/exchange (AdCenter), that matches advertisers with search queries from websites. Advertiser's bid for key words and phrases on LOOK's AdCenter platform and pay per clicks from potential customers. For example, when one does a search on Yahoo or Google, many of the results that show up are from paid advertisers that pay for their website to be put on the list of results on a per click basis. A very sophisticated software exchange engine is needed to track the billions of search queries, input the advertisements, track the clicks, and price the advertisements.

Yahoo and Google are called proprietary search advertisers because they have their own exchange platform. However, there are thousands of popular websites that don't have their own exchange platform, and thus need a third party "non-proprietary" exchanges such as LOOK's AdCenter  platform to manage and market advertisements from search queries. LOOK has one of the leading platforms as evidenced by the fact that it was voted the best search advertising platform by SES in 2008 and was a finalist in 2009.  LOOK's platform has the scale to grow significantly as it is one of the largest independent pay per click advertising networks, with over two billion daily search queries, and 243 million paid clicks during 4Q09.  LOOK was one of the first company's in this segment, with over with over 10 yrs of experience, and has invested a substantial amount of resources building its platform. The company operates in a large and growing segment of the on-line advertising market.

Thesis: LOOK seems tremendously undervalued at an 51% discount below its net cash, over $50 mil in annual revenues, and was cash generative last quarter.  I believe the company's fundamental will either meaningfully improve, or the company will be sold, and in either scenario the stock will move up substantially. I think it is more likely that the company's fundametals will improve as evidenced by its recently reported 4Q results, which indicate a turn-around due to sequential revenue growth, positive comments from management, and the fact that the company generated cash. Management also noted that they would explore strategic alternatives (I think this means a sale) if they could not execute a fundamental recovery as they expect.  Due to the small market capitalization of the stock, there are very few investors paying attention, which is why I believe the stock has not yet reflected the positive developments from 4Q.  Based on my scenario analysis I see 12 month upside potential of about 420%, with only about 6% fundamental downside in a reasonable worst case scenario. Of course with a stock this size of LOOK, it could move well above or below my fundamental value calculations.

Valuation: LOOK  is currently valued at a market capitalization of about $16.4 mil, 51% below net cash of $24.8 mil or $1.45 per share.  LOOK's current price/book is 0.53x. I calculate that if the company is able to post a moderate recovery in fundamentals the stock could move up to the $5 range (which would equal and EV/revenues of 1x and a P/E of 13x on my 2011 favorable case *adjusted EPS estimate of $0.38) which results in 420% return potential. If the company's fundamentals remain stagnant or deteriorate, I estimate the company will be able to sell itself for $2-$3 for return potential of 108-212%. I have a hard time coming up with a reasonable worst case scenario where there is meaningful fundamental downside for the stock. The worst scenario I could think of is that fundamentals deteriorate tremendously, the company begins to burn a significant amount of cash, and they are unable to sell themselves. Under this highly unlikely scenario I estimate that the company would be shuttered/liquidated with all proceeds net of closure expenses returned to shareholders. Under this scenario I calculate shareholders would end-up with $0.80-$0.90 per share.  Of course under this scenario the stock could trade below this level, and perhaps fundamentals could deteriorate below my downside expectations, although business seems to be moving in a positive direction at present.

Recent Events:  One of the primary reasons why the stock is near all-time lows is because the company's CEO Ted West resigned on 12/4/10, and the company's Executive Chairman Jean-Yves Dexmier assumed the role on an interim basis. This management change created significant uncertainty and investors were worried about what it meant for 4Q09 results. The company reported 4Q09 EPS on 3/18/10 which demonstrated improving fundamentals, and should have caused a sharp recovery in the stock. However,  LOOK stock has not moved much since the report and I could only attribute this to the fact that the market has not absorbed the news yet, because the stock has fallen off most investor's radar screens. There is no rational fundamental reason I could think of that LOOK should not currently be trading at a level substantially above net cash of 1.45, given the fact that the management situation has now stabilized, fundamentals are improving, they are generating cash, have over $50 mil in revenues, and there should be some take-out option value embedded in the stock???

The company reported an improvement in most metrics during 4Q09, and although they don't give guidance, I think the tone of the call indicated the anticipation of additional improvement throughout 2010. LOOK is very close to profitability and I estimate the company will begin making money (at least on an adjusted basis) within the next few quarters and could be as early as 1Q10. The company reported sequential growth in 4Q09 revenues which were $12.8 mil, a 2% increase over $12.5 mil in 3Q09. LOOK's 4Q EPS also improved significantly at ($0.05), vs  ($0.11) during 3Q10. LOOK also generated cash during 4Q09, reporting a sequential improvement in cash, cash equivalents and investments of $0.6 mil, and positive CFO of $1.2 mil. Gross margin increased from 31% in 3Q09 to 33% in 4Q09. Total paid clicks were 243 million, which represented a YOY and sequential increase of 21% and 11%. LOOK's 4Q traffic acquisition costs (TAC) decreased by 1.5% on a sequential basis.

My Estimates: I calculate the company could report FY10 adjusted* EPS of between $0.10-$0.20 assuming a 10-20% increase in revenues and 35% incremental gross margins which is in line with historic margins. I estimate the company could report 2011 adjusted* EPS of $0.25-$0.50 using similar assumptions. Although numbers are uncertain with this company, I think that 10-20% growth could be realistic given the following factors; 1) the company should be positively impacted by the improving environment for advertising spending; 2) I expect the company's core internet search markets to grow much faster than the general advertising markets; and 3) LOOK could gain some share given its refreshed management team and renewed focus.

 Risks:

The primary risk is that the new management is unable to turn the company around, and that positive 4Q09 results were a false start. However, in this instance the company will likely be sold for a significant premium above its current value in my view. Furthermore, 4Q09 indicated a recovery in fundamentals and the stock has not been up much since these results.

Microcap  - This stock is very thin and illiquid but I believe this is one of the primary reasons why it has flown under the radar screen, creating a vast imperfection in its current valuation.

 *Adjusted EPS adds back share based compensation and other non-recurring items. My EBIT numbers were also adjusted in the summary idea field adding back the same items in order to give investors a clearer view of the fundamentals excluding non-cash items and non-recurring factors, because the company has been going through a restructuring which is almost complete. 

Catalyst

Fundamental Recovery - I expect to see a fundamental recovery in the company's performance in the coming quarters which I estimate will result in profitability from ongoing operations within the next two quarters.  My view is based on the following factors; 1) the company hit a revenue inflection during 4Q with revenues growing from a sequential perspective the first time in a year; 2) LOOK has implemented cost reduction initiatives which should save the company about $2 mil this year and lower the revenue breakeven point to $13 mil - $13.5 mil, which is within reach of the company's 4Q revenues of $12.8 mil; 3) the company is making key hires to drive growth;  4) I believe the company's core markets are growing; 5) new management is focused on a recovery.

Potential Share Repurchase or Dividend - The company could institute a meaningful share repurchase or dividend given their strong balance sheet.  If LOOK only used 15% ($4 mil) of its cash for a dividend or share repurchase this would equal about 24% of the company's current market cap. The company has had a history of implementing significant buybacks.

Potential Sale of Company - I think the company could sell itself for a substantial premium at any time if an offer for the right price was made. I think management would prefer to improve performance and have a higher stock price before they sold the company, but I would not be surprised if a sale happened sooner. I believe many companies would be interested in LOOK due to its value and strong internet advertising platform.

Naming of a permanent CEO - I expect the interim CEO (Dr. Dexmier) to be named permanent CEO which I believe will be viewed positively because it will indicated stability at the company. The interim CEO has a strong leadership background and is as good a leader as a company the size of LOOK could hope for. I base my opinion on comments during the 4Q call when the interim CEO said he was committed to staying in his position through this point in LOOK's history.  In the unlikely event that another permanent CEO is name I also think this would be positive because it would indicate stability at the company.

New Hires - The company noted on their 4Q call that they will be making key hires in growth areas which I expect to be announced as they occur.