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Tickers in this Article: DRIV, IM, IBM, AMZN, AKAM, YAHOO, EBAY, GOOG, MSFT, SYMC
We recommended Digital River (DRIV) for our Undiscovered Growth portfolio exactly one year ago. The stock has gained 50% since that recommendation. Now that the first quarter was met with some skepticism and we enter the company's seasonally weakest quarter, is it time to take profits? No. Not even close.

The theme for this selection was ecommerce, and we cannot find a better way to participate in the hyper-growth sub-sector of ecommerce. According to the U.S. Department of Commerce, in 2005 U.S. ecommerce sales grew to $86 billion, an increase of almost 25%. Remarkably, that's a penetration (vis-à-vis total retail sales) of less than 3%.

And that's just the United States, which leads most, but hardly all, countries in internet adoption. Globally, ecommerce is still very early in the adoption curve. This is how you tilt the odds in your favor: shave your participation away from maturing sectors (e.g., traditional retail) where total value creation will be modest and toward sectors where total value creation will be excessive.

Here is a chart of Digital River's revenue (the top of the bar) and net income, by quarter:


The four quarters in 2005 illustrate their seasonality: weak in the summer and strong in the fourth quarter. Of concern, operating margin dropped by an entire four points from last quarter, down to 29%. That is significant, but it appears all of it the decrease can be attributed to higher research & development (R&D) and sales & marketing spending. We don't want to be wrong about this because there is a world of difference between lower margins caused by product commoditization (bad) and higher, perhaps non-recurring, additional outlays on research and marketing (acceptable, even good).

I don't think the company's slightly decreased second quarter guidance is relevant (nor do I think that caused the price dip -- market makers expect this obvious feature). Their full year guidance is a healthy $300 million in sales and diluted EPS of $1.36. Given a forward P/E ratio of 33x, the stock is no longer a "value" stock (as it was when originally recommended).

Rather, I would now dub it growth-at-a-reasonable price (GARP). But I do think the price is reasonable as we can expect further growth over the next few years. The pro forma P/E ratio falls to just under 26x because it excludes the option expense. But I neither think you can count on this multiple for valuation nor can you compare it to GAAP-based average multiples. So, for the time being, I'd use the GAAP number and say this stock has a forward P/E of about 33x.

To check the diluted EPS, I compared it to adjusted operating cash flow (where adjusted means that I removed current balance sheet changes). They track favorably, which signifies high earnings quality:


The stock is a challenging analysis for two reasons: Digital River has acquired over a dozen companies in recent years, and they unfortunately do not break out different reporting segments. They ought to do a better job of segment reporting; I think an analyst on the call was fair is saying the fundamentals are something of a "black box." The chart below plots diluted shares and long term debt over the last five years:


The company didn't carry any long-term debt until they issued a private $175 million note subsequent to their Element 5 acquisition (which looks to have gone smoothly). Over the five year period, the share base has grown at an compounded annual rate of about 14%. Taken together, the share accretion and the long-term debt, the capital structure is entirely reasonable given their rapid growth.

Further, stock option dilution is flatly conservative and contributes to an overall set of favorable governance practices. Their option overhang (i.e., shares available for future grant plus shares already outstanding) at quarter's end was only 15%. For their profile -- high tech, rapid growth, acquisitive -- that's about as low as it can be. The average is more like 20 to 25%. For example, their distribution partner Ingram Micro (IM) runs an overhang of almost 30%.

In the negative column, we have less transparency into reporting segments than we deserve and a rich valuation. Also, Digital River has many formidable competitors -- a recent analyst note that cited their "lack of meaningful competition on the horizon" overstates the moat situation. Much of the rationale for Digital River's acquisitions -- aside from Element 5 which was largely geographical expansion -- reflects the competitive imperative to move up the outsourced ecommerce value stack. There is a dizzying array of competition at the base, so they must constantly enhance non-commodity services like paid search, affiliate marketing, and marketing analytics.

In this space, the worst competition comes from unanticipated places. We only wish the competitive threats were limited to companies mentioned in the annual filing, including: IBM (IBM), Amazon.com (AMZN), Akamai Technologies (AKAM), Yahoo! (YHOO), and eBay Inc (EBAY). But we aren't that lucky. Google (GOOG) and Microsoft (MSFT) are potential competitors, too.


For at least three years, Microsoft unduly spooked Digital River's stock on a regular basis because of their threatened entry into the anti-virus market (the concern was not competitive per se, but rather that Microsoft would hurt Digital River's largest customer Symantec (SYMC). The market fretted over this chimera for years and, ironically, the market seems now appears to have calmed to the threat just when it's becoming real. After a few false starts, Microsoft has ably repackaged antivirus into Live OneCare (formerly Defender and now in beta). Based on early technical reviews, this could be a formidable threat to privacy and security vendors. In any case, it looks like their most capable offering in this area to date.

But on balance I would argue that Digital River is doing an admirable job of building beyond the "mere transactions" of outsourced ecommerce and into intelligent services. For example, in purchasing Commerce5 -- a competitor that won several key accounts against Digital River -- Digital River converts several global firms into brand-name customers and strengthened their offering to large enterprises. Large enterprises will be a key driver. Just like retail, big business hasn't nearly utilized outsourced ecommerce like it will.

So, at the end of the day, I think the positives with DRIV still outweigh the negatives:

•Plenty of room for further domestic and international growth, where scale and experience (i.e., in navigating jurisdictional complexities) absolutely help to make them vendor of choice.
•A continuing and robust growth trend in ecommerce, especially the inexorable shift from off-the-shelf (literally) packaged goods to downloadable digital goods.
•Proven acquisition experience and a healthy balance sheet uninjured by numerous acquisitions.

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