Tap into the Growth of Interactivity

I recently read an article in The Wall Street Journal that highlighted the emergence of interactive advertising. In the interactive world, rather than just receiving information via 30-second spots, consumers are participants in the marketing experience. By pushing the "interactive" button on the television remote while a commercial is playing--or even while a product appears on screen--you can view a full-length informational piece on the product, design one of your own if you'd like, and even order it on the spot.

As a former media analyst, I wasn't too surprised by the Journal article; media experts have been talking about interactivity for years now. What is surprising to me, however, is that so little respect is being given to one of today's leaders in interactivity,  IAC/InterActiveCorp (IACI). IAC's leader, Barry Diller, recognized the potential of interactivity earlier than almost anyone and built his company around it. Yet the stock market, in my opinion, is currently giving him little credit for his vision and effort. IAC's shares currently trade close to $25, well below the $40-$45 price tag I'd attach to them. (Morningstar analyst Sanjay Ayer estimates the stock's fair value at $40, and the stock is currently rated 5 stars.)

Interactivity isn't just about pressing a button on a remote; it's much bigger than that. Interactivity is getting people more involved in the world around them by using technology. In the world of commerce, getting consumers more involved in the shopping experience means that layers of middlemen can be eliminated, potentially resulting in big savings for the consumer.

And using the Internet as the primary means of interactivity can result in a very satisfactory buying experience for the consumer. No longer will Joe Consumer have to leave the house, fight traffic, and walk the aisles only to find that the item he wants is no longer in inventory. He can go online. Find the product he's looking for (often at a more affordable price), and have it delivered to his door in a few days (or overnight, if he needs it quickly).

IAC and Interactivity
Diller's first attempt to make the shopping experience more interactive was QVC, the at-home shopping channel. This step isn't surprising given Diller's background: Early in his career, he worked at ABC (with Michael Eisner) and later started the Fox network. Diller used the expertise acquired while at QVC when he later acquired control of HSN, the Home Shopping Network. IAC still owns HSN, and it has been a successful investment for the firm, but IAC has moved beyond television in its efforts to make buying goods and services an interactive experience.

Today, IAC's best, biggest, and fastest-growing businesses run on the Internet. Expedia.com is the leading online seller of travel services in the United States and is expanding into the corporate market and abroad. Hotels.com is the leading independent marketer of hotel rooms in the U.S. LendingTree.com is the top online lending destination for homebuyers. Ticketmaster is the number one destination for people seeking sports or entertainment tickets. IAC's Citysearch.com has yet to make a significant contribution to IAC's profits, but the product is excellent and could be key to IAC's long-term strategy. IAC will soon acquire AskJeeves.com. While AskJeeves isn't the top search portal at present, its search technology is promising, its brand is well-known, and it could get a big boost by being paired with IAC's other popular products and services. Its prospects in local search are especially strong, I think.

To me, the long-term potential for IAC is extraordinary. IAC is built on strong brand names, and businesses built on brands tend to do very well over time (think  Procter & Gamble (PG),  Gillette ,  Kraft (KFT), and  Altria (MO)). IAC is largely focused on selling services, which means it is not at all capital-intensive. Having relatively small reinvestment needs, most cash flow can be used to further enrich shareholders (dividends, buybacks, or acquisitions).

Not only is it focused on services, IAC has targeted enormous markets that are ripe for disintermediation: travel and real estate, especially. And by using the Internet for its marketing and much of its distribution, IAC can keep its costs well below those of its bricks and mortar competitors. Use of the Internet will only increase over time, and with its leading positions, IAC only stands to benefit from this expansion.

An investment in IAC isn't just a bet on its potential, however. IAC is generating lots of cash right now, thanks to HSN and Expedia.com. In 2004, IAC threw off more than $1 billion in free cash flow, an impressive 17% of sales. In the first quarter, free cash flow was just under $500 million, an even more impressive 29% of sales. This means that IAC is currently on pace to turn $0.30 of every dollar it takes in as revenue into cash that can be used for dividends, buybacks, and (most likely) acquisitions. That conversion rate will decline over the course of the year as IAC pays its suppliers, but still, you should get the sense that IAC's businesses aren't ticking dot-coms filled with promise but little investment merit. No, IAC’s businesses offer the prospect of exceptional long-term growth while throwing off loads of cash today.

The Valuation Case
Promising prospects and lots of cash flow are great, but the price always has to be right in order for an investment to make sense. I think IAC's current price is well below where it should be. In a discounted cash-flow model, it's pretty easy to get to a fair value estimate of $40-$45. Not everyone is interested in discounted cash-flow models, however. Looking at relative multiples--especially enterprise value/EBITDA and enterprise value/free cash flow--bolsters my case. (The following exercise is based on IAC's first-quarter financial results. Subsequent changes related to the AskJeeves acquisitions may have changed the math to some extent.)

IAC currently has a market value of $16.3 billion. It also had about $4.2 billion in cash and marketable securities at quarter-end. In addition, IAC has $1.5 billion of other, nonoperating assets on its books, offsetting the company's $1.5 billion in debt. So IAC's enterprise value is about $12 billion. EBITDA equaled about $315 million in the first quarter, corresponding to a run rate of $1.25 billion in 2005 and making IAC's EV/EBITDA a relatively low 9.6 times. (Morningstar analyst Sanjay Ayer estimates 2005 EBITDA will be $1.375 billion, which would lower the EV/EBITDA multiple to 8.7 times.) This multiple is downright cheap when considering the quality of the assets, the prospects, and the high rate of cash conversion.

I already said that IAC is on pace to throw off $2 billion in free cash flow this year. An enterprise value/free cash flow multiple of 6 times is absurdly low for a business like IAC. I also said that free cash flow generation would likely taper through the course of the year. Even if free cash flow were to remain at 2004's $1 billion level, at 12 times free cash flow, investors would still be getting a good deal.

If you think interactivity will be big in advertising, then you have to like its prospects for commerce. IAC has positioned itself very well to benefit from the increased use of the Internet to buy and sell goods and services. And right now, the stock looks like a steal.