Small Cap Stocks

Even though we hate selling stock during major market corrections, we still decided to exit from our remaining position in WWWW following the company’s earnings announcement this morning.

After having waited for nearly a year and half for our investment thesis on WWWW to play out, we think it’s time to book our, now small, profit here and move on.

Today’s report has proven to us that the management team here has little to offer in terms of sustainable and profitable growth strategies. Interestingly, management seems more focused on strategizing about the company’s huge tax loss carryforwards, rather than on improving the bottom-line. Ironically, continued losses keep adding to the value of the company’s NOL’s, but of course minority shareholders will never benefit from this asset under the current management team.

As we have stated in the past, we don’t see much downside in WWWW’s stock given the company’s low relative valuation, but we also fail to see any upside scenario either. With the stock market sell-off gaining steam, there are now plenty of other investment options to consider, which have a more favorable risk/reward profile.

Even though we’ve been critical of Web.com’s (WWWW) management in the past, we think the stock is an interesting value at current prices, following the stock’s over 40% drop from its yearly high and the recent M&A activity in the company’s sector. The company reports earnings on November 7, and judging by past results we expect about $12 million in revenue and a slight EBITDA profit.

Our basic investment thesis remains that the predictable nature of Web.com’s recurring revenue stream makes the company more valuable that the current share price implies, especially considering recent consolidation in the SMB web hosting industry. We would also note that the stock currently trades beneath the average exercise prices of a large junk of options, significantly reducing selling pressure in the stock at current levels. The CEO, who takes no salary from the company, also recently exercised options for 25,000 shares.

What Went Wrong?

We think that Web.com’s stock has been in free fall over the past few months, because of:

• Botched Acquisition of WebSource Undermined Management’s Credibility
• Cancelled GoDaddy.com IPO Forced Speculators Out of the Stock
• Management’s Adoption of what we view as a questionable shareholder rights plan.

What Has Changed?

So why consider a position in Web.com (WWWW) now?

• Stock Has Declined Far More Than is Warranted Than the Above-Mentioned Negatives Warrant
• Recent M&A in Sector Supports a Higher Price
• We believe that following their “screw-up” with WebSource, Web.com’s management team has finally decided to just buckle down and run a profitable business instead of chasing deals.

As far as M&A, we would note that Website Pros (WSPI) recently acquired 1ShoppingCart.com, a well-known SMB e-commerce provider for $12.5 million or about 2.7X sales. Website Pros is in our opinion the best public comp for WWWW. WSPI itself trades at an EV/Sales ratio of over 2X.

In other acquisition news, Aplus.Net , a SMB web hosting provider, has been purchased by New York-based Catalyst Investors for an undisclosed sum. Gabriel Murphy, who co-founded CommuniTech.Net and later sold that company to Interland (now Web.com) in February 2002, and the venture capital group now hold stakes in San Diego-based Aplus.Net, which was founded by Ivan Vachovsky in 1995.

Since the purchase price for Aplus.net has not been disclosed we can’t comment on any valuation measures. But, it is of course interesting to note the Web.com connection. Overall, we think that given the recurring nature of the revenues, SMB hosting companies are easily worth 2X EV/Sales.

Web.com is currently valued at little more than 1X EV/Sales, excluding any value for the company’s tax loss carryforwards. This is despite the fact that the company remains one of the largest players in the SMB web hosting market.

What Can Go Right? What is the Upside?

Based on our estimates, we think the company is worth at least $6.50 per share (2X EV/Sales) in the event that management decides to put the company up for sale. In fact, since management has a very large stake in the company, we expect them to sell the company if they show little results from their growth strategy over the next year.

What Can Go Wrong? What is the Downside?

As we’ve mentioned in the past, we don’t see much downside risk in WWWW. The company has a large enough customer base, with minimal churn, to allow it to generate well over $40 million in recurring revenue for quite some time. The balance sheet is also strong with more than enough cash to invest in new growth opportunities in the sector.

The major risk here is another stupid acquisition by management. But we think they have learned their lesson and in the worst case the company’s growth remains sluggish and the company is put up for sale.

We therefore don’t see the stock trading much beneath current levels of 1X EV/Sales.