2 Internet Companies to Buy, 1 to Sell

Zain is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

E-commerce continues to show signs of accelerating growth as consumers shift more of their purchases online to take advantage of superior pricing, selection and convenience. While non-travel US e-commerce growth improved modestly, that measure fails to account for mobile, which grew over 50% for both Amazon and eBay in 1Q.

In this rising e-commerce trend, Internet companies are clearly the beneficiaries. However, many believe that small-cap companies might not benefit as much as the large companies due to their small size.

Is it true?

We have a set of small-cap Internet players that are reporting next week. These companies are pure plays on rising e-commerce trends.

Shutterfly (NASDAQ: SFLY), the provider of photo-related products, is expected to post its results on May 1. The quarterly revenue is forecasted to be $109.4 million, which will be up 20% on year-over-year basis. This is basically near the high end of the guidance range of $107.2 million -$110 million. The adjusted EBITDA will come in at -$2.5 million, which will again be near the high end of the guidance range of -$3.5 million to -$2.5 million.

In 2012, the company faced some intense competition from the market in the form of aggressive pricing and marketing. However, this has largely disappeared as channel checks suggest that competitors like Snapfish have not been into heavy discounts and promotional activity lately. This can be of interest to investors as this could mean that the company might be able to beat 1Q estimates (in case the company is not exercising aggressive pricing).

Focus areas

Investors will look for info on following topics in the conference call:

1) Update on pricing - How has Shutterfly responded to the ‘relaxed’ pricing approach of competitors?

2) Market share gains - Increase in market share is gauged by increase in unique number of visitors to the website and increased number of minutes (time they spent on the website). Recently both metrics have been decelerating for the company but luckily at a slower rate as compared to Snapfish and Vistaprint (another competitor). Analysts will like the company to comment on it.

3) Mobile strategy – increased usage of mobile has attracted the attention of many online players. Similarly, Shutterfly has been aggressively pursuing M&A activity to bolster its mobile strategy. Important acquisitions include Treat and Penguin Digital. How will the company proceed in the future?

Taking an overall picture of the stock, it might seem an expensive one with a forward earnings multiple of 53x. Also the stock recently achieved its 52-week high. However, to me, the stock looks a great buy. The demand for online digital printing is growing at a vociferous speed. Now the pricing in the industry is also shifting into positive momentum, which will help the company to improve its margins. Apart from that, the company, through its active M&A activity, is destined to increase its market share in this industry in the near term.

OpenTable (NASDAQ: OPEN) is another player of the same field that is expected to announce its earnings this week. According to comScore, unique visitor growth to OpenTable moderated slightly in 1Q to 33% from 38% in 4Q, while user engagement growth accelerated with page views up 36% year-over-year from 23% in 4Q.

The company provides free, real-time online restaurant reservations for diners through an online booking service. If this growth pattern is carried through to seated diner growth (one of the segments of the company), the market can expect an upside to the consensus estimates despite the continued pressures on subscription revenues.

The company has three main growth levers in the future:

1) Seated diner growth: Diner growth is outpacing growth in overall revenue of the company. The company is expected to shed some light on further growth prospects in this category.

2) International expansion: Growth in the UK seems to be in the limelight. The company is testing broad-based brand campaigns in the UK to help increase awareness and penetration.

3) Technological Innovation: Recent tech developments include the Toptable iPhone app launch in the UK in December, the Facebook integration, and the acquisition of Foodspotting, which will allow the company to add richer content to its site and bring in-house some strong mobile and social developer talent.

These three growth prospects make the stock a buy case. However, a lot depends on how the company capitalizes on these growth levers.

Many at this point would say that small-cap Internet companies are not worth investing after Zynga’s (NASDAQ: ZNGA) terrible results for the last quarter. The company posted a staggering 30% decline in its bookings (a measure to gauge in-game virtual goods purchase). Total revenues also fell by 18% year-over-year.

However, what these results do not show are the consensus estimates. The company topped both revenue and earnings estimates. However, investors might be concerned about the weak guidance given by Zynga. In this respect, I want to say that Zynga is a different story altogether. The fact that the stock is down 60% in the last 12 months has nothing to do with the industry dynamics. The stock has been badly punished as it struggles to transition from its former dependence on Facebook, which at one point in time accounted for almost 90% of Zynga’s total bookings.

Zynga’s turnaround hinges on developing a sustainable mobile and Zynga.com business. While some positive signs have recently appeared on the horizon, it is too early to jump into the stock.

My Foolish Take

The very first thing that the earnings preview shows is that the small cap stocks are also expected to benefit from improving e-commerce trends in the industry. Talking stock-wise, Shutterfly remains a buy on the basis of rising market share and aggressive mobile strategy, which I believe is the upcoming theme in the Internet industry. OpenTable is also a buy on the basis of strong growth prospects. However, Zynga fails to get that respect due to its flaky business model and immature transition from its Facebook partnership.

Zain Abbas has no position in any stocks mentioned. The Motley Fool recommends OpenTable. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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