Digital River Flows Upstream - TheStreet

Digital River Flows Upstream

Long-term investors see a potential for another stock run-up.
Author:
Publish date:

It's starting to go smoothly again for

Digital River

(DRIV) - Get Report

.

The Minneapolis-based company, which handles e-commerce operations for other companies, was one hot stock for much of 2006. After dipping below $24 in November 2005, the stock had pushed above $60 12 months later -- a one-year return of 140% that few other issues could deliver.

Since then, though, Digital River has slumped a bit. Part of that is expected as a natural correction following such a breathless run-up.

But some of it stemmed from concerns that the company's efforts to expand overseas would cause costs to rise faster than revenue.

The uncertainty factor grew stronger on Dec. 22, when the

Securities and Exchange Commission

asked the company for documents on the stock options it gave to executives over the past eight years. Digital River's stock fell as low as $54.55 on Jan. 26, a 21% drop in a little more than a month.

Since then, Digital River has regained about half of that lost ground, much of it on Friday, when its fourth-quarter earnings report helped push the stock up 5% in a single day. On Monday, the stock closed off 25 cents to $54.81.

Digital River's 47-cent-a-share in profit it delivered on Friday was only a penny ahead of the Street's forecast. But its report showed a more modest restatement of 2006 earnings than some had expected, coupled with raised full-year guidance in line with what analysts had been forecasting. That allowed investors who believe in the stock's long-term promise to breathe a sigh of relief.

"We believe DRIV has positioned itself to experience strong revenue and earnings growth over the next several years," wrote First Dallas analyst Preston Silvey in a research report on Friday. First Dallas doesn't engage in underwriting securities.

"With a growing number of software publishers distributing products online and growth in e-commerce both domestically and internationally, as well as the potential for future acquisitions, we continue to believe the outlook for DRIV is bright and expect long-term shareholders to be further rewarded," Silvey said.

The warm reception that the market gave to Digital River on Friday suggests that Wall Street may be extending a forgive-and-forget attitude toward companies that have strong earnings growth potential. Digital River's earnings report included a $2.2 million adjustment for noncash, stock-based compensation expense, but on Friday, analysts' focus was elsewhere.

In particular, many were watching how the company's recently expanded relationship with

Microsoft

(MSFT) - Get Report

will boost its business. Digital River is supporting online downloads of Microsoft's new Vista operating system and its 2007 Microsoft Office applications.

"While the Microsoft download opportunity has only been live for about 9 days, management indicated that early signs have been encouraging," wrote DeutscheBank analyst Jeetil Patel in a note Friday. DeutscheBank has no underwriting relationship with Digital River.

"Feedback on the Office product

has been positive, and we think revenues should start to ramp in the coming quarters," Patel said. "There is still significant opportunity beyond the Office/Vista products and could see some additional launches in the near future."

In addition, a similar contract that Digital River has with

Symantec

(SYMC) - Get Report

, which had been slowed down in the fourth quarter because of integration snafus, should start to kick in during the current quarter, Digital River said in its earnings call.

The company also signed new agreements with companies such as ACD Systems, Fisher-Price and Skype, in addition to longer-term customers such as

Autodesk

(ADSK) - Get Report

,

eBay

(EBAY) - Get Report

and

Trend Micro

(TMIC)

.

One remaining concern for Digital River is how fast it can reinflate margins that flagged in 2006 because of the company's expansion abroad. Building out its network caused gross margins to fall to 88% last year from 88.7% in 2005.

Similarly, expenses for SG&A and R&D both ballooned faster than sales, driving the 2006 pretax income margin down to 29.1% from 32.4% in the previous year.

In the fourth quarter, pretax margin was 29.9%. That was above the previous quarter's margin of 27% but below the year-ago figure of 32.9%.

If the promise of growth from Microsoft, Symantec and Skype pan out, the company's income statement should look more impressive this year. Provided the company can also steer clear of any ugly encounters with the SEC, investors may feel better about floating their boats on Digital River again.