|Shares Out. (in M):||32,934||P/E||108.8x||60.4x|
|Market Cap (in $M):||358,322||P/FCF||27.9x||18.8x|
|Net Debt (in $M):||0||EBIT||9,115||13,159|
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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.
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.
Calendar Year P&L
Y/Y % Grth:
Cost of Goods
% of rev
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:
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