Description

KNOT is a classic case of a good company with a number of attractive attributes facing some temporary challenges causing consternation in its shareholder base and stock price. With many of these issues either behind the company or being addressed, the opportunity for a patient value investor with an 18-24 month time horizon is to look beyond these issues to more normalized level of profitability and cash flow, which makes for an attractive valuation.

The company appears to offer a number of appealing fundamental characteristics, including:

-- a good and sustainable business marked by a very attractive base of highly desirable members to potential advertisers,

-- a dominant market position (80% of new brides register with the company) with a 4x advantage over its nearest competitor in website visitors,

-- a low cost viral-effect word of mouth marketing model, that gives KNOT a competitive advantage,

-- strong brand awareness and sustainable competitive barriers,

-- a highly scalable financial model with a cost structure sized for growth,

-- the opportunity for significant growth from: 1) growing its relationship with its members past the wedding period through different lifestyle changes including initial home life (The Nest) and pregnancy/parenting (The Bump); 2) geographic expansion (with China being the major focus) and 3) a expanded publishing initiative,

-- healthy cash flow dynamics,

-- a solid, debt free balance sheet with about $4.13 per share (or about 40% of market cap) in cash.

From a valuation perspective, the shares do not look especially attractive on a TTM basis relative to cash flow or especially GAAP earnings. However, should the company's profitability levels return to anything close to historical levels, as some of the temporary issues abate and the margin leverage begins to kick in, the valuation begins to look much more attractive. Noteworthy, the current operating margins of about 5% are well below the mid-to-upper teens levels posted pre-2008, with the pressures on margins related to a buildup in operating expenses (gross margins have been stable during the post 2007 period). Cash flow runs about 2-3x in excess of GAAP earnings due to a number of other cash items, including: significant D&A, reserves for returns and stock based compensation. Thus, I believe it is more appropriate to value the company on potential future cash flows, as opposed to traditional EPS measurements. Given management's belief that cash flow in 2011 could at least match the $19 million generated in 2009, the FVF/EV yield of about 9% on that basis becomes modestly attractive. With further margin leverage benefits accruing in 2012 and thereafter, the company's cash flow potential and valuation are even more appealing. Should growth accelerate from the 8-10% levels I have modeled and/or profitability return closer to past levels, the shares could once again attract more growth oriented investors and show more meaningful appreciation. I suspect that given the various initiatives taking place there will likely be some positives and negatives relative to management's ability to accelerate growth and drive margin leverage in upcoming quarterly results, but the longer-term direction should be positive. Note, from its peak of about $31 in 2007, the shares have dropped about 65% to their current level (versus about a 10% decline in the market) creating an opportunity for patient value investors over the next 18-24 months, if management can execute on its growth and margin expansion strategies. For investors with shorter time horizons and/or those who focus primarily on GAAP EPS (as opposed to cash flow), I suspect this idea will not be of interest.

A potential catalyst for the shares is the fact that most sell-side analysts are not aggressively promoting the shares as they have adopted a wait and see attitude on the company's financial turnaround. Conversely, one issue overhanging the stock is that Macy's, which owns 3.67 million shares (10.9% of total shares outstanding), has filed a shelf and announced its intention to sell its ownership. I believe this issue has kept management from aggressively repurchasing stock under its current buy back authorization to allow it to act on this stock if and when it becomes available.  From the perspective of downside protection, the $4.86 tangible book value and $4.13 per share cash position provide some support. However, I believe the real support is tied to the company's asset of value in its large base of highly valuable members to advertisers which could make it an attractive acquisition target. 

 Industry Points:

• In the U.S. there are about 2.2 million weddings per year. The number of weddings has been declining about one-half of one percent per year over the last decade. The number of pregnancies is running about 4.5 million per year.
• Total wedding related expenditures are estimated at about $75 billion per year and management estimates the market for what it calls "the five years of firsts" (wedding, home & baby) to be $180 billion.
• As most brides view their wedding as a once in a lifetime occurrence, they allocate significant expenditures (about $25K-$30K on average) to the event. Management estimates the total registry gift giving market at over $12 billion each year.
• While there is an ongoing shift to the Web, only 12% of bridal related spending takes place on the Internet today.
• In the U.S. there are about 4.5 million pregnancies per year.
• Recent surveys of internet advertising buyers suggest that the outlook remains favorable relative to the recent improvement in spending trends continuing with growth in the low teens forecasted in the 2011/12 periods. 

Company Points:

• The strategy of the company has been to establish www.theknot.com as the leading web site and portal for all the needs of soon to be wed couples (especially targeted at brides), from a wide range of products, to advice to planning tools. In addition, www.WeddingChannel.com has established itself as the leading bridal registry site online, which searches and aggregates registries from most of the leading retailers in one place. The combination of the size of the company's 20 million members and amount of page views coupled with the spending potential of this group, present a very valuable asset to advertisers. The company's business model is to leverage this asset to sell ads to both local and national advertisers, to market merchandise on its web site to these members, to collect royalties from directing registry customers to retailers, and to publish a number of magazine that leverage its brand to this target market.

• Membership in any of the company's websites is free. The company does very little direct advertising to promote its brand and websites. It enjoys a healthy benefit from the viral effect generated from word of mouth and promotional activity. Noteworthy, 70% of new members are generated organically (i.e. by typing in the web site name), while 20% is from search sites and 10% from referrals. These data points appear to be unique among web based advertisers and speaks to the strength of the company's brand.

• One of the company's major growth initiatives is to leverage its existing infrastructure and grow from a bridal exclusive focus to a "life stage" centric relationship company by expanding its relationship with many of its members though their newlywed and pregnancy life stages with the creation of The Nest and The Bump brands. This strategy appears to be gaining traction, especially at The Bump. For example, KNOT has recently surpassed the threshold of over one million visitors to www.thebump.com and signed a couple of national advertisers. In Q3 25% of revenues were derived from non-bridal revenue sources.

• Another major growth initiative is to expand the company's brands internationally, with the focus on China. Noteworthy, China is the largest market for weddings and with an affinity for western styles, could be consistent with the company's business model and provide a big opportunity for growth. In 2009 KNOT established a software development center in Guangzhou, China and opened a business office in Beijing. The company just announced the launch of its Chinese portal www.ijie.com in November. The company spent about $1.8 million in 2010 in China and expects to spend about $3.2 million in 2011. China appears likely to remain in an investment mode for KNOT for sometime, with the timing of significant revenue contribution unclear. Management has not finalized its business strategy in China yet as it is evaluating different possibilities (go it alone, JV or advertising partnerships) and will come to a decision in the next 12 months.

• The company is hoping to improve publishing revenues by increasing the publication of The Knot National Magazine from semiannually to four times a year beginning in 2010.

Major Issues: 

• After a period of rapid growth of over 30% through 2007 and increasing operating margins (in the mid-to-upper teens at its peak), a number of factors beginning in 2008 have pressured revenue growth and margins. Revenue growth was negatively impacted by the combination of the poor economy, vendor attrition from planned price increases, a change in sales management and the restructuring of its relationship with its major customer, Macy's. Margins were impacted by a decision to invest in upgrading the company's IT infrastructure to both support the company's growth initiatives and decrease churn among its advertising customers. These constant disappointments led to a turnover in the shareholder base away from growth oriented investors and most sell-side analysts adopting a wait-and-see attitude towards the stock. From its peak of over $30 in 2007, the shares have declined about 70% to there current level creating an opportunity for patient value investors. The key to improving the company's financial performance will be to: 1) grow new advertising clients, 2) increase the average spend per client and 3) lower customer churn rates.

• One of the major issues that has negatively impacted the company is an increase in churn of its base of local advertising customers. Over the last two years the local churn rate has increased from a targeted level in the high 20%-to-low 30% range to the mid 30% range. Management is addressing this issue by using some of the improvements to its IT systems, including a new content management system, to provide advertisers a better return on their investment. Advertisers now can use a separate dashboard to see the amount of traffic they have received and the names of the brides who have viewed their sites. KNOT has also improved their customer service team and provided simplified tools to allow users to create their own profiles. In Q3 the local customer churn rate of 35.6% showed the first decline in a number of quarters. Continues success in this effort will help drive on-line ad revenue growth (from both current and new clients) and margin improvement.

• From a competitive perspective, KNOT is the 800-pound gorilla in the bridal market in terms of market share and awareness and unlike other internet companies does not have the equalivant of an Amazon or Wal-Mart to compete against. In terms of visitors to its web site, KNOT has about 4x advantage relative to its closest competitor (WeddingWire.com).

• A major initiative of KNOT is to drive on-line revenue growth. Management acknowledges that it has been much more successful in its marketing efforts focused on the consumer than it has been with potential advertisers. In order to address this issue, the company has made changes to its sales force and compensation structure to better align the sales team with the corporate goals. The changes to its IT systems are targeted at not only improving customer retention but give the company greater pricing flexibility in local markets and freeing up the sales force to pursue new accounts. The degree of success in improving on-line revenue growth will be a key determinant to a higher share price.

• In January 2010 Macy's, the company's largest customer accounting for 8.6% of revenues, signed a new registry agreement with the company. Under the new agreement, KNOT will no longer host and manage registry websites for Macy's and Bloomingdale's. Macy's brought its bridal registry services in-house and shifted its relationship with KNOT to an affiliate partnership arrangement similar to the agreement the company has with its other retail customers. Macy's signed a new three year agreement with KNOT, including a commitment to spend $3 million in on-line advertising during the next year.  However, the new agreement will not generate the same revenues as in the past as the company will not receive commissions on 100% of Macy's and Bloomingdale's online registry transactions. Given that margins in the company's registry services and online advertising business are about comparable, KNOT should receive about similar margins from the new relationship. While such a change is not inconsistent with the industry norm, the timing of the move has added another layer of investor concern and will pressure yr/yr comparisons through early 2011.

• Macy's owns 3,671,526 shares or 10.9% of the stock. Given the change in the business relationship it has with KNOT, Macy's has decided to sell its equity interest in the company and has registered the shares. Management believes Macy's is waiting for a higher price to sell the stock. This created somewhat of an overhang to the stock price.

• The company announced a $50 million stock repurchase program in February 2010, but has not purchased a significant amount of stock (even when the shares were at a 52-week low in June). Some have criticized the company saying if management does not have the confidence to buy its own stock during the current period why should investors? For its part, management stated they are open to repurchasing any Macy's stock if it comes available.

Financials: It's all about potential margin leverage

The key to the story from a financial perspective is the significant margin leverage tied to an improvement in sales growth. Aided by a number of investments the company has made to its infrastructure, the company has a highly scalable financial model which can support a much larger revenue base. Thus, should the combination of a improved economy (which should have a positive impact on wedding expenditures), the favorable outlook for internet ad spending, and success in some of the company's marketing initiatives begin to kick-in and help accelerate KNOT's revenue momentum, we should see a notable improvement in the company's margins. While the company has added a modest layer of costs to support its IT and expansion initiatives, I suspect with adequate revenue growth, it is conceivable that operating margins could get close to 2006/07 levels. I would submit that very little has changed relative to the economics of the business to not allow this to happen over time. Noteworthy, during the last few years the company's gross margins have remained very strong as competitive pressures have not been a major issue. While I expect to see progress in the company's plan to raise its profitability over the next 18-24 months, I suspect there will be elements of the plan that are more/less successful from a timing perspective and that investors should not expect a rapid, but more gradual, improvement in margins.

The following table illustrates some of the basic assumptions that I have modeled for the company. In order to be conservative relative to the success of some of the company's initiatives, I have modeled revenue growth of 9% and 10% in the 2011/12 years, which is below the low teens growth that some recent industry surveys of internet ad spending suggest. In addition, I have modeled operating margins expanding from the current levels of about 7% to 8.2% in 2011 and 12.7% in 2012 (which is below the 2006/2007 levels). Noteworthy, the expansion in operating margins are driven by the combination of the modest improvement in revenues and a mid-single digit growth in operating expenses.

Risks: 

Clearly the primary risk is that management's strategies to accelerate sales growth and increase margins are either unsuccessful (in which case they can be scaled back or modified) or take longer to gain traction. The company's dominant competitive position gives the company ample time for these initiatives to develop. Notwithstanding this, I would point to the following as other risks:

• The loss of any major client partnerships.
• The loss of any retail registry relationships.
• A decline in Internet traffic to the company's websites.
• Increased penetration from competitors such as Brides.com, WedingWire.com or Marthastewart.com.

Catalyst

• An acceleration in on-line revenues, especially from local advertisers.
• An increase in the average spend per client.
• Improving local customer churn rates.
• Continued growth in non-Macy's registry revenues.
• Success in the company's new growth initiatives at The Nest and The Bump.
• Financial leverage from an improvement in margins.
• An increase in FCF generation.
• Removing the overhang from the sale of the Macy's shares.