Digital Generation Breakup Seen Doubling Stock Value

With Digital Generation Inc.’s stock languishing below the value of deals its executives completed in the past year, shareholders would double their money if the television and online advertising businesses were split.

A 71 percent drop since last year’s peak has left Digital Generation trading at a 44 percent discount to the value of its net assets, the cheapest multiple among U.S. ad companies larger than $250 million, according to data compiled by Bloomberg. At $295 million, its market value trails the $560 million Digital Generation spent creating its online unit through the 2011 purchases of MediaMind Technologies Inc. and EyeWonder LLC.

Digital Generation disclosed last week that it hired Goldman Sachs Group Inc. to explore options including a sale, less than two months after a person familiar with the matter said the company rejected an offer from Extreme Reach Inc. exceeding $20 a share. Divorcing the television and online advertising units could push the value of the company’s assets to $25 a share, according to Janney Montgomery Scott LLC, 133 percent higher than last week’s closing price.

“I do worry that this Internet segment is being stifled a bit by forced integration” with the TV business, Richard Fetyko, a New York-based analyst with Janney Montgomery, said in a phone interview. “It may be a difficult one from an ego standpoint because they just acquired some of these assets a year ago, but I think that they are trying to fit a square peg into a round hole.”

Two Businesses

JoAnn Horne, an outside spokeswoman for Irving, Texas-based Digital Generation, said the company had no comment beyond last week’s statement about the hiring of Goldman Sachs to explore alternatives.

Digital Generation is organized into two divisions. One unit distributes advertisements to television and radio stations, while the other helps customers manage online marketing campaigns. The company built the Internet business with the 2011 acquisitions of MediaMind for $499 million and EyeWonder for $61 million. To fund the deals, the company increased long-term borrowing to $435 million as of March from zero in June 2011.

The company as currently structured trades for about five times this year’s estimated earnings before interest, taxes, depreciation and amortization, Christopher Ferris, an analyst with Noble Financial Group Inc., wrote in a report on July 17, when the shares closed at $11.80. The stock lost 0.3 percent to $10.68 today, posting a smaller slump than the 0.9 percent decline in the Standard & Poor’s 500 Index.

‘Worth More’

Digital Generation’s online division should be valued at 20 times forecast 2012 Ebitda of $19 million, giving it a valuation of about $370 million, he said. The TV division’s projected value is five times estimated profit of $110 million, Ferris wrote. Given that, and after subtracting estimated year-end net debt of $376 million, the company should be valued at $19 a share, he said in the report.

“Clearly, it’s worth more than where the stock’s trading right now,” he said in a phone interview last week.

The shares, which closed last week at $10.71, trade for 0.56 times book value, or assets minus liabilities, which is less than all similarly sized peers, data compiled by Bloomberg show. The ratio dropped to a 10-year low of 0.41 on May 11.

Extreme Reach recently made an offer of more than $20 a share for rival Digital Generation that was rejected by the advertising-management company, a person with direct knowledge of the situation said at the beginning of June. Also last month, RDG Capital LLC’s Russell Glass said he was weighing an offer for the company, which has fallen from last year’s peak of $37.01 in May. RDG accumulated a 4.9 percent stake, Glass said June 7.

Prior Attempt

Digital Generation also tried to sell itself a year ago, when its name was DG FastChannel, three people with knowledge of the situation said at the time. That process stalled after its acquisition of MediaMind, a person with direct knowledge of the situation said last month.

Companies from Yahoo! Inc. to Adobe Systems Inc. and Dentsu Inc. might be interested in Digital Generation’s Internet business, said Janney Montgomery’s Fetyko, who said Digital Generation’s value would range between $18 and $25 a share in a breakup.

“The easiest, most straightforward way of increasing the value” of the company is jettisoning the Internet business, Fetyko said in a phone interview. That segment “consists of the acquisition of MediaMind, which is a really established, really well-recognized online ad delivery, campaign management and ad delivery service.”

Robert Coolbrith, an analyst for ThinkEquity LLC in San Francisco, said Yahoo may be interested in the “long-term strategic value” that the online ad management business segment could bring as it competes with Google Inc., which bought advertising company DoubleClick Inc. in 2008.

Cash Generation

Dana Lengkeek, a spokeswoman for Yahoo, said the company doesn’t comment on rumors and speculation. Yahoo’s new chief executive officer, former Google official Marissa Mayer, started her job last week. Colleen Rodriguez, a spokeswoman for Adobe, didn’t respond to phone calls and e-mails seeking comment. James Miller, a representative for Dentsu, didn’t respond to an e-mail requesting comment.

Private-equity firms might be drawn to the TV business given its cash generation, Coolbrith said.

“The traditional TV ad delivery business is very profitable,” he said. “Investors may have questioned the rationale behind the foray into the online business.” The challenge, though, is that “it is increasingly clear that there are limited opportunities for reinvestment of cash flow within the TV business itself.”

Deterring Buyers

The company borrowed to fund last year’s acquisitions, driving debt above the stock’s market value. That may deter private-equity buyers interested in the entire company or breaking it up, Noble’s Ferris said.

“It makes sense for a private-equity-type player, but private equity doesn’t particularly like a company that is levered up,” he said in a phone interview.

Digital Generation has accumulated debt amounting to 4 times Ebitda, compared with the average of 2.5 times among U.S. advertising firms valued at $250 million or more, according to data compiled by Bloomberg. Still, Digital Generation will produce about $70 million to $100 million in free cash flow annually, meaning it can pay off its net debt in three to four years, Ferris said.

Short sellers are boosting bets that the shares, already trading at a discount to net assets, will keep falling. The percentage of stock borrowed and then sold was 10.3 percent as of July 18 and climbed to a 21-month high of 12.8 percent on June 13, according to data compiled by Markit.

Biggest Shareholders

Two of the company’s biggest shareholders endorse Digital Generation’s evaluation of deals and other options.

“We are supportive of the board’s decision to formally explore strategic alternatives,” RDG Capital’s Glass said last week. “We and other significant shareholders have communicated this view to management and appreciate their responsiveness to shareholders’ input.”

Jim Roumell, the founder of Roumell Asset Management LLC, said in a phone interview from Chevy Chase, Maryland, that the company’s debt level isn’t enough to deter a potential buyer because the business generates so much cash.

While Roumell, whose fund holds about 5 percent of Digital Generation’s shares, said he sees the value of the two segments of the company being kept together, the company should explore any option that would boost returns for stockholders.

“If someone shows up with a fair price, I’m not wed to the company being kept together,” he said. “I’m wed to maximizing shareholder value.”

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