As was written in our First Quarter 2000 Report:
”Of the 350 Internet IPO’s in the last 2 years, relatively few will be success stories for the investors who got in after the IPO. However, a small minority will indeed dominate niches, generate very large economic profits on a small capital base, and make investors rich.”
Indeed, though the Internet boom sowed many seeds, few trees survived. At the same time, it is clear that some very important companies have established a vigorous presence in the new digital business world. EBay, Google, Yahoo, VeriSign, and Amazon stand out. Less known is e-commerce enabler Digital River, which came public in 1998 at about $12, peaked over $60 in the midst of the Internet boom, and then plunged in the Internet crash.
Digital River (DRIV 39) is the leading builder and manager of online retail stores. Digital River provides an end-to-end e-commerce solution that enables its clients to reach retail customers all over the world, crossing borders of language and currency. Counted amongst its 40,000 clients are Adobe, Autodesk, Canon, Circuit City, CompUSA, eBay, eCost, Intuit, McAfee, Microsoft, Newegg, Symantec, and Trend Micro. Software companies, in particular, are experiencing a rapid conversion of physical sales of boxed products to “digital” sales, sales fulfilled by the downloading of the software product via the Internet. Digital sales are more convenient for the customer and more profitable for the retailer. Digital River’s growth is driven both by 20% per annum expansion of e-commerce and by the need of online retailers for an experienced partner in building and operating webstores. By outsourcing e-commerce to Digital River, retailers can promote and maintain their brands while leveraging Digital River’s investment in infrastructure and technology. Clients thereby avoid the expense of building online digital retailing infrastructure, shift the technological risk and operating expense, and shorten time to market. The rapid growth of Internet retailing is manifested by Digital River’s financial results: revenue growth of 52% in 2004 and 46% in the last quarter, accompanied by even faster earnings growth.
Digital River’s webstore platform consists of website development and hosting, order management and fulfillment, fraud prevention, payment processing, export controls, sales tax collection, multi-lingual customer service, reporting, and “Strategic Marketing Services”. The retail webstores that Digital River designs and manages for its clients visually match the client’s established branding and image, so as to provide a seamless experience for end-users navigating from clients’ websites. The Symantec Store Site at www.symantecstore.com is a good example. “Strategic Marketing Services” draws on statistical and web analytics to increase customer acquisition, retention, and business levels. Site merchandising helps clients feature, promote, up-sell, and cross-sell specific products and services to increase sales. Fulfillment services delivers products to customers and order management secures payment. Customer service is offered on a 24x7 basis. Since the Internet is worldwide, as soon as a client’s new webstore is opened, the company becomes an international merchant, and must be able to deal with different languages, currencies, and business customs. Digital River takes care of this transparently to both its clients and their customers.
Digital River is paid by collecting recurring fees on sales transactions generated on webstores it manages and for services associated with creating and managing webstores. Gross margins exceed 80%, so revenue growth is driving large increases in net income and cash flow.
Risks include technological change, overall world economic vitality, and competition. Currently, competitors are fragmented, providing only portions of Digital River’s broad service package. However, barriers to entry are small, so competitors could broaden their service offerings. The ability to combine different competencies, such as reliable infrastructure and productive marketing, has proven to be a unique strength of Digital River. One specific short-term risk for the stock is the rumored entry of Microsoft into the antivirus software business. The leading antivirus companies, Symantec, McAfee, and Trend Micro, are Digital River’s largest customers, and would be hurt by the entry of Microsoft into their business. It is uncertain how negative this would be for Digital River, since Microsoft is also a client. Economic vigor affects retail sales. It is interesting to note that gasoline prices may accelerate the evolution of retail sales from the mall to the home computer.
The 20% growth rate of e-commerce is likely to persist for years to come. Sales over the Internet, also called digital commerce, are growing rapidly. Increasing numbers of consumers are finding the convenience and price competitiveness of Internet stores attractive and exciting. Meanwhile, web presence erodes the size and branding advantage of large retailers. Retailing over the web is more cost effective than maintaining a physical presence, such as a store in a mall, allowing webstores to be extremely price competitive. Therefore, almost all retailers are finding the establishment and operation of webstores both an offensive and defensive necessity.
Digital River is likely to experience a decline in its scorching growth rate in coming quarters, which could put a temporary ceiling on this intrinsically inexpensive stock. Although long-term growth is relatively difficult to put a percentage rate on, intrinsic value in the range of $45 to $50 is supportable. Persistence of long-term growth at even half the current rate should provide dramatic returns for investors, and price weakness should be viewed as an opportunity to acquire a pure play in digital commerce infrastructure, services, and expertise.
Monsanto (MON 65): The biggest home runs are yet to come. Monsanto started its seminal work in unlocking the plant genome in the early ‘80’s, when it was only known as a chemical company. The huge head start established by the pioneer in seed genetics has resulted in 90% trait market share in 2004’s 175 million acres of biotechnology crops. Monsanto’s dominance in seed traits parallels that of the great wireless communications innovator, Qualcomm, in cdma. The acceptance of Roundup Ready Corn in Europe for both food and animal feed consumption diminishes the opposition to genetically engineered crops. Hybridization and breeding practiced in agriculture for centuries is genetic modification, just as is genetic engineering, with the difference being the rate of genetic change.
Current traits focus on insect, disease, and herbicide resistance. They save costs and labor for farmers, combat food price pressure, and reduce the pesticide poisoning of our planet. These traits have sold well because of economics for farmers, but their commercial potential pales in comparison to upcoming traits that appeal to food consumers. Monsanto’s new product pipeline is packed. Drought resistant seeds will permit the planting of food crops in regions with less rainfall, and reduce the risk of crop loss for farmers from drought. The economic and humanitarian impacts of this trait are enormous, certainly in countries in which low rainfall correlates with a starving population. A particularly attractive trait for food consumers will reduce or remove unhealthy fat from oils used in food processing. Imagine heart healthy Oreo’s! Monsanto’s Vistive soybeans will have a genetically engineered oil structure, eliminating trans fats, making soy oil as healthy as olive oil. This coincides nicely with new food industry requirements expanding disclosure of the presence of trans fats in processed food.
The markets better understand the economic proposition for Monsanto shareholders now than when we bought the stock, as manifested by the substantial appreciation of the share price. Monsanto is paid a royalty for each trait incorporated into a seed. Stacking multiple traits increases the economic value of seed to customers, permitting Monsanto to multiply what it charges. The cost to Monsanto of producing seeds with multiple traits is negligibly higher as reported under GAAP, which ignores the years of development and research expenses deducted from previous years’ earnings. And, acreage planted with Monsanto seed and/or traits is growing rapidly worldwide. Hence, Monsanto’s earnings are growing rapidly. The expanded profitability of Monsanto’s innovations has many years to run. Earnings per share this year should exceed $2.00, possibly followed by about $2.70 in 2006 and $3.40 in 2007. Intrinsic value is estimated at about $66 and could double over the next five years.
It is important to understand that short-term risks inherent in Monsanto offset the current attractiveness of this proven innovator in a business in which the fundamental long-term need is clear and unquestioned. First, weather impacts agriculture and agriculture-based businesses dramatically and unpredictably. Weather can impact one part of the world, or all. Monsanto cannot sell a new product until it gets regulatory approval. This increases the risk, time, and capital investment of getting a product to market, concurrently creating large barriers to competitive entry.
Taking all this into account, Monsanto is one of our favorite long-term investments. However, the stock is now fully priced compared to its estimated intrinsic value. A weather or regulatory hiccup could provide a juicy opportunity.
Steven
L. Ré, CFA August
22, 2005
This report contains the current opinions of the author and such opinions are subject to change without notice. It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The information contained herein is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results. Earnings projections often miss, and markets go up and down. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.