does business in a profitable niche.
The Irving, Texas-based company acts as a conduit between advertising agencies and their audience, ensuring a cost-effective channel between an ad's source and end medium, whether it's television, the Internet or print. Its subsidiary,
, maintains an extensive database of advertisements, allowing agencies to search for content, directors and composers.
The business is both profitable and defensible. DG FastChannel's third-quarter operating margin widened from 21% to 27%, and the company has boosted profit 85% annually, on average, over the past three years and juiced revenue an average of 45%. Revenue growth tapered over the past year.
First- and second-quarter results were lackluster, with earnings per share falling from year-earlier figures. But third-quarter profit increased as the recession waned and companies' advertising budgets thawed. Despite a market value of just $688 million, DG FastChannel has gotten investors' attention. Its shares have soared 65% over the past three months, outpacing U.S. indices.
Consequently, valuation is a concern. DG FastChannel is trading at a premium to its average communications-equipment peer based on trailing earnings, sales and cash flow. The stock is undervalued on the basis of book value and projected earnings. Still, the recent surge could instigate profit-taking if confidence declines. A slew of our small-cap picks forfeited gains this fall as investors rotated into safer, large-cap stocks.
DG FastChannel's balance sheet is well-managed, holding $27 million of cash, which translates to a quick ratio of 1.6. Its 0.3 debt-to-equity ratio reflects a conservative capital structure. But the reliance on equity financing has been a drag on its return on equity, a key measure of profitability. In the latest quarter, return on equity dropped from 7% to 5% and lagged behind the industry average of 12%. Return on assets is equally unimpressive at 3%.
Considering the stock's 2.1 book value, it's a bit overpriced. Still, investors are betting profits will continue to ramp up as the economy recovers.
-- Reported by Jake Lynch in Boston.