QUINSTREET INC QNST
September 12, 2011 - 8:24pm EST by
scott737
2011 2012
Price: 10.87 EPS $0.59 $0.72
Shares Out. (in M): 48 P/E 16.3x 13.2x
Market Cap (in $M): 522 P/FCF 8.1x 7.8x
Net Debt (in $M): -61 EBIT 69 80
TEV ($): 461 TEV/EBIT 6.7x 5.8x

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Description

               QuinStreet is a specialized online marketing and lead generation company.  Through some combination of investors' confusion, unfamiliarity, dislike of its business, macroeconomic fears, its small size & trading liquidity, lumpy/volatile short-term results, etc., over the past 6 months QNST's shares have been driven down by over 50%.  QNST now trades at a FCF multiple of 7.8x (market cap less net cash, treats stock comp charge as a cash expense).  This strikes me as far too low for a business with the following attractive attributes:

--  Consistent 15% or greater annual historical revenue growth with the potential for this to continue for many years

--  Very stable 20% or greater adjusted EBITDA margin (company's definition, excludes stock comp.) and consistent free cash flow generation equal to 13-15% of sales

--  Has $1.27/share of net cash& marketable securities

--  Minimal capital intensity / cash reinvestment needs

--  CEO is a co-founder with 12% equity ownership and an impressive long-term track record, also two directors recently bought stock in the open market at around today's price

 

               On the negatives side, QNST generates 44% of its sales from clients in the for-profit education industry.  Recent regulation threatened to seriously damage that industry but turned out much better than feared and should not impact QNST.  For-profit education companies have also recently experienced declining student enrollments & revenue and this trend may have scared investors away from QNST.  In reality, QNST's services have remained in high demand and its revenue from for-profit education clients grew 17% in FY11 (QNST's fiscal years end June 30) and is expected to continue growing at this rate.

               I believe QNST will generate $1.22/share of FCF this year and it is worth at least 16x this ($19.59) plus $1.27 of net cash, or $20.86 total.  At today's closing price of $10.87, QNST is almost but not quite the proverbial dollar-for-fifty-cents and the upside to fair value is 92%.  This isn't as far-fetched as it appears as the stock traded there as recently as five months ago and not much has changed besides somewhat lumpy quarterly results and the market-wide shift in risk aversion.  Also, the company I consider most comparable to QuinStreet is Bankrate.com, which currently trades at 13x EBITDA and 18x FCF.

              

QuinStreet specializes in online marketing for a few industries (called "verticals" in online marketing lingo) - mainly the controversial for-profit education (FPE) industry and financial services.  QNST matches specifically targeted segments of website visitors with its clients'product offerings of probable interest to them.  QuinStreet generates 30% of its revenue from its own "Owned & Operated" websites and 70% from a network of partner websites.  QuinStreet relies on both organic (not-paid-for) visitor traffic and also traffic generated through its own paid advertisements.

QuinStreet was founded in 1999 by its Chairman & CEO Doug Valenti.  The company was first profitable in FY02 on $13MM of revenue.  By FY05 QuinStreet had grown to $110MM of revenue and generated a 22% EBITDA margin.  From FY05 to FY11 QuinStreet grew sales at a compounded 24% and generated a steady 20-22% Adjusted EBITDA margin (the main adjustment is adding back stock comp).  QuinStreet IPO-ed in February 2010, selling 10MM new shares at $15/share.  During the IPO process the price declined from an initial $25 price talk to a range of $17-19 and finally $15, mainly from concerns over the health of the FPE industry in light of tough proposed new regulations that later turned out fairly benign.  Since the IPO QuinStreet's shares have remained volatile, likely due to the newness/immaturity of its business model (which can lead to revenue volatility) and investors' unfamiliarity with it.  Following the IPO at $15, the share price went to $18, down to $10, up to $24 and back down to today's $10-11 range, all in the past 18 months.  In contrast to the stock's volatility, QNST's business is fairly steady and growing impressively.

QuinStreet specializes in providing very high quality leads to its clients by "pre-qualifying" them as interested in a client's service through its informational comparison shopping websites.  For example, a visitor to QuinStreet's Carinsurance.com website will enter personal information and shop for their best-matched auto insurance policy among a list of policies from QuinStreet's auto insurance clients.  After finding the best rate, the visitor will click on that company's listing and be transferred to the company's website to complete the application process.  In this way QuinStreet matches a potential customer with a client's product or service in a way that the customer and product offering are heavily matched by geography, personal data and interest.  If you've ever comparison shopped at Bankrate.com for a mortgage loan or savings account, you're familiar with the process.

QuinStreet's websites attract most of their visitors from search engines, including both paid listings and unpaid or natural search results.  QuinStreet's sites are designed to be relevant and informative to its targets, which enable them to attract "organic" traffic, meaning visitors who arrive there through the natural results of a search engine or a link from another website.  QuinStreet supplements its organic traffic by purchasing search advertising in the form of pay-per-click ads that appear next to a search engine's natural results.

QuinStreet delivers leads which have been qualified through the prospect having submitted on a website their personal information and a request for information on a client's specific product.  The client pays QuinStreet for each lead and then attempts to convert the prospect into a customer, typically through a call center or their own website.  QuinStreet maintains extensive databases of website visitors' data and their responses to websites and various targeting methods (clients share conversion rates with QuinStreet so it can measure effectiveness).  QuinStreet employs a heavily analytical, data-driven approach to marketing, using its databases, proprietary analytics and 12 years of experience to optimize its clients' marketing dollars' return on investment.

QuinStreet is paid on a per-lead or per-click basis.  In the for-profit education industry, QuinStreet is believed to receive about $35 per lead, a relatively large fee that is indicative of its leads' high quality nature - a meaningful percentage convert into paying customers.  QuinStreet's financial services revenue per lead is believed to range from $3 - 10.QuinStreet maintains an "Owned & Operated" (O&O) network of 300 websites it uses to gather leads, and also partners with a network of over 2,500 third party websites.  The O&O websites contain proprietary content tailored to the focused vertical - including informative articles, industry data, and consumer purchasing guides.  Along with this content, QuinStreet's websites include a traditional lead generation form which allows a visitor to request additional information, and/or a "comparison shopping" or "marketplace" service a visitor can use to search through many companies' offers to find the one tailored to them.

The online lead generation industry has attracted negative attention from some companies' illegal, deceptive or consumer-unfriendly methods.  QuinStreet maintains high ethical standards and the best practices in the industry and has never been accused of engaging in any of these practices.  QuinStreet is probably tainted in some eyes by this industry association, as well as from working with the for-profit education industry, whose practices have also come under scrutiny recently.  But in June 2011 FPE regulations were finalized in a way that should have limited effect on QuinStreet's clients or QuinStreet's own business, removing a major overhang.

QuinStreet operates around 300 websites.  This provides a good amount of diversification against potential site-specific problems such as a search engine modifying its algorithm in a way that disadvantages a website's search ranking.  Management noted that it saw limited impact from Google's recent algorithm adjustment that was designed to eliminate low quality websites from its search results.  QuinStreet's top 3 websites contribute less than 10% of revenue and the top 20% of its websites contribute 30% of its revenue.  QuinStreet also syndicates out its comparison shopping software to partner websites.  This is a key competitive advantage, as a website publisher can make more money using QuinStreet's software, which closely matches a website visitor with a particular product, than the publisher can make with a basic display advertisement.  In its FPE vertical (its oldest operation), QuinStreet gets around 45% of revenue from its owned & operated sites, above the corporate average of 30%.  Over time QuinStreet would like to grow its revenue share from O&O sites from today's 30% to 50%.

Of its various revenue sources, QuinStreet websites' organic traffic is the highest margin.  Traffic generated through search engines is the lowest margin, and partner websites are in between.  QuinStreet's has invested heavily in building and managing its search engine advertising software technology.  This software conducts over 20,000 advertising campaigns using over 70 million search keywords.  The software is updated daily with new data to optimize the campaigns.  Purchasing search engine keywords is competitive and costly so QuinStreet's technology and experience in this area are another competitive advantage.  Many of QuinStreet's partner websites have long-term relationships with QuinStreet and for many of them QuinStreet is their exclusive advertising/monetization partner.

Currently the FPE vertical accounts for 44% of sales, financial services 45%, and the remaining 11% is QuinStreet's Others (three smaller verticals - health care, home services, and B2B services.  QuinStreet's major customers in FPE include DeVry and Apollo, with a total of 6 large customers accounting for 50% of FPE vertical revenue.  In financial services QuinStreet's major clients include: in insurance, Geico, New York Life, eHealth, MetLife and Allstate; in mortgages, Nationwide, AmeriSave, BofA and Quicken Loans; in deposits, CapitalOne, ING Direct and Ally; in Credit Cards, Citi, Discover, American Express, Capital One and JPMorganChase.

QuinStreet has completed over 120 acquisitions of third-party website publishing businesses at a total cost of $255MM. Many of these acquisitions are fairly small purchases of websites with attractive economics from QuinStreet's partner network, so QuinStreet is very familiar with their capabilities, ability to generate visitor traffic and the conversion of those visitors into paying customers.  QNST typically acquires sites that have generated a strong, consistent and growing organic traffic base of visitors through their high quality and targeted content.  Acquired sites typically generate most or all of their revenue from sources other than QuinStreet's lead generation model.  For example, Insurance.com and CarInsurance.com were operated by insurance agencies that attempted to generate commissions from selling insurance policies to the sites' visitors.  Similarly, Internet.com was supported mainly by traditional third party display advertising.  QuinStreet believes it can generate greater revenues and profits by converting these sites' organic traffic bases into its lead generation business model.  Effectively, QuinStreet does not acquire revenues or profit but instead acquires website content with the ability to generate future organic traffic, which it then monetizes through its technology platform.

QuinStreet's very high reported revenue growth rates - ranging from 15-35% over the past few years - have been boosted by its M&A activity.  QuinStreet notes that in recent quarters organic growth has been responsible for 50-75% of its growth.  Based on this guidance and reported revenue growth, QuinStreet's organic growth has been around 15%.  As peoples' comparison shopping activity shifts online, marketing spending will inevitably continue to follow it.  As an example, shopping for car insurance was nearly entirely conducted offline as recently as 5-7 years ago but is now migrating online, and one can envision online comparison shopping becoming the most popular way to buy insurance due to its convenience and quick preference matching & price discovery.  QNST directly benefits from this powerful secular trend and this should enable it to achieve double-digit sales growth for many years.

According to the Direct Marketing Association, Americans spend 35% of their media consumption time on the internet but only 16% of the $149BN spent annually on direct marketing is spent online.  This parallels Forrester research's report that only 12% of total advertising spending is online.  This implies that online advertising and marketing could roughly double in size over the next 5-10 years.  If total U.S. advertising grows 2-3% annually, this market share shift should enable online advertising to continue growing at 10-15% rates over the next decade.

QuinStreet's estimates for each of its verticals' current market size (2010) and potential total market size (including the expected growth of online advertising over the next 5-10 years) are:

For FPE, direct marketing spending of $500MM (QuinStreet's $150MM of revenue is a 30% market share) and a total potential market size of $1.1BN.

For financial services, direct marketing spending of $2.4BN (QuinStreet's $144MM of revenue is a 5% market share) and a total potential market size of $5BN.

For QuinStreet's Other verticals, a current total market of $4BN currently (QuinStreet market share 1%) and a potential total market of $8BN.

 

QuinStreet's competitive advantages include its vertical focus & its expertise in its sectors, its ability to deliver measurable ROI on marketing spend for clients, its proprietary technology and client relationships, and its scale.  QuinStreet has developed proprietary technology and databases over the past decade which enable it to custom tailor a marketing program, optimize its targeting at a specific audience and measure and manage programs.  QuinStreet has invested over $100MM in engineering and product development into its websites, databases and lead-matching/revenue optimization technology.  These are key competitive advantages and explain why website publishers are willing to share revenue 50%/50% with QuinStreet and QNST can consistently achieve a 20% EBITDA margin.  QuinStreet's total customer base is over 2,600 companies.  In its IPO prospectus, QuinStreet noted that it had zero churn among its customers generating revenue of over $100,000 in FY09 or the first half of FY10.  However, marketing budget shifts by large customers have impacted QuinStreet's revenue growth in the past. 

QuinStreet historically specialized in online lead generation for the for-profit education industry.  QuinStreet's early growth was driven by the FPE industry's growth.  As of FY05, the FPE industry accounted for 90% of QuinStreet's revenue, but this has declined to 75% in FY08 and 44% in FY11.  QuinStreet's largest customer, DeVry, accounted for 23% of revenue in FY08 but has declined below 10%.  QuinStreet has diversified into financial services where it is believed to have a 5% market share, and is also expanding into other verticals.  Within financial services, QuinStreet specializes in insurance, and specifically auto insurance, but is also active in lead generation for mortgages, credit cards and savings accounts.  Insurance accounts for 60-70% of the financial services vertical.

The immaturity of QuinStreet's business, as well as its customer & industry concentration, have led to some business volatility.  In November 2009, DeVry reduced its marketing budget with QuinStreet by 50%, which reduced QNST'sFPE vertical revenue growth in that year to zero.  DeVry had previously relied very heavily on QuinStreet but hired an advertising agency and spread its marketing spending out more widely into other internet advertising as well as traditional advertising and to generate more leads internally.  This appears to have been motivated by a desire to diversify in light of regulatory changes, rather than any dissatisfaction with QuinStreet, and DeVry remains one of its largest clients.  Similarly, in 3QFY11 QuinStreet disclosed that its largest auto insurance customer was shifting marketing dollars away from QuinStreet and towards branding initiatives.  This unexpected shift again reduced QuinStreet's revenue growth from its prior guidance and spooked short-term-focused investors. 

Increased regulation of the FPE sector was initially viewed as a negative for QuinStreet as it was expected to reduce the size of the industry and therefore reduce marketing spending.  Over the past year QuinStreethas actually benefited from a "flight to quality" from its FPE clients, and QuinStreet expects to continue to benefit from this phenomenon.  It has been driven by several factors.  First, clients are seeking to acquire higher-quality leads - more interested students who are more likely to persist in their education and not drop out and/or default on their loans.  Second, regulations have reduced clients' flexibility with their own sales forces (such as the ability to pay out incentive compensation) so they are more reliant on high quality partners (QuinStreet's activities are fully permitted by regulations).  Finally, as the boom in enrollment from the 2009 recession peters out and new students are becoming harder to come by, clients are becoming more reliant on QNST to fill their schools.

While the FPE concerns have finally largely abated, recently QuinStreet's financial services business was hurt by increased competition from a low-quality, unscrupulous competitor in auto insurance lead generation.  Auto insurance companies are willing to pay a certain amount of money for an online lead if the potential customer is willing to fill out an application form, based on their experience that someone willing to spend time filling out a form is highly interested in getting a new auto insurance policy.  A new competitor is taking advantage of this by sending very low quality leads to auto insurance companies and undercutting QuinStreet on price.  The main tactic has been offering people free points in online games as an incentive for filling out an online insurance application.  These people have no actual interest in getting insurance, they only want those free points.  Because the insurance companies are only recent adapters of online lead generation, they don't yet have tools to analyze the quality of leads and their tendency to convert into paying customers.  The competitor's gaming the system forced QuinStreet to temporarily reduce pricing while they work to educate customers on what is happening and help them build tools to analyze the quality of their leads.  QNST's disclosure of this sent its shares down 25% in early June 2011.  QuinStreet has been through two similar episodes in the FPE industry in 2003 and 2006 and in both cases the effects were only temporary.  QNST noted on its 4Q11 conference call that it had made progress educating its clients and expects to quickly work through this issue.

               QuinStreet's Chairman & CEO is Doug Valenti.  He is 51 years old and co-founded QuinStreet.  He was previously a partner at venture capital firm Rosewood Capital and a consultant at McKinsey.  Mr Valenti owns 12% of QuinStreet, currently worth $62MM.  QuinStreet's pre-IPO venture capital investors still own a combined 25% of the company.  QuinStreet's board includes 3 directors from these venture capital firms, 2 from management and 3 other directors.  Over the summer, two of the three directors representing the venture capital firms bought approx. $300K and $500K of QNST's shares in the open market at prices ranging from $10.50 - $11.50.

In FY11, QuinStreet grew sales by 20%, with the FPE vertical growing 17%, financial services by 26% and Others by 14%.  QuinStreet's official guidance is for long term revenue growth of 15-20% annuallyand a 20% Adjusted EBITDA margin (the main adjustment is adding back stock based compensation).  In FY12 QuinStreet expects revenue growth to be at the low end of this range due to the temporary weakness in its financial services vertical.  QuinStreet has historically generated a very stable EBITDA margin, typically at or a few points above its 20% target.  QuinStreet essentially manages its business to this 20% margin as it believes a higher margin (higher pricing) would create room for competitors to undercut it on price while a lower margin is unsustainable and would not leave room for continued investment and an acceptable return to investors.  In other words, QuinStreet will invest "extra" profit above its 20% target into growth initiatives and can reduce spending to maintain a minimum 20% margin in tougher economic times as in 2009.  QuinStreet has mentioned it could achieve a profit margin "many points higher" if the business was run for near term cash rather than investing in attractive growth initiatives.  QuinStreet benefits from an unleveraged balance sheet and limited CAPEX needs, so other than income taxes it has few expenses in between EBITDA and free cash flow.  Historically QuinStreet has generated a fairly stable 15% FCF margin on its revenue.

At year-end FY11 (June 30, 2011) QuinStreet had $106MM of debt, mainly bank loans at a 2.5-3.0% interest rate.  QuinStreet also had $167MM of cash & marketable securities, making its net cash balance $61MM or $1.27/share.  In FY11 QNST generated sales of $403MM (up 20% YoY), EBITDA of $76MM (19% margin) and FCF of $57MM (treating $14MM of stock comp as a cash expense that's included within EBITDA & FCF).  In FY12 I project 15% sales growth to $463MM, EBITDA of $88MM and FCF of $59MM.  This FCF works out to $1.22/share.  I believe QNST is worth at least 16x its FCF, even in today's depressed market, balancing its impressive long-term growth opportunity against somewhat concerning risks from the FPE industry &the potential for increased competition.  A 16x FCF multiple is roughly consistent with a DCF valuation using a 10% discount rate in which QNST grows its FCF by 10% annually for 10 years and zero growth thereafter.  Using a 16x multiple and FY12E FCF of $1.22/share works out to $19.59 and adding in the $1.27 of net cash yields a fair value of $20.86.

 

$ millions           FY06           FY07            FY08           FY09           FY10            FY11         FY12E








FPE vertical revenue 119.3 129.5 142.2 151.4 150.7 175.5 208.8
Growth % 20% 9% 10% 6% 0% 16% 19%








Financial services vertical 2.6 11.8 21.6 79.7 144.0 181.9 192.8
Growth % 333% 354% 83% 269% 81% 26% 6%








Others revenue 20.5 26.0 27.9 29.4 40.2 45.7 61.6
Growth % 109% 27% 7% 5% 37% 14% 35%

             








Total revenues 142.4 167.4 192.0 260.5 334.8 403.0 463.3
Revenue growth % 30% 18% 15% 36% 29% 20% 15%








FPE % of total 84% 77% 74% 58% 45% 44% 45%
Fin Serv % of total 2% 7% 11% 31% 43% 45% 42%
Others % of total 14% 16% 15% 11% 12% 11% 13%








               
















Total revenues 142.4 167.4 192.0 260.5 334.8 403.0 463.3
Revenue growth % 30% 18% 15% 36% 29% 20% 15%








COGS -85.8 -108.9 -130.9 -181.6 -240.7 -292.0 -335.9
Gross Profit 56.6 58.4 61.2 78.9 94.1 111.0 127.4
Gross margin % 40% 35% 32% 30% 28% 28% 28%








Product development -17.3 -14.1 -14.1 -14.9 -19.7 -24.2 -26.0
Sales & marketing expenses -7.2 -8.5 -12.4 -16.2 -16.7 -17.4 -19.0
General & Administrative expenses -6.8 -11.4 -13.4 -13.2 -18.5 -20.4 -22.0
Total operating expenses -31.3 -34.0 -39.8 -44.2 -54.9 -61.9 -67.0








Operating income 25.3 24.4 21.3 34.7 39.2 49.1 60.4
Operating margin % 18% 15% 11% 13% 12% 12% 13%








D&A from cash flow statement -7.2 -9.6 -11.7 -16.0 -18.8 -27.3 -27.5
EBITDA 32.5 34.0 33.1 50.7 58.0 76.4 87.9
EBITDA margin % 23% 20% 17% 19% 17% 19% 19%








Interest expense -0.4 -0.7 -1.2 -3.5 -4.0 -4.2 -4.4
Interest income 1.3 1.9 1.5 0.2 0.1 0.2 0.1
Other (expenses)/income -0.9 -0.1 0.1 -0.2 1.5 0.1 0.0
Earnings before taxes 25.4 25.4 21.7 31.2 36.9 45.1 56.1
Income tax expense -9.8 -9.8 -8.9 -13.9 -16.3 -17.9 -21.3
Income tax rate % 39% 39% 41% 45% 44% 40% 38%
Net income 13.8 15.6 12.9 17.3 20.6 27.2 34.8








Basic shares outstanding 36.1 36.1 36.1 36.1 45.1 46.2 48.0








Basic EPS 0.38 0.43 0.36 0.48 0.46 0.59 0.72
Growth % 5.4% 13.4% -17.6% 34.3% -4.5% 29.0% 23.1%
               








Net cash flow from operations 21.0 23.1 21.5 26.4 25.1 64.2 66.8
CAPEX & software development -1.1 -3.5 -3.6 -2.4 -4.1 -7.2 -8.0
Free cash flow 19.9 19.6 18.0 24.0 21.0 57.0 58.8
               

Catalyst

Revenue growth, free cash flow generation
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    Description

                   QuinStreet is a specialized online marketing and lead generation company.  Through some combination of investors' confusion, unfamiliarity, dislike of its business, macroeconomic fears, its small size & trading liquidity, lumpy/volatile short-term results, etc., over the past 6 months QNST's shares have been driven down by over 50%.  QNST now trades at a FCF multiple of 7.8x (market cap less net cash, treats stock comp charge as a cash expense).  This strikes me as far too low for a business with the following attractive attributes:

    --  Consistent 15% or greater annual historical revenue growth with the potential for this to continue for many years

    --  Very stable 20% or greater adjusted EBITDA margin (company's definition, excludes stock comp.) and consistent free cash flow generation equal to 13-15% of sales

    --  Has $1.27/share of net cash& marketable securities

    --  Minimal capital intensity / cash reinvestment needs

    --  CEO is a co-founder with 12% equity ownership and an impressive long-term track record, also two directors recently bought stock in the open market at around today's price

     

                   On the negatives side, QNST generates 44% of its sales from clients in the for-profit education industry.  Recent regulation threatened to seriously damage that industry but turned out much better than feared and should not impact QNST.  For-profit education companies have also recently experienced declining student enrollments & revenue and this trend may have scared investors away from QNST.  In reality, QNST's services have remained in high demand and its revenue from for-profit education clients grew 17% in FY11 (QNST's fiscal years end June 30) and is expected to continue growing at this rate.

                   I believe QNST will generate $1.22/share of FCF this year and it is worth at least 16x this ($19.59) plus $1.27 of net cash, or $20.86 total.  At today's closing price of $10.87, QNST is almost but not quite the proverbial dollar-for-fifty-cents and the upside to fair value is 92%.  This isn't as far-fetched as it appears as the stock traded there as recently as five months ago and not much has changed besides somewhat lumpy quarterly results and the market-wide shift in risk aversion.  Also, the company I consider most comparable to QuinStreet is Bankrate.com, which currently trades at 13x EBITDA and 18x FCF.

                  

    QuinStreet specializes in online marketing for a few industries (called "verticals" in online marketing lingo) - mainly the controversial for-profit education (FPE) industry and financial services.  QNST matches specifically targeted segments of website visitors with its clients'product offerings of probable interest to them.  QuinStreet generates 30% of its revenue from its own "Owned & Operated" websites and 70% from a network of partner websites.  QuinStreet relies on both organic (not-paid-for) visitor traffic and also traffic generated through its own paid advertisements.

    QuinStreet was founded in 1999 by its Chairman & CEO Doug Valenti.  The company was first profitable in FY02 on $13MM of revenue.  By FY05 QuinStreet had grown to $110MM of revenue and generated a 22% EBITDA margin.  From FY05 to FY11 QuinStreet grew sales at a compounded 24% and generated a steady 20-22% Adjusted EBITDA margin (the main adjustment is adding back stock comp).  QuinStreet IPO-ed in February 2010, selling 10MM new shares at $15/share.  During the IPO process the price declined from an initial $25 price talk to a range of $17-19 and finally $15, mainly from concerns over the health of the FPE industry in light of tough proposed new regulations that later turned out fairly benign.  Since the IPO QuinStreet's shares have remained volatile, likely due to the newness/immaturity of its business model (which can lead to revenue volatility) and investors' unfamiliarity with it.  Following the IPO at $15, the share price went to $18, down to $10, up to $24 and back down to today's $10-11 range, all in the past 18 months.  In contrast to the stock's volatility, QNST's business is fairly steady and growing impressively.

    QuinStreet specializes in providing very high quality leads to its clients by "pre-qualifying" them as interested in a client's service through its informational comparison shopping websites.  For example, a visitor to QuinStreet's Carinsurance.com website will enter personal information and shop for their best-matched auto insurance policy among a list of policies from QuinStreet's auto insurance clients.  After finding the best rate, the visitor will click on that company's listing and be transferred to the company's website to complete the application process.  In this way QuinStreet matches a potential customer with a client's product or service in a way that the customer and product offering are heavily matched by geography, personal data and interest.  If you've ever comparison shopped at Bankrate.com for a mortgage loan or savings account, you're familiar with the process.

    QuinStreet's websites attract most of their visitors from search engines, including both paid listings and unpaid or natural search results.  QuinStreet's sites are designed to be relevant and informative to its targets, which enable them to attract "organic" traffic, meaning visitors who arrive there through the natural results of a search engine or a link from another website.  QuinStreet supplements its organic traffic by purchasing search advertising in the form of pay-per-click ads that appear next to a search engine's natural results.

    QuinStreet delivers leads which have been qualified through the prospect having submitted on a website their personal information and a request for information on a client's specific product.  The client pays QuinStreet for each lead and then attempts to convert the prospect into a customer, typically through a call center or their own website.  QuinStreet maintains extensive databases of website visitors' data and their responses to websites and various targeting methods (clients share conversion rates with QuinStreet so it can measure effectiveness).  QuinStreet employs a heavily analytical, data-driven approach to marketing, using its databases, proprietary analytics and 12 years of experience to optimize its clients' marketing dollars' return on investment.

    QuinStreet is paid on a per-lead or per-click basis.  In the for-profit education industry, QuinStreet is believed to receive about $35 per lead, a relatively large fee that is indicative of its leads' high quality nature - a meaningful percentage convert into paying customers.  QuinStreet's financial services revenue per lead is believed to range from $3 - 10.QuinStreet maintains an "Owned & Operated" (O&O) network of 300 websites it uses to gather leads, and also partners with a network of over 2,500 third party websites.  The O&O websites contain proprietary content tailored to the focused vertical - including informative articles, industry data, and consumer purchasing guides.  Along with this content, QuinStreet's websites include a traditional lead generation form which allows a visitor to request additional information, and/or a "comparison shopping" or "marketplace" service a visitor can use to search through many companies' offers to find the one tailored to them.

    The online lead generation industry has attracted negative attention from some companies' illegal, deceptive or consumer-unfriendly methods.  QuinStreet maintains high ethical standards and the best practices in the industry and has never been accused of engaging in any of these practices.  QuinStreet is probably tainted in some eyes by this industry association, as well as from working with the for-profit education industry, whose practices have also come under scrutiny recently.  But in June 2011 FPE regulations were finalized in a way that should have limited effect on QuinStreet's clients or QuinStreet's own business, removing a major overhang.

    QuinStreet operates around 300 websites.  This provides a good amount of diversification against potential site-specific problems such as a search engine modifying its algorithm in a way that disadvantages a website's search ranking.  Management noted that it saw limited impact from Google's recent algorithm adjustment that was designed to eliminate low quality websites from its search results.  QuinStreet's top 3 websites contribute less than 10% of revenue and the top 20% of its websites contribute 30% of its revenue.  QuinStreet also syndicates out its comparison shopping software to partner websites.  This is a key competitive advantage, as a website publisher can make more money using QuinStreet's software, which closely matches a website visitor with a particular product, than the publisher can make with a basic display advertisement.  In its FPE vertical (its oldest operation), QuinStreet gets around 45% of revenue from its owned & operated sites, above the corporate average of 30%.  Over time QuinStreet would like to grow its revenue share from O&O sites from today's 30% to 50%.

    Of its various revenue sources, QuinStreet websites' organic traffic is the highest margin.  Traffic generated through search engines is the lowest margin, and partner websites are in between.  QuinStreet's has invested heavily in building and managing its search engine advertising software technology.  This software conducts over 20,000 advertising campaigns using over 70 million search keywords.  The software is updated daily with new data to optimize the campaigns.  Purchasing search engine keywords is competitive and costly so QuinStreet's technology and experience in this area are another competitive advantage.  Many of QuinStreet's partner websites have long-term relationships with QuinStreet and for many of them QuinStreet is their exclusive advertising/monetization partner.

    Currently the FPE vertical accounts for 44% of sales, financial services 45%, and the remaining 11% is QuinStreet's Others (three smaller verticals - health care, home services, and B2B services.  QuinStreet's major customers in FPE include DeVry and Apollo, with a total of 6 large customers accounting for 50% of FPE vertical revenue.  In financial services QuinStreet's major clients include: in insurance, Geico, New York Life, eHealth, MetLife and Allstate; in mortgages, Nationwide, AmeriSave, BofA and Quicken Loans; in deposits, CapitalOne, ING Direct and Ally; in Credit Cards, Citi, Discover, American Express, Capital One and JPMorganChase.

    QuinStreet has completed over 120 acquisitions of third-party website publishing businesses at a total cost of $255MM. Many of these acquisitions are fairly small purchases of websites with attractive economics from QuinStreet's partner network, so QuinStreet is very familiar with their capabilities, ability to generate visitor traffic and the conversion of those visitors into paying customers.  QNST typically acquires sites that have generated a strong, consistent and growing organic traffic base of visitors through their high quality and targeted content.  Acquired sites typically generate most or all of their revenue from sources other than QuinStreet's lead generation model.  For example, Insurance.com and CarInsurance.com were operated by insurance agencies that attempted to generate commissions from selling insurance policies to the sites' visitors.  Similarly, Internet.com was supported mainly by traditional third party display advertising.  QuinStreet believes it can generate greater revenues and profits by converting these sites' organic traffic bases into its lead generation business model.  Effectively, QuinStreet does not acquire revenues or profit but instead acquires website content with the ability to generate future organic traffic, which it then monetizes through its technology platform.

    QuinStreet's very high reported revenue growth rates - ranging from 15-35% over the past few years - have been boosted by its M&A activity.  QuinStreet notes that in recent quarters organic growth has been responsible for 50-75% of its growth.  Based on this guidance and reported revenue growth, QuinStreet's organic growth has been around 15%.  As peoples' comparison shopping activity shifts online, marketing spending will inevitably continue to follow it.  As an example, shopping for car insurance was nearly entirely conducted offline as recently as 5-7 years ago but is now migrating online, and one can envision online comparison shopping becoming the most popular way to buy insurance due to its convenience and quick preference matching & price discovery.  QNST directly benefits from this powerful secular trend and this should enable it to achieve double-digit sales growth for many years.

    According to the Direct Marketing Association, Americans spend 35% of their media consumption time on the internet but only 16% of the $149BN spent annually on direct marketing is spent online.  This parallels Forrester research's report that only 12% of total advertising spending is online.  This implies that online advertising and marketing could roughly double in size over the next 5-10 years.  If total U.S. advertising grows 2-3% annually, this market share shift should enable online advertising to continue growing at 10-15% rates over the next decade.

    QuinStreet's estimates for each of its verticals' current market size (2010) and potential total market size (including the expected growth of online advertising over the next 5-10 years) are:

    For FPE, direct marketing spending of $500MM (QuinStreet's $150MM of revenue is a 30% market share) and a total potential market size of $1.1BN.

    For financial services, direct marketing spending of $2.4BN (QuinStreet's $144MM of revenue is a 5% market share) and a total potential market size of $5BN.

    For QuinStreet's Other verticals, a current total market of $4BN currently (QuinStreet market share 1%) and a potential total market of $8BN.

     

    QuinStreet's competitive advantages include its vertical focus & its expertise in its sectors, its ability to deliver measurable ROI on marketing spend for clients, its proprietary technology and client relationships, and its scale.  QuinStreet has developed proprietary technology and databases over the past decade which enable it to custom tailor a marketing program, optimize its targeting at a specific audience and measure and manage programs.  QuinStreet has invested over $100MM in engineering and product development into its websites, databases and lead-matching/revenue optimization technology.  These are key competitive advantages and explain why website publishers are willing to share revenue 50%/50% with QuinStreet and QNST can consistently achieve a 20% EBITDA margin.  QuinStreet's total customer base is over 2,600 companies.  In its IPO prospectus, QuinStreet noted that it had zero churn among its customers generating revenue of over $100,000 in FY09 or the first half of FY10.  However, marketing budget shifts by large customers have impacted QuinStreet's revenue growth in the past. 

    QuinStreet historically specialized in online lead generation for the for-profit education industry.  QuinStreet's early growth was driven by the FPE industry's growth.  As of FY05, the FPE industry accounted for 90% of QuinStreet's revenue, but this has declined to 75% in FY08 and 44% in FY11.  QuinStreet's largest customer, DeVry, accounted for 23% of revenue in FY08 but has declined below 10%.  QuinStreet has diversified into financial services where it is believed to have a 5% market share, and is also expanding into other verticals.  Within financial services, QuinStreet specializes in insurance, and specifically auto insurance, but is also active in lead generation for mortgages, credit cards and savings accounts.  Insurance accounts for 60-70% of the financial services vertical.

    The immaturity of QuinStreet's business, as well as its customer & industry concentration, have led to some business volatility.  In November 2009, DeVry reduced its marketing budget with QuinStreet by 50%, which reduced QNST'sFPE vertical revenue growth in that year to zero.  DeVry had previously relied very heavily on QuinStreet but hired an advertising agency and spread its marketing spending out more widely into other internet advertising as well as traditional advertising and to generate more leads internally.  This appears to have been motivated by a desire to diversify in light of regulatory changes, rather than any dissatisfaction with QuinStreet, and DeVry remains one of its largest clients.  Similarly, in 3QFY11 QuinStreet disclosed that its largest auto insurance customer was shifting marketing dollars away from QuinStreet and towards branding initiatives.  This unexpected shift again reduced QuinStreet's revenue growth from its prior guidance and spooked short-term-focused investors. 

    Increased regulation of the FPE sector was initially viewed as a negative for QuinStreet as it was expected to reduce the size of the industry and therefore reduce marketing spending.  Over the past year QuinStreethas actually benefited from a "flight to quality" from its FPE clients, and QuinStreet expects to continue to benefit from this phenomenon.  It has been driven by several factors.  First, clients are seeking to acquire higher-quality leads - more interested students who are more likely to persist in their education and not drop out and/or default on their loans.  Second, regulations have reduced clients' flexibility with their own sales forces (such as the ability to pay out incentive compensation) so they are more reliant on high quality partners (QuinStreet's activities are fully permitted by regulations).  Finally, as the boom in enrollment from the 2009 recession peters out and new students are becoming harder to come by, clients are becoming more reliant on QNST to fill their schools.

    While the FPE concerns have finally largely abated, recently QuinStreet's financial services business was hurt by increased competition from a low-quality, unscrupulous competitor in auto insurance lead generation.  Auto insurance companies are willing to pay a certain amount of money for an online lead if the potential customer is willing to fill out an application form, based on their experience that someone willing to spend time filling out a form is highly interested in getting a new auto insurance policy.  A new competitor is taking advantage of this by sending very low quality leads to auto insurance companies and undercutting QuinStreet on price.  The main tactic has been offering people free points in online games as an incentive for filling out an online insurance application.  These people have no actual interest in getting insurance, they only want those free points.  Because the insurance companies are only recent adapters of online lead generation, they don't yet have tools to analyze the quality of leads and their tendency to convert into paying customers.  The competitor's gaming the system forced QuinStreet to temporarily reduce pricing while they work to educate customers on what is happening and help them build tools to analyze the quality of their leads.  QNST's disclosure of this sent its shares down 25% in early June 2011.  QuinStreet has been through two similar episodes in the FPE industry in 2003 and 2006 and in both cases the effects were only temporary.  QNST noted on its 4Q11 conference call that it had made progress educating its clients and expects to quickly work through this issue.

                   QuinStreet's Chairman & CEO is Doug Valenti.  He is 51 years old and co-founded QuinStreet.  He was previously a partner at venture capital firm Rosewood Capital and a consultant at McKinsey.  Mr Valenti owns 12% of QuinStreet, currently worth $62MM.  QuinStreet's pre-IPO venture capital investors still own a combined 25% of the company.  QuinStreet's board includes 3 directors from these venture capital firms, 2 from management and 3 other directors.  Over the summer, two of the three directors representing the venture capital firms bought approx. $300K and $500K of QNST's shares in the open market at prices ranging from $10.50 - $11.50.

    In FY11, QuinStreet grew sales by 20%, with the FPE vertical growing 17%, financial services by 26% and Others by 14%.  QuinStreet's official guidance is for long term revenue growth of 15-20% annuallyand a 20% Adjusted EBITDA margin (the main adjustment is adding back stock based compensation).  In FY12 QuinStreet expects revenue growth to be at the low end of this range due to the temporary weakness in its financial services vertical.  QuinStreet has historically generated a very stable EBITDA margin, typically at or a few points above its 20% target.  QuinStreet essentially manages its business to this 20% margin as it believes a higher margin (higher pricing) would create room for competitors to undercut it on price while a lower margin is unsustainable and would not leave room for continued investment and an acceptable return to investors.  In other words, QuinStreet will invest "extra" profit above its 20% target into growth initiatives and can reduce spending to maintain a minimum 20% margin in tougher economic times as in 2009.  QuinStreet has mentioned it could achieve a profit margin "many points higher" if the business was run for near term cash rather than investing in attractive growth initiatives.  QuinStreet benefits from an unleveraged balance sheet and limited CAPEX needs, so other than income taxes it has few expenses in between EBITDA and free cash flow.  Historically QuinStreet has generated a fairly stable 15% FCF margin on its revenue.

    At year-end FY11 (June 30, 2011) QuinStreet had $106MM of debt, mainly bank loans at a 2.5-3.0% interest rate.  QuinStreet also had $167MM of cash & marketable securities, making its net cash balance $61MM or $1.27/share.  In FY11 QNST generated sales of $403MM (up 20% YoY), EBITDA of $76MM (19% margin) and FCF of $57MM (treating $14MM of stock comp as a cash expense that's included within EBITDA & FCF).  In FY12 I project 15% sales growth to $463MM, EBITDA of $88MM and FCF of $59MM.  This FCF works out to $1.22/share.  I believe QNST is worth at least 16x its FCF, even in today's depressed market, balancing its impressive long-term growth opportunity against somewhat concerning risks from the FPE industry &the potential for increased competition.  A 16x FCF multiple is roughly consistent with a DCF valuation using a 10% discount rate in which QNST grows its FCF by 10% annually for 10 years and zero growth thereafter.  Using a 16x multiple and FY12E FCF of $1.22/share works out to $19.59 and adding in the $1.27 of net cash yields a fair value of $20.86.

     

    $ millions           FY06           FY07            FY08           FY09           FY10            FY11         FY12E








    FPE vertical revenue 119.3 129.5 142.2 151.4 150.7 175.5 208.8
    Growth % 20% 9% 10% 6% 0% 16% 19%








    Financial services vertical 2.6 11.8 21.6 79.7 144.0 181.9 192.8
    Growth % 333% 354% 83% 269% 81% 26% 6%








    Others revenue 20.5 26.0 27.9 29.4 40.2 45.7 61.6
    Growth % 109% 27% 7% 5% 37% 14% 35%

                 








    Total revenues 142.4 167.4 192.0 260.5 334.8 403.0 463.3
    Revenue growth % 30% 18% 15% 36% 29% 20% 15%








    FPE % of total 84% 77% 74% 58% 45% 44% 45%
    Fin Serv % of total 2% 7% 11% 31% 43% 45% 42%
    Others % of total 14% 16% 15% 11% 12% 11% 13%








                   
















    Total revenues 142.4 167.4 192.0 260.5 334.8 403.0 463.3
    Revenue growth % 30% 18% 15% 36% 29% 20% 15%








    COGS -85.8 -108.9 -130.9 -181.6 -240.7 -292.0 -335.9
    Gross Profit 56.6 58.4 61.2 78.9 94.1 111.0 127.4
    Gross margin % 40% 35% 32% 30% 28% 28% 28%








    Product development -17.3 -14.1 -14.1 -14.9 -19.7 -24.2 -26.0
    Sales & marketing expenses -7.2 -8.5 -12.4 -16.2 -16.7 -17.4 -19.0
    General & Administrative expenses -6.8 -11.4 -13.4 -13.2 -18.5 -20.4 -22.0
    Total operating expenses -31.3 -34.0 -39.8 -44.2 -54.9 -61.9 -67.0








    Operating income 25.3 24.4 21.3 34.7 39.2 49.1 60.4
    Operating margin % 18% 15% 11% 13% 12% 12% 13%








    D&A from cash flow statement -7.2 -9.6 -11.7 -16.0 -18.8 -27.3 -27.5
    EBITDA 32.5 34.0 33.1 50.7 58.0 76.4 87.9
    EBITDA margin % 23% 20% 17% 19% 17% 19% 19%








    Interest expense -0.4 -0.7 -1.2 -3.5 -4.0 -4.2 -4.4
    Interest income 1.3 1.9 1.5 0.2 0.1 0.2 0.1
    Other (expenses)/income -0.9 -0.1 0.1 -0.2 1.5 0.1 0.0
    Earnings before taxes 25.4 25.4 21.7 31.2 36.9 45.1 56.1
    Income tax expense -9.8 -9.8 -8.9 -13.9 -16.3 -17.9 -21.3
    Income tax rate % 39% 39% 41% 45% 44% 40% 38%
    Net income 13.8 15.6 12.9 17.3 20.6 27.2 34.8








    Basic shares outstanding 36.1 36.1 36.1 36.1 45.1 46.2 48.0








    Basic EPS 0.38 0.43 0.36 0.48 0.46 0.59 0.72
    Growth % 5.4% 13.4% -17.6% 34.3% -4.5% 29.0% 23.1%
                   








    Net cash flow from operations 21.0 23.1 21.5 26.4 25.1 64.2 66.8
    CAPEX & software development -1.1 -3.5 -3.6 -2.4 -4.1 -7.2 -8.0
    Free cash flow 19.9 19.6 18.0 24.0 21.0 57.0 58.8
                   

    Catalyst

    Revenue growth, free cash flow generation
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