A Beaten-Down Stock in an Up Market

 | Feb 21, 2013 | 2:00 PM EST
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While the markets flirt with record highs, attractive stock prices are harder to come by. The list of 52-week lows is fraction of what it was a year ago or even six months ago. What remain on the 52-week-low list are mainly names that don't offer compelling prospects, such as several gold-mining stocks and other names that have a knack for consistent unprofitably. But some battered names are sitting at or near 52-week lows whose compelling stories could lead to superior returns.

As a result of several acquisitions, Digital Generation (DGIT) has become the world's leading ad management and distribution platform. Its technology is considered first rate, and when it acquired MediaMind, Digital Generation became one of the main players in online advertising distribution. Earlier this week, Digital reported earnings that included a $230 million impairment charge. In addition, the company announced that it had concluded its strategic review process without any satisfactory offers. This one-two punch sent shares down nearly 30% to an all-time low of $7 a share. Just over a year ago, shares were trading north of $20.

Never mind what the shares once traded for, today's price values Digital Generation at $190 million, along with net debt of $450 million, for an enterprise value of about $640 million. Digital Generation borrowed these funds to finance the acquisition of MediaMind. The debt is not due until 2018. The company did note in its earnings release that it expects to breach its borrowing covenants later this year because the required ratio was lowered. So on the surface, Digital Generation looks like an over-leveraged mess, and stockholders are selling first and asking questions later.

I wouldn't be so quick to throw in the towel. Digital Generation generates strong cash flows from little capital expenditure. Under such conditions, high leverage is the optimal capital structure.

More importantly, Digital Generation is at the forefront of a vastly growing industry via online advertising. When you read The Wall Street Journal on an iPad, Digital Generation has a hand in many of the ads displayed. This type of targeted advertising -- putting a financial-services ad in the investing section or a luxury fashion ad in an article about fashion -- is powerful. In addition to online, Digital also has a strong, steady, profitable TV segment. HDTV continues to grow, and TV still captures millions of viewers each night.

Finally, Digital has some big shareholders who have recently gone public with their desire to effect change. It's almost certain that they bought in at prices well above $10 per share, and it's possible that they were big buyers or sellers the past couple of days when shares tanked on huge volume. If so, the appropriate SEC filings will show that in the upcoming days.

Digital Generation is going through a rough patch, but the company has assembled an incredibly valuable collection of assets that promise growth and growing cash flows. Complex investment scenarios often have the potential to yield abnormal returns, since many people prefer to avoid them rather than doing the work. Digital Generation appears to fit that scenario.

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