ValueClick is one of the largest pure internet advertising agencies. The company has 4 primary operating segments. The largest is the Media business (more than 60% of sales), which creates internet only ad campaigns for it's customers, and distributes the ads through search, e-mail, and a network of over 16 thousand web sites that reach over 75% of all U.S. internet users, a reach second only to Yahoo!. The Affiliate Marketing business (20-25% of sales) allows advertisers to use their own ad creatives to build an affiliate network using publishers that receive commissions through ValueClick. The company probably runs the largest affiliate marketing program in the world through their Commission Junction subsidiary. The third unit is Comparison Shopping (28% of sales), which runs the Smarter.com and Pricerunner.com comparison shopping sites allowing consumers to research and compare products and prices. Last and least is the Technology unit (6-7% of sales), which provides software tools for both advertisers and publishers to track the efficiency of ad campaigns.

I really like ValueClick's business and it just missed making it as a Top Buy. Internet marketing is a great business, and ValueClick's MFI return on capital figures illustrate this. Over the last 5 years the company has averaged nearly 150% MFI return on capital, and even in weakening conditions over the past year it still sits at 128%. These numbers probably put it in the top 1% of all public companies. Very little capital investment is needed to grow revenues, and low fixed costs make it easier to pare down expenses when revenues are weak, a nice attribute with a revenue stream as heavily cyclical as ad spending. ValueClick has an outstanding balance sheet too, with 161 million dollars and no debt. This, plus a very healthy free cash flow margin of 15%, allow management to provide shareholder value in numerous ways, from acquiring new businesses to buying back shares.

And there is plenty of growth potential. Some estimates have the internet ad market growing at a 20% annual clip through 2012. ValueClick has shrewdly used acquisitions to build out a wide breadth of services, and will likely continue that strategy. Continued roll-out of services in Europe is just the beginning of geographic expansion. Growth should not be a problem, although it will slow down from the trailing 5-year revenue CAGR of 40%.

Of course, since it's a Magic Formula stock, the price is right too - earnings yield of 10.5%, free cash flow yield of 8.2% are both very attractive numbers for this kind of growth. This price will likely be a bargain in the short term, as a poor macro-economic outlook is causing advertisers to cut down on spending. This is not a ValueClick specific problem. It's competitors are seeing the squeeze as well. As I've said many times before, uncontrollable macro-economic reasons for a cheap stock price is a good time to consider buying. Also, with the consolidation going on in the industry, there is a good possibility that a larger competitor may place a generous bid to acquire ValueClick's varied businesses and large affiliate network.

My biggest concerns with ValueClick, and the reason it does not make the Top Buy cut, is tough competition and no built-in moat characteristics. On the former, ValueClick currently competes with some heavyweights in internet marketing, including Yahoo!, Google, Microsoft, and AOL. Although ValueClick is holding it's own, it is likely that traditional ad agencies will soon move into internet marketing. This is a bigger problem, because these agencies already have relationships with big-spending advertisers, and can also offer newspaper, radio, and television services as well (Google is already moving in this direction with their Adwords program). Also, there are no switching costs that provide a durable competitive edge. Any advertiser can easily drop ValueClick in a heartbeat if a better deal comes along from a competitor. A lot of competition, low switching costs, and low barriers to entry will eventually lead to major price competition, which severely limits potential profits, regardless of how big the overall market grows.

In summary, ValueClick is a great business, at a good price, and is a fine pick for your MFI portfolio. But tough competition and low switching costs prevent it from building a long-term moat, and thus prevent it from being a Top Buy.