Stock in Focus: Should I add XLMedia to the portfolio?

With painful memories of Globo, Plus500 and Quindell fresh in the minds of many UK investors, I made sure that I had some wriggle room when I designed the Stock in Focus portfolio. I am allowed to reject qualifying stocks if I think that Stockopedia’s rankings don’t accurately reflect the risks involved.

This week’s stock is a possible example. XLMedia is a new qualifier for my screen, with a StockRank of 99. The firm’s fundamentals seem strong and both cash flow and generous dividends are real. Yet this is an AIM-listed Israeli tech stock that operates in the gaming sector. Recent history suggests it could be a risky buy.

I’m going to explore the arguments for and against adding XLMedia to the SIF portfolio. But first, it’s worth understanding exactly how XLMedia makes money.

How do you achieve 51% annual sales growth?

XLMedia’s revenue has grown at an average of 51.5% per year since 2010. Profits have risen by an average of 39.4% each year.

The company generates its revenue by supplying new users to online gaming sites. According to this video presentation, these include big names such as Ladbrokes, as well as smaller online casino operators.

XLMedia doesn’t get a flat fee to supply a certain number of users. Instead, the firm spends its own money generating leads for its customers. This is known as performance marketing. XLMedia attracts potential gaming site users through its own websites and with paid advertising such as Google AdWords and Facebook ads.

For each new player who signs up with a gaming operator and meets certain other criteria, XLMedia receives a share of the revenue from the player’s activity. In the online gaming sector it’s common for this performance payment to be a share of lifetime user revenue. This means that good quality users will generate revenue for XLMedia for many years after their initial signup. This can be very valuable: XLMedia said in 2014 that its average revenue-sharing rates were 35-55%.

Risks vs rewards

Performance marketing has become an important industry that’s grown up alongside ecommerce. Price comparison businesses such as Moneysupermarket.com are performance marketers, as are cashback and discount code websites.

It’s also a sector I understand well, as I’ve worked in performance marketing for a number of years. I’ve done similar things to XLMedia, but on a much smaller scale (and in a different sector). The big attraction is that this business can scale quite easily.

XLMedia claims to run more than 2,000 websites, most of which it says are informational. For example, XLMedia probably runs websites providing tips on poker strategy. From here, a proportion of users will click on tracked links to online casinos where they may sign up and become paying customers. If XLMedia’s websites rise up Google’s search results, they will generate more new users without requiring any additional investment.

Similarly, if conversion rates from XLMedia’s paid advertising are strong, the firm can increase its ad spend to drive more traffic, without having to generate new advertising concepts.

On the other hand, the downside can be brutal. I remember very well the sickening feeling I had towards the end of 2011, when changes to Google’s algorithms led to my main income-generating website losing the majority of its traffic for a period of time. Another risk is that revenue-sharing rates can be cut without notice.

XLMedia’s scale and diversity should provide some protection from this kind of risk, but only up to a point. The company doesn’t seem keen to provide examples of its websites, but my experience suggests that many will have certain recognisable characteristics. These could be targeted by Google in future algorithm updates.

This lack of visibility makes it’s hard to judge the quality and durability of XLMedia’s business. It may also be one reason why the firm’s recent strategic review failed to find a buyer.

Proven track record = value?

The key lesson I’ve taken away from my years in performance marketing is the need to constantly update and reinvent my business. XLMedia’s scale and profitable track record suggest it has been very successful at this.

As Paul Scott has pointed out more than once in his SCVR reports, although the firm’s profits are flattered by a constant emphasis on EBITDA, the cash flow and dividends are real.

XLMedia’s shares currently trade on a trailing P/E of 10.2 and a price to free cash flow ratio of 17.7. Last year’s 5 cent per share dividend was covered comfortably by free cash flow. With a trailing yield of 5.1%, XLMedia does have some appeal.

Are falling margins a quality concern?

One area which concerns me is XLMedia’s falling profit margins. Stockopedia shows that the group’s operating margins have fallen from 46.2% in 2012 to 25.7% last year.

The firm has alluded to this fall in its commentary, saying that greater scale in more regulated markets will lead to higher volumes at lower margins. That’s okay, but if XLMedia’s user acquisition costs rise while the firm’s income remains the same, cash generation could weaken.

While XLMedia scores quite well on quality, the QualityRank uses 5-year average margins. These can make a company with falling profit margins appear more profitable than it really is.

Who owns XLMedia?

XLMedia’s significant shareholder list includes a number of well-known institutional investors. Noted small-cap specialist Hargreave Hale is present with a 3.9% shareholding, as are Slater Investments and Investec. Interestingly, all three have trimmed their stakes over the last year.

Chief executive Ory Weihs has a 5.16% interest, which I’d normally find reassuring. However, Mr Weihs’ interest actually forms part of a concert party including Webpals Enterprises Limited, which has a 42.4% shareholding in XLMedia.

In total, 56.4% of XLMedia’s shares are not in public hands. Private shareholders are unlikely to have any voting power. A restricted supply of shares also make it easier for the stock to be squeezed higher on low volumes.

Indeed, I think it’s worth asking why XLMedia was looking for a buyer so soon after its IPO in March 2014. Was the company floated simply to help the firm’s original backers find a way of cashing out at a higher price?

Is strong momentum a buy signal?

I’m going to close off this article by highlighting the recent surge higher in XLMedia’s MomentumRank. This has risen by 20 places to 96 over the last month.

The main reasons for this appears to be a recent broker upgrade and the earnings beat reported with the last results:

I’m not yet convinced that this is enough to make the stock a buy. XLMedia may continue to trade well and pay generous dividends. But the firm’s business model faces continual regulatory and technological risks. The collapse of Blinkx is a good example of how profitable internet marketing businesses can go from hero to zero with no warning.

I’m not going to add XLMedia to the SIF portfolio this week, but I’ll record an open verdict for now. I’d really welcome your views on this stock -- are you invested, would you invest and why?