This will be an atypical VIC write-up for me because it is more GARP than deep value, and I hesitate to post it here for that reason, and also because my prior forays into GARP – full disclosure – have been among my least successful posts.  So caveat emptor!  But the reason I still wanted to present this name is that out of all the stocks I own, it is probably the only one that has the potential to be a multi-bagger.   After a multi-year bull market comprised of tons of multiple expansion into a fairly tepid economy, I have a ton of ideas that could go up 30, 40, maybe best case 50%...but virtually none that could double or triple.  This is one that could do that, although the flip side of that is much more risk than the typical name I own.  The downside risk can be managed with position size or options.

RetailMeNot was a 2013 IPO in the internet sector.  Like many tech IPOs of that period, SALE has a relatively short operating history and a large theoretical total addressable market.  What distinguishes it from many of the other recent IPOs of its vintage are its high margins and its current profitability. 

SALE operates online digital coupon sites where consumers can collect coupons they redeem for discounts when shopping on or offline.  Their main site is retailmenot.com in the US, and they own several international sites.  They built the business organically in the US, Canada, and Germany, and they acquired businesses in France, the UK, and the Netherlands.  They offer over 500K coupons from tens of thousands of retailers every month.  They source their coupons four ways: using contract offshore data aggregation (40%), through user-generated content (35%), directly from retail partners/affiliates (20%), and through an in-house team (5%).  It’s notable that all the user-generated content is proprietary, as is some portion of the affiliate content (the subset that is exclusive deals).  While there has been a proliferation of coupon sites, as new entrants have been attracted by the high margins in this business, they have maintained a dominant position, partly due to first/early mover advantage, partly due to retailer/affiliate relationships, partly because of SEO competency, and partly because of superior content.  The way they make money is they get a commission from the retailers they have paid relationships with.  When a user completes an order online, they get a commission (varies, but generally around 5%), and the accounting is based on last click attribution done by a third party performance marketing network.  Consumers also can use the coupons in-store by offering a code at checkout that they can display on their smartphone, either using a mobile web browser or the RetailMeNot app.  SALE gets most of its traffic through unpaid sources – 68% organic search (aided by considerable in-house SEO – search engine optimization – competency), 17% direct, 5% from emails, 3% other unpaid, and 7% paid search. The company, like most internet companies, is getting an increasing amount traffic from mobile versus desktop browser.  They are also in the process of moving customers onto their smartphone app.  This to me is crucial to the long-term prospects of the company.  First, direct customer access from the app mitigates one of the two main risks to the company, an increase in the cost of consumer customer/traffic acquisition.  The less reliant they are on search, and the more people who come to them directly through the app, the less vulnerable they are to disintermediation by Google.  Second, app usage by their consumer customer base will allow them to roll out a series of location-based marketing solutions which are of higher value than just digital coupons to their paying retailer customers, and thus mobile app adoption is the key to the company’s long-term growth and differentiation within an increasingly competitive discount and deal landscape.  Over time SALE can grow its existing coupon business by growing visitors to its sites and apps both domestically and internationally, increasing the number of paid retailer relationships it has, participating in the overall growth of the digital coupon industry, and finding ways to monetize the large amount of consumer data it has amassed.  But over time, the real upside is if they can morph into a true mobile marketing partner for retailers, becoming a channel for exclusive deals and an arms merchant for retailers to pursue location-based and ultimately hyper-local marketing programs.

As someone who spends 90% of their time on consumer/retail and media/internet/telecom, two things attracted me to this company.  From the consumer side, I am of the belief that we are in an era of perennial discounting.  The consumer has been trained to look for a deal, and with the exception of a handful of very high end brands/retailers, no one is willing to pay full price for anything ever…so coupons are here to stay as a secular trend.  Also, in a viciously competitive market, retailers are really looking for ways to target consumers in increasingly specific ways – based on their personal product/brand preferences, and based on retailer needs, such as the desire to balance out regional inventory imbalances.  Also, online/offline shopping habits are converging and so are marketing budgets and strategies.  So SALE plays into all the things happening in retail right now.  And from the tech perspective, like many internet companies, SALE has very high gross margins (90%+), but unlike many of its young, small cap, recently IPOd peers, it has very high EBITDA margins (peaked above 50% before retreating to the mid 30%s on investments, although should be able to recover to at least 40%).

Propelled by a fantastic Q4 result, SALE ran from the mid $20s early this year to a high of $46.98.  They reported Q4 results in February which blew away the street.  In Q4, they grew the topline 55% (desktop +43% and mobile +179%) versus expectations and guidance in the mid 30%s.  All the metrics were fantastic and accelerated from Q3.  Customer visits were +24% v +19% in Q3.  Mobile app sessions were +153% v +74% in Q3.  Email subs were +106% v +81% in Q3.  They managed all this growth over holiday but didn’t destroy profitability to get it, posting a 35% EBITDA margin in the quarter.  Despite great results, the stock succumbed to the April sell off that hit almost all internet names, especially the smaller cap, less mature ones.  SALE followed up the strong Q4 beat with an equally impressive Q1.  Sales beat consensus by 10% and the growth rate was 51% versus the 37% that was expected.  Adjusted EBITDA margins came in 160 bp above expectations at 34.9% and Adj EBITDA beat by 8%. Despite Q1 being a much less important shopping quarter, app sessions were 8% higher in Q1 than Q4 and customer visits (combined across desktop and mobile) accelerated from 24% growth in Q4 to 27% in Q1.   Guidance was issued above the street for Q2.  The stock initially opened strongly up, but when it couldn’t hold its gains, momentum sellers piled in.  Short interest was reported at 1.8 mm share of 5% of the float on 4/30, a few days before earnings, and stood at 9.4 mm shares of 29% of the float as of 7/15.

So with all this short interest, what’s the bear case?  There really are two main knocks against the company.  The first has to do with its dependence on SEO and the second has to do with industry risks surrounding last click attribution.

SEO, or search engine optimization, is the process of gathering organic traffic by engineering your web content so that it screens well through search engine algorithms (particularly Google’s, given their market share).  SALE has always been excellent at that.  If you typed a brand name plus the word coupon into Google, they would almost always have shown up #1 or #2 in the unpaid results.  This leaves them vulnerable to Google algorithm changes, regardless of whether Google intends to hurt them specifically with the changes or their loss of placement is merely a byproduct of something else Google wants to achieve.  For further background on SALE’s historical SEO dominance and the risks associated with it, I encourage you to read this article: http://priceonomics.com/the-seo-dominance-of-retailmenot/.  In late May, Google started rolling out its latest update, Panda 4.0, and on 5/21/14, blog searchengineland.com reported on several companies, most notably EBAY and SALE, dropping in search results.  SALE dropped 19% the next day (from $31 to $25) and then another 5% the next day.  Despite the company saying it had regained its positioning in about 2/3 of searches through its SEO efforts within a couple of weeks, the stock has never recovered and has bounced around the low to mid $20s ever since as short interest has soared.  The consensus opinion is that while the company may have managed to get themselves out of this hole this time, the fear is that SEO is outdated as a business strategy for customer acquisition, and eventually there will be an update they can’t out-engineer.  If they have to start paying for their traffic, the cost structure will permanently re-rate upwards, margins will come down, and the growth won’t materialize.  The memory of Demand Media (DMD), a company crushed a couple of years ago by Google algorithm changes, looms large.  Some people may even think GOOG is out to intentionally crush SALE, although this seems a little far-fetched to me given Google Ventures own 1.7 mm shares of sale.  While I agree SEO dependence is a serious risk, I think it is mitigated by the fact that there is a material migration to the RetailMeNot app in process.  They have had over 18.5 mm downloads of the app and it is already the third largest shopping app after AMZN and EBAY.  SALE has already disclosed 2.2 mm app downloads in Q2 (v. 2.6 mm in Q1) and 162 mm app sessions in Q2 (v. 125 mm in Q1).  Once people are on the app, not only can SALE serve them better offers (from both the consumer and retailer perspective), but they are no longer dependent on web search to get traffic.  Also, the more time that elapses without them being disintermediated, the more they will have built their own brand, where people automatically turn to them as their go to coupon destination.  The Panda 4.0 issue was barely a blip for EBAY, because everyone knows what EBAY is and while some people do get there via a product listing in a search result, plenty of people go there direct.  So while SEO dependence is a risk, it is more than reflected in the current valuation.  And the bigger SALE can get, and the more people they can get onto the app, the less of an issue this becomes.  So holding their place among the coupon sites for the next year or two is critical, and if they can do that, I think the problem pretty much goes away.

The other big knock is a fear that commission rates could come down, or certain commissions could be eliminated, as retailers push back against and question the validity of last click attribution.  The idea is that often customers might go to a retailer site, shop, then go to SALE to get a coupon for that retailer, then go back to the site and make their purchase with the coupon.  Should the retailer really pay 5% for that transaction?  Because SALE really isn’t responsible for that traffic.  The customer was there anyway on their own first.  While the issue of last click attribution is currently a hotly debated subject across the internet, and people are looking at alternate measurements for commission measurement (such as first click attribution or navigation-determined algos to determine commission rates), and this is clearly a material risk…I think the need to close sales in a tepid retail environment that is brutally competitive for market share somewhat offsets this risk.  I also think this risk is in the valuation.  Cart abandonment is a huge problem for retailers – some surveys estimate it could be as high as 60-80%.  If the use of the coupon that the customer retrieves on SALE makes them less likely to abandon their cart, I think retailers will continue to pay the 5%.  Also, the average annual commission paid to SALE by retailers in the Top 500 retailers is a few hundred thousand dollars, which while not nothing, is a relatively small annual line item to retailers of their size.  I think the other key here is not what SALE can offer the retailers now (traffic, engagement with the customer, and some user data), but what they can offer them in the near to intermediate future in terms of location-based marketing to app users.  RetailMeNot has invested in geo-fencing 15,000 malls and street shopping areas around the country (this number was 6000 as of the end of 2013).  No one else has done this.  They also have a partnership with mall owner General Growth to test beacon technology in their malls.  When you have the RetailMeNot app installed on your smart phone and you enter one of these geo-fenced areas, you get a pop up alerting you to deals in your immediate area.  If you have given RetailMeNot information about which retailers are your favorites, you will get even more targeted offers alerting you to deals from your favorite retailers.  This kind of push technology is of great use to retailers and is exactly what they are all trying to roll out.  As an illustration: if due to a late start to summer on the East Coast, Macy’s is heavy in warm weather inventory on the East Coast, they could use RetailMeNot to push digital coupons on bathing suits and shorts to customers as they get near a store in NY, Boston, or DC, while customers in LA and Phoenix, where weather patterns were more normal, do not get pushed that deal.  Eventually there should be opportunities to offer in-store deals.  For example a customer who is in Macy’s shopping the shoe department and has favorited Gymboree and Children’s Place as retailers could be identified and offered a coupon to be used on children’s clothes at Macy’s that day.  RetailMeNot app users have already favorited their preferred retailers over 70 mm times – so the data is there.  These are just two examples of the type of things retailers are working on internally and that SALE is in a superior position to enable.  The dream for the retailer is to eventually be able to offer hyper-local deals, specific down to the point of which aisle in the store you are standing in.  Because consumers want aggregation, they are unlikely to download an app for each of the stores they shop at.  There will be an aggregator as this now imagined mobile marketing becomes a reality, and I would argue SALE is in the best position at this point to become that aggregator given their large user base overall as well as the almost 19 mm app installs they have already achieved.  Also the near 50/50 split of the smartphone-using world into iOS/Android means that retailers who want to go it on their own will need to develop for both platforms, which raises costs to an extent that further supports the move to aggregation. 

Other knocks on the company are competition and content quality.  As far as competition, there is a lot.  The other coupon sites are primarily smaller and private, with the exception of the recently public COUP, although that site has more of a CPG-focus.  GRPN, in its quest for a sustainable business model, has branched out into coupons as well but its content is inferior and while it has a large user base, it is behind on retailer relationships and geo-fencing.  GOOG would clearly be the most threatening potential entrant but they recently exited their online coupon business so I am less worried about that since the exit (see: http://recode.net/2014/06/02/google-will-kill-off-its-digital-coupon-business-zavers/

).  As for content quality, no doubt there are some bad coupon codes on there.  But SALE has devoted more resources to scrubbing the coupons for accuracy than any of its competitors.  Also, the engaged user base at SALE provides a lot of real time feedback and ratings on coupon usability, which makes the site’s content of more consistent quality than any of the competition’s.  I should also note that they, like everyone in the sector, is a generous user of Stock Based Comp which while non-cash, is of course a long-term cost.

Right now SALE is trading at 9.5x 2015 consensus EBITDA estimates which I think are do-able.  In order to make those numbers, SALE needs to grow about 31% in Q2-4 of this year and 25% next year, versus the last four quarter’s growth of 51%, 55%, 39% and 44%.  A fair amount of deceleration is built in, despite there being no signs of deceleration in customer acquisition (although we will see how badly Panda 4.0 hit them in Q2 tonight) or in the digital coupon industry more generally.  Margins are expected to trough in Q2 around 33% on the investment spending in Sales & Marketing and Product Development and eventually recover back to the 40% level, consistent with 2013 levels, but much lower than 2012 at 49% and 2011 at 65%, albeit years when there was less competition and less focus on the next generation of products beyond just coupons.   I see this trade as rather bimodal.  Either the bears are right, and their business gets disintermediated or competed away, margins collapse, the EBITDA gets cut in half, the multiple collapses, and you get a $10 stock.  Or they maintain their positioning and margins, and they have an extremely long runway for growth.  If they can do that, they should trade at 15x EBITDA on just the current business, inline with the group in the short term, which would yield a $40 stock.  While that sounds like a pretty balanced risk/reward - $15 up, $15 down – given management’s track record of strong execution and the strong business momentum from the past few quarters, I would probability-weight the upside scenario.  Also with the stock cut in half from the highs, and short interest having gone from almost nothing to near 30% of the float on the way down, if results come in even inline, I would hope to see some short term recovery.  Longer-term, I think you have optionality around the new mobile product set, which retailers desperately need in their tool box for a retail environment that likely remains extremely promotional and brutally competitive.  If they can get the new mobile products right and leverage their user base and retailer relationships into being a mobile marketing and software partner for their existing retailer clients, then this company could grow into a market cap 2-3x where it is now.  The company is very well-capitalized with about $160 mm of net cash and has been generating $20+ mm in cash per year, despite the hyper growth of the last few years.  While it is not core to my investment thesis at this time, it would not shock me to see this company eventually become a take out candidate for any of the players focused on mobile commerce – GOOG in a way makes the most sense strategically, but given their stated acquisition strategies, EBAY and YHOO would also seem likely candidates.  Other less likely but potentially interested parties could include Rakuten, Alibaba, MSFT, or AMZN.

Note that SALE reports tonight after the close.  I have wanted to write this up since the dislocation in late May but just couldn’t carve out the time.  I have managed to get this done just in time to look like a fool tomorrow if Panda 4.0 really did blow the company up.  But I did want to get this up to serve as a primer ahead of the quarter for those who might be interested.