Frank Voisin is the author of the popular value focused website Frankly Speaking, found at http://www.FrankVoisin.com
When a company wishes to sell its wares online, it has the option of developing the capabilities to do this in-house or outsourcing this work. In-house development presents significant challenges not just in terms of getting a functional site built but also in ongoing maintenance and with state-by-state regulations, customer service, and security (the loss of sensitive customer data could present significant risks), so many companies choose to outsource to a company with the requisite skills and a proven track record.
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Enter Digital River Inc (NASDASQ: DRIV), a Minnesota-based company that has been developing and hosting online e-shops and providing related services since the mid-90s. It counts among its clients Microsoft Corp (NASDAQ: MSFT), Hewlett-Packard (NYSE: HPQ), Logitech (NASDAQ: LOGI) and Autodesk (NASDAQ: ADSK). As of the time of writing, the company has fallen by 50% over the last year despite extending its contract with HPQ and expanding its relationship with MSFT to cover internet sales for Microsoft’s retail stores. The company now trades for a market cap of around $680 million, but has $466 million in net cash, for an enterprise value of just $214 million. This compares to three year average free cash flow of $65 million, yielding 30%!
The company evidently thinks the decline in its share price is not warranted; it has repurchased $115 million worth of its shares over the last two years and seems intent on continuing to do so. Furthermore, insiders own 7.2% of the company, with the CEO feeling the pinch of the declining share price most, losing more than $15 million over the year (3x his annual compensation, which is largely paid in stock).
But before we jump to the conclusion that the company is a value opportunity based solely on its free cash flow and low EV, we need to look at the sustainability of its performance. Recall above that companies can always choose to develop their e-shops in-house. This effectively makes DRIV a competitor with its own clients which can be expected to regularly re-evaluate the fees they pay DRIV, which are made up largely of variable costs (a percentage of each sale) in light of the fixed cost of developing in-house. This is not an ideal situation, and combined with the short-term nature of DRIV’s contracts, we see there is reason to worry about the company’s future revenues.
In fact, the risk of a client shifting from DRIV to in-house development is more than just an academic concern: it happened with the company’s biggest customer. In 2009, Symantec (NASDAQ: SYMC), which accounted for 21.5% of the company’s revenues that year, elected to not renew its contract:
Symantec informed Digital River on Friday, October 9th that it expects to move all of the online traffic currently outsourced to Digital River to an internally developed Symantec e-commerce system before the current contract expires. …
“We are surprised and deeply disappointed that Symantec has chosen to move to an internally developed system, but we remain very confident in the future of our business,” said Joel Ronning, Digital River’s CEO.
One would hope that the company would have taken this as a wake-up call and over the next two and a half years worked to build a more diversified revenue base. Alas, it appears the company has gone in the opposite direction, allowing MSFT to become an even greater portion of its revenue than SYMC had been:
Sales of products for one client, Microsoft, accounted for approximately 27.7% of our revenue in 2011.
There are a number of things a company can do to diversify its revenue base. It can expand its product offerings, target different market segments, etc. Don’t be fooled into thinking customer concentration like this is an inevitable occurrence. It is either a conscious (and foolish) move, laziness or ineptitude. While the CEO expressed surprise at suddenly losing SYMC, he seems unconcerned about the MSFT concentration.
I am far more concerned about the MSFT revenues than I would have been about SYMC. MSFT has significant capabilities in web development and, while it may be convenient to use DRIV’s services now, it would be much easier for MSFT to build out its own e-commerce capabilities than it ever was for SYMC.
As they say, fool me once, shame on you; fool me twice, shame on me. Except in this case, shame on investors.
Until investors can gain confidence in the company’s future revenues (e.g. greater revenue diversification or longer contracts), an investment even at these reduced prices is really just a gamble on MSFT’s disinterest in doing e-commerce in-house.
One more thing: they have a classified board and a number of other anti-takeover provisions. I hate these, and so should you.