In a recent piece, we wrote about three companies in the new digital advertising sector titled A Look @ SmallCap Digital Advertisers, in which I discussed the likely scenario that the subsector would consolidate. It came as a surprise to see Gravity4 get hyper aggressive with an acquisition attempt of Rocket Fuel Inc. ($FUEL), but I can tell you the price was right in line, the company was worth about $275 million, and he (CEO of Gravity4) needed to bid slightly above the market if he wanted to buy it on that day.
I will be watching upcoming moves by Gravity4 CEO Gurbaksh Chahal. I think he is early, which is why the deal fell apart. The entire group (three companies) by my account, have a total valuation of $500M, and the sector is overvalued in current share price by about 30%. I expect to see this shake out over the next few quarters.
A Lack of Cash Keeps this Rocket from Igniting
Rocket Fuel rejected a $350 million takeover bid from Gravity4, saying it was "not credible." At the time that Gravity4 originally made its unsolicited offer, Rocket Fuel's stock surged 18% in the pre-market and briefly stopped trading. To me, the odd thing was that the bid was exactly the right price to buy the company on that day in May 2015, but I think that if you wait a few quarters, you can buy it cheaper. Shares look like they are about to test the old lows, so really, you will be able to buy Rocket Fuel for $250M later this year if you sit and hold your water for a minute. However, by that time, I think Chahal will have spent all the money he has available, and he will need cash flow to satisfy whatever acquisition he makes. I don't think a decent run rate exists yet in this new sector, which is why valuations will fall.
Shares of Rocket Fuel have been trading lower since 2013, and recently announced layoffs that cut 11% of the workforce has raised questions about the viability of digital marketing platforms. This is normal, and consolidation is healthy. I think Gurbaksh knows the honeymoon is over for the sector and a consolidation is likely. Salesman and executives can talk about new media marketing and utilizing platforms to be a better digital marketer, but in 2015 companies like Rocket Fuel will need to prove that they can make money. I agree with Chahal, who said"I have observed that Rocket Fuel has hit a road block in this environment, and continues to struggle with its declining gross margins, as evidenced by its recently reported loss of $13.6 million in Q1, with no guidance as to what the remainder of 2015 holds in store...for Rocket Fuel, the status quo is not an option."
The Status Quo is Not an Option In this Sector
Rocket Fuel is currently worth $350M, Sizmek ($SZMK) is worth $200M, and YuMe Inc. ($YUME) is worth $150M, making the entire group worth $700M at today's prices, or about $30% to high. Thus, I expect all three will fall, but if I had to pick one, I would buy Sizmek, and I fully expect someone will buy them. I believe these three companies will NOT operate a year from now. They consolidate, get swallowed up, or go out of business – I’ve seen it a hundred times.
Rocket Fuel fell back to earth after the bid, but this is not really rogue bidding…it’s the new way smaller companies get rolled up in an age of social media and global financing. Gravity4 has made, and will make acquisitions with their maverick CEO Chahal. It seems he is one of the few who grasp valuation. The question is...can he close deals? One thing is for sure – the space will be remarkably different next year…
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer