XO Group (XOXO)

Summary

XO Group (XOXO) provides multi-platform media services primarily to the wedding market and also to the newlywed, and pregnancy markets in the U.S.  XOXO operates a network of websites that offer content and services tailored to the engaged, new-married, and pregnant audiences under various brands, including TheKnot.com, a wedding website, and weddingchannel.com, a wedding registry site and wedding vendor review site; theNest.com, a site for newlyweds and new couples; and theBump.com, a prenatal and pregnancy website.  TheKnot.com and weddingchannel.com together have a leading position in the online wedding planning market.  While the Company has sought to diversify from weddings with theNest.com and theBump.com, we believe that weddings remain the dominant source of its revenue base, representing 90% or more of total revenues of $125m in FY11.

XOXO is a very high-margin (80% gross margins), non-capital intensive business that generates large amounts of free cash flow.  Further, it appears this cash generation could be accelerating as recent investments pay off.  Over the past few years, XOXO has been using its large gross margin dollars to increase its investment in: (1) product and content development (from $14m in FY07 to $24m in FY11) and (2) sales and marketing (from $25m in FY07 to $39m in FY11).  These investments have enabled it to grow gross profit dollars every year during the Recession, from $81m in FY07 to $99m in FY11.  We think this is a very impressive achievement. We note that even during the Recession, XOXO’s gross margins held pretty steady near 80%.  Over the past five and a half years (since FY07), cumulative cash from operations generated by XOXO has been about $107m, which compares to an EV of about $140m or about 75% of EV.  (We believe maintenance capital expenditures are very modest at about $3m per year). We believe that if the next five years are similar to or better than the last five years, XOXO’s stock price is likely to go much higher.  XOXO also has a “Ft. Knox” balance sheet, with about one-third of its market cap in cash.  The management team appears to have noticed these attractive features, given that XOXO has repurchased $90m of its common stock (9.6m shares) over the past two years or about 28% of total shares.  The Company had 34m shares outstanding at December 2010 and has reduced this to 25m shares outstanding at June 2012. 

While the economy has improved since 2008-9, we think it remains weak and favor business models with goods or services that are less discretionary.  We believe XOXO has such a business model and would point to its performance since FY07 as evidence.  Over LTM, XOXO has generated about $22m of FCF versus an EV of about $140m, so XOXO is trading at about 6.5x FCF or a 16% unleveraged FCF yield.  (We define FCF as Adjusted EBITDA less maintenance capital expenditures).  We think this is cheap for a business which has a leading position in online wedding planning and advertising, which held up very solidly through the Recession, which provides a highly-prized and targeted set of consumers to advertisers, which has 80% gross margins, which has a very high ROIC (100%+) business model, which has a subscription-based online local advertising business, and which generated cumulative cash from operations of almost 75% of EV during the last five and one half years. 

We note that XOXO was the subject of an excellent write up by Bentley883 under its prior name TheKnot and we refer interested readers to this write-up.  The Company changed its name to XO Group in June 2011.  There are consistently about 2.2m weddings per year and about 4m births per year in the U.S., so XOXO’s customer base is replenished every year.  The average amount spent on a wedding is about $25,000 and about $70b in total is spent per year on weddings in the U.S.  Wedding consumers are less likely to cut back on weddings, even in tough economic times, and wedding planning is an extensive, complicated, and information-intensive process, which makes wedding planning sites all the more important.  

We believe investors have not yet picked up on the Company’s strengthened business model but this could change if recent improvements continue.  Adjusted EBITDA margins declined steeply starting in FY08 due to the investments discussed above but margins have started to improve.  Adjusted EBITDA margins improved from 14% in FY10 to 17% in FY11 and from 14.6% to 18.7% for six months of FY12.  This is still well below the 27% Adjusted EBITDA margin achieved in FY07 but we believe investors may start to notice if the Company can continue to improve margins and grow revenues.

Leading Online Wedding Sites

XOXO has a leading position in online traffic and advertising for weddings with TheKnot.com and weddingregistry.com together receiving traffic estimated by management as twice the nearest competitor (weddingwire.com) and about four times the third competitor (thebride.com, owned by Conde Naste).  A large and active membership is critical and annual new membership to the Company’s network of wedding sites has remained fairly consistent in recent years.  Membership enrollment is free and gives members important services.  We believe about 1.7m new members were added in FY11 or about 70% of all brides.

One factor that should be considered is the increasing trend towards mobile devices and how this might impact XOXO’s business model.  On the most recent call, management indicated about 20% to 30% of traffic access is from mobile devices, depending on which particular site, and this trend is increasing.  They believe the trend towards mobile can be an overall positive for the business but it is unclear exactly how this will play out.

FY12 and FY13 Estimates

XOXO has five segments.  Of these, Online Local and Online National Advertising are the largest and among the highest margin segments and generate most of total gross margin dollars.  In FY12 and FY13, we expect the Online Local Advertising and Publishing segments to grow revenue and we expect the Online National, Registry, and Merchandising segments to be at least stable. We believe total FY12 and FY13 revenues can grow 5% per year or more with gross margins stable near 80% and operating expenses growing mid-single digits.  We believe XOXO can achieve an EBITDA margin of 20% or more in FY12 and FY13.  LTM Adjusted EBITDA is about $25m.  Importantly, LTM Adjusted EBITDA is burdened by about $4m of incremental expenses related to the Company’s initiative in China (began in 2010) which has yet to produce much revenue and which is masking some of the operating leverage inherent in the Company’s business model. 

We have added non cash stock compensation back to our adjusted EBITDA numbers but others may not want to count this towards adjusted EBITDA which would adjust down the unleveraged FCF yield to an 11% unleveraged FCF yield.

XOXO has significant non-cash expenses so we prefer to focus on FCF rather than GAAP net income.  LTM non-cash expenses included D&A of $5m, stock-based compensation of $6m, deferred taxes of $2m, and reserves for returns of $4m.  (We are not including the latter two items in our EBITDA numbers but we are including stock-based compensation expense).  The Company has limited capital expenditure needs (about $3m per year) and working capital needs.  We believe XOXO can generate FCF of $23m to $25m in FY12 and FY13 which compare favorably to an EV of $140m.

Strong Local Online Advertising Business

We believe Online Local Advertising is the “crown jewel” of XOXO.  It’s subscription-based service and local focus gives it a very strong competitive position in each of the 85 separate local markets that it competes in.  Local advertisers, who are wedding vendors (flowers, music, venue, etc.), sign up on a subscription basis for 6 to 12 months so the Company has good visibility on these revenues.  These local advertising revenues are diversified among 22,000 vendors who pay an average of about $2300 per annum for their online advertising positions.  Increased IT investments over the past few years have allowed the Company to more surgically price in local markets for better or larger placements and also to show vendor customers the traffic they are getting to their online ads.  The result has been reduced churn among local vendors (from 36% to 30%) and slightly higher average revenue per vendor as well as more vendors (see chart below).  The Company has also increased its sales force focused on local online advertising over the past few years (currently about 60 local sales reps) and shifted their compensation towards signing new customers versus taking renewals.  These actions by management required increased investment in sales and marketing and product development from FY08 to FY11 but these higher operating expenses appear to be paying off as the Online Local Advertising segment sales grew 22% in FY11 and 18% in six months of FY12.   

The chart below shows how the investment in upgraded technology and increased sales and marketing resources have enabled the Company to reduce churn, increase vendors, and increase advertising revenue per vendor.  Management says its local strategy is to “sell more vendors, who stay longer, and spend more”.  The combination of these three factors has resulted in very significant leverage in the Online Local Advertising business model which has driven consistently higher sales and gross profit results in the past 18 months.  Online Local Advertising segment has been a major driver in XOXO’s higher revenues and gross margin dollars over the past few years.

Macy’s Relationship

Macy’s was historically the Company’s largest customer, representing about 9% of total sales in FY09.  However, in early 2010, Macy’s changed its registry agreement with XO Group such that XOXO would no longer host and manage registry websites for Macy’s and Bloomingdales (and receive 100% of their registry business) as Macy’s brought its bridal registry services in-house.  Macy’s changed its agreement with XOXO to its standard agreement with other retailers.  The Company’s registry revenues, which are 100% gross margin, declined in FY10 as a result, from $10m in FY09 to $6.7m in FY10 and seem to have stabilized near these levels.  Macy’s was also one of the largest shareholders in XOXO with 3.7m shares and the Company repurchased these shares in early 2010 for $10.25 per share.  Despite the large drop in Registry gross profits in FY10, XOXO was able to increase total gross profits in FY10 as improvements in the Online Local and National Advertising and Publishing segments more than offset the decline in Registry gross profits.

Business Segments

XOXO has five high-margin business segments.  These are (1) Online Local Advertising; (2) Online National Advertising; (3) Merchandising; (4) Publishing; and (5) Registry Services.  In FY11, Online Local Advertising was about 35% of total revenues; Online National Advertising segment was about 21%; Merchandising was about 21%; Publishing was about 18%; and Registry was about 5%.  In FY11, Online Local Advertising grew 21%; Publishing grew 15%; Online National grew 8%; Merchandising declined 3%; and Registry declined 5%.

We believe the revenue and gross profit performance shown above though the Recession indicates a very strong and resilient business model.  XOXO was able to grow total revenues and total gross profit in every single year from FY07 to FY11.  We think this performance speaks to the strong competitive position of the Company.  It also reflects that fact that wedding expenditures are relatively recession resistant as participants are less likely to cut back expenditures on this major life-altering event.  We believe that weddings in the U.S. are likely to continue near 2.2m per year.  We also believe the expenditures related to these weddings are likely to be at least stable and possibly may increase if the economy improves.

Online Local Advertising – Online Local Advertising is especially recession resistant and has been the Company’s strongest segment over the past two years, growing revenues 22% in FY11 and 18% in six months of FY12.  The ability to reach an extremely targeted customer base that is likely to make a vendor selection in the near term is highly attractive to local vendor advertisers.  These local vendors also advertise with XOXO on a subscription basis and, consequently, local online advertising revenues have been very sticky over the past few years.  The cost of subscription is modest relative to the potential benefits.  The highly localized focus of this segment makes its competitive position extremely strong. 

Online National Advertising – Online National Advertising segment has very high gross margins similar to the Online Local Advertising segment.  Revenue grew 8% in FY11 but declined 4% for six months of FY12 due to increased economic uncertainty.  National advertising revenues tend to be less stable than local advertising revenues and are not subject to subscription contracts as with Online Local Advertising.  The Company presently has about 10 to 12 national sales people.  Three of the largest national advertisers are Target, Bed Bath, and Macy’s.

Publishing - Publishing revenues grew 14% in FY11 and 12% for six months of FY12 as XOXO’s magazines have defied industry trends and increased pages by about 10%.  This contrasts to competitors who have been downsizing and reducing their publishing operations.  XOXO’s publishing segment includes The Knot Wedding magazine published four times per year and The Knot Weddings Local Magazines published semi-annually in 17 local markets around the U.S and The Bump Magazine (pocket-sized book for moms) and The Knot Books (library of books) and The Nest Books and The Bump Books. 

One reason for recent strong publishing results is that about one year ago, Conde Naste shut down its regional magazine group, while the Company added to its regional magazine capacity.  XOXO increased its national magazine to four issues per year from two issues while Conde Naste reduced its Brides magazine (primary national competitor) from 12 issues to 6 issues per year.  XOXO is able to offer national advertisers a national and local magazine presence and an online presence. 

Merchandising – Merchandising revenues are from online shops that sell a comprehensive array of gifts and favors related to the wedding and pregnancy.  XOXO sells directly to the consumer through The Knot Wedding Shop, the Wedding Channel Store, and The Bump Baby Store.  Merchandising revenues were down 3% in FY11 and down 9% for six months of FY12 due to IT system upgrades by management to improve service and performance in this segment.

Registry Services – Registry Services is a 100% gross margin business where the Company receives a fee for directing sales to one of the many retailers covered by its registry site.  Registry services revenues dropped sharply in FY10 as the Company’s exclusive relationship with Macy’s was ended and Macy’s converted to a traditional registry relationship.  XOXO’s registry services business basically covers all the major retailers where couples register for wedding gifts.  The Company has focused on improving its technology to allow wedding parties to consolidate all their separate registries at various retailers at one site to make it easier for guests to purchase gifts.  Registry revenues have also been below normalized levels as management has worked to upgrade legacy IT systems to handle a more robust Registry search process.  The Company hopes to have this upgraded IT system in place by early 2013.

Operating expenses

The major operating expenses for XOXO are below and indicate one factor related to the Company’s share price decline from over $30 per share in 2007 to $8.50 at present.  In 2007, management made the decision to make major investments in: (1) product and content development and (2) sales and marketing, both of which strengthened its competitive position but also sharply reduced operating income.

We believe that most of the Company’s “story” is told on the income statement.  There are limited amounts of working capital and capital expenditures required for this business model.  Almost all of the investment in the business is expensed through the income statement.  We believe the increase in operating expenses which started in FY08 has stabilized and is paying off in the form of increased gross profit dollars, especially from Online Local Advertising.

Management

XOXO is led by CEO David Liu who founded the Company as The Knot with his spouse, Carley Roney, who is the Chief Content Officer of the Company.  CEO Liu owns about 1m shares or about 4% of total shares outstanding.  The Company was founded in 1997 and is one of the rare survivors of the dot-com era.  We believe that over time management has done an excellent job in making the business model stronger and more durable, partly by folding in adjacent wedding-related properties and partly by making strategic investments.  We believe management has built a high-ROIC, cash-generative business with sustainable competitive advantages.  The Company has built up a strong brand name and relationships with its online membership base which renews each year and also with its national and local advertising customers. 

XOXO has a significant amount of non-cash stock compensation expense and this has increased in recent years, with about $6m of total stock compensation expense in LTM.  The idea is to give employees a meaningful amount of stock based compensation in an effort to replicate what opportunities are at other companies in the online advertising industry.

Competitors

XOXO’s flagship websites, theknot.com and weddingchannel.com, have a strong market position.  Competitors include weddingwire.com, brides.com, and marthastewart.com.  Management has indicated that web traffic to theknot.com and weddingregistry.com is about two times the nearest competitor (weddingwire.com) and four times the number three competitor (brides.com).  The Company has increased its investment in product and content development from $13.8m in FY07 to $24.3m in FY11 in order to maintain its leading position.

Weddingwire.com was formerly owned partly by Martha Stewart who sold a large stake to a private equity firm.  Most recently, Spectrum Equity, another private equity firm, invested $25m into weddingwire.com to repurchase existing equity and to fund growth opportunities.  Weddingwire.com is the primary competitor of the Company in the local advertising segment and it appears focused on growing this opportunity (and this bears close watching).  We believe Weddingwire.com is a smaller company than XOXO, with about 100 employees versus about 600 employees for XOXO and Weddingwire.com also seems less content-focused than XOXO.  Conde Naste formerly had a local advertising effort but closed this down along with closing its local wedding magazine operations about one year ago (although Conde Naste may be developing a relationship with Weddingwire.com).   

The Publishing segment has increased its market share in recent years as primary competitor Conde Naste shut down its regional wedding magazines about one year ago and cut back on the publications of its national magazine.  Conversely, XOXO increased the publication of its 17 regional wedding magazines and also increased the publication frequency of its national wedding magazine.

Key competitive strengths include a highly-recognized the brand name and well-established reputation, product content on its websites, its network of local advertising vendors, and its local and national sales forces.  We do not think these competitive strengths could be easily replicated by competitors.

Online Advertising Industry

The online advertising industry has grown substantially over the past few years and is expected to continue to grow as consumers spend more time online.  This has been to the significant detriment of print advertising, both newspaper and magazine.  Gartner’s projections indicate the online advertising industry is expected to grow at about 12% in 2012 and a similar rate in future years.  We believe XOXO has a very strong and well established niche in the online advertising industry.  Its local and national advertisers have a well-established history with the Company and understand the benefits of advertising on its websites.  Online Local Advertising subscriptions are driven by the effectiveness of the online advertising in generating new leads and business for local vendors and the improving churn rate among these customers is a good indication they are getting benefits from their advertising dollars. As people spend more time online it make senses that advertising dollars are going to follow them.

Growth Strategy

The Company’s key strategies include the following:

• Leverage brands and new media platforms for cost-effective member acquisition - it is critical to maintain brand recognition in consumer marketplace to attract an audience that refreshes 100% every year;
• Deepen the relationship with the audience – a large and active membership is critical to success and annual new membership to its network of wedding sites has remained consistent in recent years.  Membership enrollment is free and gives members important services;
• Connect audience with advertisers – the Company’s platforms and services are designed to connect highly targeted audiences with advertisers in national and local markets;
• Improve product and service offerings to profitably grow its lifestyles businesses
• Expand its brands internationally.  With a large number of weddings and an affinity for western styles, management believes there is a substantial opportunity to serve Chinese couples, and did this through its launch of Ijie.com in 2010.

Some of the growth initiatives undertaken by XOXO in recent years have yet to bear fruit.  For example, XOXO is spending about $4m to $5m per year on its initiative to bring its wedding business model to China and this effort has to date generated very limited revenues.  Also, XOXO’s effort to diversify into non-wedding areas (e.g., thebump.com and thenest.com) has not yet become a large portion of total revenue (we believe it is less than 10%).  However, the investments to build up the Online Local Advertising and Online National Advertising businesses through improved technology and enhanced sales and marketing have paid off strongly thus far, with Online Local Advertising growing 22% in FY11 and 18% for six months of FY12.  Online Local Advertising has been a major driver of improved revenues and gross margins dollars for XOXO in FY11 and for 6mos FY12.

Corporate Background

The Company had a presence on America Online in 1996 and launched its website (theKnot.com) in July 1997.  The Company published its first book in January 1999, The Knot Guide to Weddings in the Real World.  In 1999, the Company acquired Bridalink.com, an online wedding supply store, to develop its supply business.  In 2000, the Company acquired Weddingpages Inc, the nation’s largest local wedding magazine publisher, extending its brand to the local level.  In 2004, the Company launched TheNest.com, and extended its audience relationship beyond weddings with the first online destination for newly married couples.  In 2006, the Company acquired weddingchannel.com, the operator of the leading wedding registry website for about $80m in cash and stock.  The Company made the acquisition to increase market share and provide additional opportunities to leverage core assets.  In 2007, the Company entered the baby market with the launch of TheNestBaby.com, a new website for soon to be parents.  In 2008, the Company acquired Bump Media, a publisher of local print guides that feature pregnancy, maternity, and baby resources.  The Company rebranded TheNestBaby.com as TheBump.com and redesigned the local print guides.  In 2010, the Company launched Ai Jie by The Knot online at Iije.com which provides multiplatform resources providing Western inspiration and local advice for weddings, relationships, and pregnancy for the Chinese consumer.

Strong Cash Flow Generation and Solid Business Model

XOXO has a solid business model with limited capital expenditure ($3m of maintenance capital expenditures per year) and working capital needs.  In FY11, XOXO generated about $18m in FCF (Adjusted EBITDA less maintenance capital expenditures) with EBITDA of $21m.  We estimate FCF of about $22m in FY12 for an unleveraged FCF yield of about 16%.  The business model generates high ROIC (over 100%) and is not capital intensive.  Investments in sales and marketing and R&D are funded by high gross profit dollars.  Over the past five and one half years, the Company has generated about $107m of cumulative cash from operations or roughly 75% of current EV.  XOXO’s business model should continue to be highly cash-generative in FY12 and FY13. 

Key competitive strengths include the brand name and reputation, product content on its websites, its network of local advertising vendors, and its local and national sales forces.  We do not think these competitive strengths could be easily replicated by competitors.

Strong Position within A Growing Online Advertising Industry

The online advertising industry is expected to grow about 12% in 2012 according to Gartner.  XOXO is well positioned within this growing industry, which continues to take share away from traditional media such as printed newspapers and magazines.  As consumers continue to spend more time online, we believe advertising dollars will continue to follow them.  The Company believes that local advertisers are a big opportunity as many of these smaller businesses have not yet fully realized the benefits of online advertising to their businesses.

Valuable and Targeted Viewership Base for Advertisers

The online traffic viewership which XOXO’s websites generate is highly attractive to advertisers.  About $70 billion was spent on weddings in the U.S. in 2011.  There are about 2.2m weddings in the U.S. each year and the average amount spent per wedding is about $25,000.  XOXO’s websites are the leading online wedding planning sites and its online viewership represents a large number of consumers who are likely to spend a significant amount on a wedding which is an imminent event.  Both local and (especially) national advertisers place a high value on the Company’s online traffic viewership.

Diversified Base of Advertising Customers

XOXO has a highly diversified base of advertising customers, with close to 22,000 local vendor customers and no one customer exceeding 5% of total revenues. theknot.com and weddingregistry.com are the leading websites in terms of visitors for information on weddings and it is estimated that almost 70% of all brides visit the sites.  The Company estimates that its wedding sites have twice the traffic compared to its next closest competitor and four times the traffic as the third competitor.  Further, management has invested heavily in product development in recent years to continue to build XOXO’s competitive position.  We do not believe it will be an easy task for a competitor to take a large share of traffic away from XOXO. 

Stable Business Model in a Recessionary Climate

XOXO has a stable business model which performed well during the Recession.  Wedding consumers are less likely to cut back on spending for their big event.  Local vendors that advertise on the Company’s websites realize the large amount of wedding-related traffic that occurs and view the advertising cost as a very necessary expenditure to their local businesses.  The Company’s websites continue to generate a leading share of online traffic related to weddings (an estimated 70% of all new brides sign up as members).  Management has invested heavily in recent years to maintain and build up relevant content related to weddings.  Consequently, XOXO’s revenues have remained stable through the Recession and XOXO’s gross margins have been steady.  We believe this reflects its strong market position.

High Gross Margin Revenues

XOXO’s gross margins have enabled it to fund the build-out of a stronger competitive position.  XOXO’s gross margin in FY10 and FY11 was about 80%.  These high gross margin dollars have enabled XOXO to fund large investments in: (1) sales and marketing expenses and (2) research and development expenses, both of which we believe represent investments in building up the customer base of the Company and building up its online content.  In effect, these high gross margin dollars help fund an investment in strengthening the competitive position or “moat” which supports the Company.

“Ft. Knox” Balance Sheet and Expected Steady Build Up in Cash Position.

XOXO has a very strong balance sheet.  Even after purchasing $90m of its common stock since December 2010 (about 9.6m shares), the Company retains a net cash position of $70m (or one-third of market cap and close to $3 per share in cash) as of 6/30/12.  We believe XOXO will further build this net cash position to $85m+ by FYE12 absent further share repurchases or a special dividend.

Solid Results for FY11 and 6mos FY12 As Recent Investments Appear to Being Paying Off

Recent investments in higher operating expenses appear to be paying off, as Online Local revenues continue to grow strongly and Adjusted EBITDA margins have been improving.  Revenues for FY11 were $124m versus $113m in FY10 or up about 10% driven by the Online Local Advertising and Publishing segments.  FY11 gross margin was 79.8% versus 79.5% in FY10.  EBITDA margin improved from 14% in FY10 to 17% in FY11.  LTM cash from operations was $32m with about $3m in maintenance capital expenditures, which highlights XOXO’s highly cash generative business model.   

FY12 six months revenues improved from $62m to $65m; six months gross profit improved from $49m to $54m; six months Adjusted EBITDA improved from $9m to $12m; six months Adjusted EBITDA margins improved from 14.6% to 18.7%.  These results were largely driven by an 18% increase in Online Local Advertising sales as investments in technology and sales and marketing programs over the past couple years continued to bear fruit.

Large Share Repurchase Program Executed and Excellent Potential for Additional Share Repurchases or Dividends

The Company has spent about $90m to repurchase 9.6m shares over the past two years or about 28% of total shares outstanding.  We believe management is well aware of the current depressed relative valuation of its stock.  We believe that if XOXO’s share price remains undervalued, there will be further major share repurchases and/or a major dividend program.  Total shares outstanding have decreased from about 34m at December 2010 to about 25m at June 2012.

Industry Consolidation Prospects

We believe that XOXO would be an attractive acquisition for a strategic purchaser or a private equity firm, given its very strong market position, strong free cash flows, stable performance through the Recession, highly attractive online traffic and customer base, and its excellent position to benefit from growth in online advertising at the expense of traditional print media.  A strategic purchaser might purchase XOXO for its highly-targeted and valuable base of online visitors and its strong relationships with local and national advertisers.  Candidates might include traditional media players seeking to protect their franchises or an internet advertising company seeking a proprietary online traffic flow.  Alternatively, its high margins and strong free cash flows could make it attractive to a private equity purchaser.

Conclusion and Target Price

Based on 10x our FCF estimate of $25m for FY12 and FY13 plus a projected $85m net cash position at FYE12, we believe XOXO could trade for an EV of $335m or $13.50 per share or more versus $8.50 per share today (+60%).