Geeknet: Questionable Business Model And High Valuation

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Geeknet (GKNT): Questionable Business Model and High Valuation

Company Overview

Geeknet is predominantly an online retailer that specializes in selling "geek"-themed products. It operates the website Thinkgeek.com. Many of its products fall into the Star Wars genre, or have their own special humor or eccentricities. The company derives its revenue from two sources - its website and wholesale revenues. A bull might say it has a cult following (over 600,000 Facebook likes); a bear may call it a fad.

The company had a rough Q4 and FY2013, appreciating a $0.2 million net loss down ($0.04 per share) from $13.9 million in 2012 ($2.12 per share). As a result, its share price recently fell 16.9% to $14.34 following its Q4 conference call. The stock is thinly traded, has 6.6 million shares outstanding, and has just a few small-cap analysts covering it. No surprise, most are bullish.

Business Model

My main concern is the company's business model. It is not built for long-term success. 84% of Geeknet's revenues come from its website, and the vast majority of the items on the website are either resold or available for significantly less on Amazon.com and other online retailers.

For example, the Legend of Zelda Link Figma figure sells for $54.99 on Thinkgeek.com, and $46.19 on Amazon.com. The OLight S15 Baton sells at $79.99 on ThinkGeek, and $70.95 on Amazon. The Doom Razor Attacknid sells for $79.99 on ThinkGeek and $66.76 on Amazon. Although the website certainly must have items that sell at a discount to the large online retailers, it doesn't appear significant enough to be competitive over time.

Understanding this, the company has begun creating its own products to service its customer base via its Technology & Design efforts. Full credit to Geeknet, this may be a unique way to grow the business - but it comes at a cost. Its innovation costs via technology and design have risen 227% from 2011 through 2013, from $1.86M to nearly $6.1M. These expenses, along with sales & marketing will have to increase significantly in order to execute management's strategy to build out the wholesale channel. The revenue from the website is already showing signs of flattening, and the segment's gross margin hasn't improved either. This may suggest the customers' migration to mobile, but it could also be a plateau.

GEEKNET, INC. Segment Data (In thousands, unaudited)
	Website		Wholesale		Total Company
Year Ended December 31, 2013
Net revenue	$115,909		$22,353		$138,262
Cost of revenue	96,458		14,687		111,145
Gross margin	19,451		7,666		27,117
Gross margin %	16.8%		34.3%		19.6%
Year Ended December 31, 2012
Net revenue	$111,938		$6,975		$118,913
Cost of revenue	92,758		5,090		97,848
Gross margin	19,180		1,885		21,065
Gross margin %	17.1%		27.0%		17.7%
Year Ended December 31, 2011
Net revenue	$93,691		$5,366		$99,057
Cost of revenue	79,568		4,034		83,602
Gross margin	14,123		1,332		15,455
Gross margin %	15.1%		24.8%		15.6%

Source: Geeknet corporate website

Management points to the strong wholesale channel growth to justify its promising future. Credit to them, wholesale revenue has grown 317% over the past couple of years ($5.37M to $22.35M) accompanied by an expanding gross margin (24.8% to 34.3%). However, the larger business's (website) revenue only grew 3.5% over the past year, down from 19.5% the previous year. It is hard to see how the wholesale channel growth over time will significantly offset the slack website growth. I would argue that one feeds the other.

If the website revenues continue to flatten or decline, the effect will eventually pinch the wholesale channel. If wholesale partners see weak website demand, they'll certainly question whether they should begin or continue to take on new ThinkGeek inventory.

This may already be starting to happen. ThinkGeek's days sales in inventory, a measure used to determine on average how many days goods spend in inventory - has been increasing. In 2012, it was 62.1 days, and for the year ending 2013, 66.3 days. Comparable niche online retailers are much lower than this. For instance, diamond retailer Blue Nile (NILE) had a DSI of 37.4 in 2012, and 34.4 in 2013. Online wedding retailer XO Group (XOXO), which runs theknot.com, had DSI of 35.9 in 2012 - in line with Blue Nile.

Valuation

The street had forecast $0.28 EPS and $0.40 FCF per share for FY 2013. Geeknet ended up losing $0.04 a share and losing $0.93 FCF per share. The forward 2014 estimates (before potential future revisions) are for EPS of $0.54 and $0.61 FCF per share. The implied valuation is 34x 2014 earnings and 31x 2014 FCF. These do not appear reasonable given the lackluster recent performance. However, even if we did accept the Street's flawed 2014 EPS and FCF per share estimates, the trading multiples would still be out of whack.

As I mentioned before, I consider XO Group and Blue Nile comparable companies. Both are focused, specialty online retailers. Both companies have put up solid performances in the past. Analysts expect 25x forward earnings for both Blue Nile and XO Group, along with 16x FCF for Nile and 19x for XO Group. Geeknet should at best trade in line, but more likely trade at a discount to these peers.

This would imply Geeknet should be valued at $13.50 on earnings, or between $9.76 and $11.59 on a free cash flow basis. If we use the average of the two P/FCF (17.5x) multiples and blend it together with the earnings multiple, we arrive at an implied value of $12.08 per share. This is 20% below where it currently trades, and actually quite conservative. If we apply a discount to its peers, say 20x earnings and 15x FCF, we arrive at an implied valuation of $9.97 per share. This is 32% below where it currently trades. ($14.77) I believe this is a fairer valuation.

Conclusion

Geeknet currently has a difficult business model and an inflated valuation. Based on its current business model, I expect future earnings growth to be an uphill climb. The ultra-competitive nature of online retailing will likely curb its future website sales growth. This will result in tremendous pressure and incredible expectations for wholesale channel growth. Shareholders should recognize the depth of this challenge.

Although it does appear overvalued, this is a secondary component of my argument. I would hesitate to recommend entering a short position purely on the basis of valuation. Companies can remain overvalued for long periods of time, and it's not much fun waiting for the market to revalue them. That said, the challenge of executing spectacular future performance with an awkward business model will keep me short for the near term.

Source: Geeknet: Questionable Business Model And High Valuation

Disclosure: I am short GKNT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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