There is one clear risk when looking at companies that may be “in play.” Even when companies are in the acquisition cross-hairs, a huge amount of patience is still required: a company may be actively holding discussions to sell itself, but any actual agreement can take months to hammer out.

That’s a lesson clearly forgotten by momentum investors that piled into Digital Generation (Nasdaq: DGIT) this spring in hopes of making a quick buck. Media reports circulated in late May that the company had just rejected a $20-a-share buyout offer. Traders quickly sensed that other offers could soon emerge, so the stock started to move higher. Today, with no signs of a buyout in hand, these same investors are now shifting out of this stock in search of quick gains elsewhere. For the rest of us, the resulting sell-off gives a fresh chance to wade in, as this stock appears quite inexpensive — even if a buyout doesn’t happen in the near-term.

#-ad_banner-#A valuable asset with falling margins
Digital Generation, formerly known as DG Fast Channel, was, not long ago, one of the hottest growth stocks in the media landscape. The company saw its sales rise at least 30% every year since 2006 (with the exception of 2009 when sales “only” grew 16%). Year after year, the company signed up more TV stations for its syndicated advertising insertion platform. 

It’s a remarkably profitable business. Thanks to minimal capital spending needs, DGIT generated $165 million in cumulative free cash flow from 2009 through 2011on $748 million in revenue. That works out to be 22% free cash flow margins for that time frame, which is remarkably high.

Yet management, which had pulled off a series of savvy acquisitions, finally blundered when DG announced plans to spend $481 million in the summer of 2011 to acquire Internet-focused ad-serving firm MediaMind. Management thought this huge acquisition would reap major synergies as the line between TV and Internet advertising began to blur. 

You can see how much the deal has hurt the bottom line by comparing the first-quarter results. The MediaMind acquisition boosted sales by roughly 50%, but a much higher level of operating expenses suddenly made the company look bloated.

The Internet business, as it turns out, isn’t nearly as profitable as TV, and it dragged down companywide gross margins by nearly 50%. Adding insult, the increased debt taken on to pay for the MediaMind acquisition really hurt net profits. Of the company’s $10 million in quarterly operating profit in the most recent quarter, $8 million had to be paid out in interest expense. Pretty quickly, it was easy to see why this stock, which traded at $35 at the start of 2011, dropped to just $8 by May 2012.

The rumor mill churns
By late May, media reports started to circulate that DGIT would stop fighting angry investors and put the company up for sale. Reuters reported that the company had retained Goldman Sachs (NYSE: GS) as an advisor, and noted that at least four private-equity firms had requested to see the company’s books. 

Two weeks later, Bloomberg reported that Digital Generation had turned down an offer to buy the company for more than $20 a share. That offer allegedly came from a rival, Extreme Reach, but DGIT’s board apparently decided that any merger between the two firms might create anti-trust concerns. 

Rumors turned into fact on June 7 when Russell Glass, the founder of RDG Capital, admitted he was in talks to buy the company. RDG had previously announced a 4.9% stake in the company, just below the threshold that would have forced RDG to file all future purchases and sales with the S.E.C. Glass noted that he believed DGIT’s anti-trust concerns were overblown, and a deal with Extreme Reach was worth pursuing.  

By the middle of June, shares were approaching $13 as investors grew to anticipate another possible offer in the previously-cited $20 range. But no new deal was announced. Shares held firm until last week, but have since fallen 18% in the past six trading sessions. The momentum that poured into this stock a month ago is gone, and investors are now rushing for the exits as a buyout announcement has failed to appear. However, the rush to sell is likely to prove to be short-sighted…

Risks to Consider: DGIT topped first-quarter forecasts only after sharply lowering the bar just weeks before. Had the company not taken that step, it would have badly trailed estimates for the fourth straight quarter, so investors should be braced for another tough quarterly announcement.

Action to Take –> It’s increasingly clear that DGIT is up for sale. Outside of Extreme Reach, other potential buyers may be looking to pay somewhat less than the above-cited $20-a-share price. But by simply retaining Goldman Sachs as an advisor, and then holding talks with various interested parties, the cat is out of the bag. Pulling the company from buyout discussions is likely not an option at this point, as it would send shares to fresh lows, where they’d stay until management can fix the margin problems.

If those margin problems begin to resolve, then it could still help to move shares upwards, but that would be a six-18 month process — unlike the more sudden pop that a buyout would bring. One way or another, there is still value to be unlocked in this business model.