THE DAY AHEAD: Is Alloy Online a 'best small cap investment idea'?

Alloy Online (Nasdaq: ALOY) creamed Wall Street estimates in its fourth quarter and grabbed a significant investment from Liberty Digital. Now Alloy only has to get Wall Street excited.

After the closing bell Thursday, Alloy topped estimates by two pennies with a fourth quarter operating loss of 28 cents a share on sales of $15.7 million. Revenue easily topped forecasts of about $11.2 million. Margins were 58.5 percent, well above a year ago. As of Jan. 31, Alloy's database of Generation Y names reached about 3.2 million, with about 500,000 users established as buyers.

Alloy Online: A bargain?

But Alloy, an e-tailer that also offers content and community to Generation Y, suffers from a host of problems outside of its control. Alloy is a business-to-consumer stock, and shares have been stagnant along with its B2C peers. Alloy also is hard to categorize -- it's an e-commerce and content hybrid that offers everything from edgy teen clothing to chat.

Alloy most directly competes with iTurf (Nasdaq: TURF), but also battles Gap Inc.'s (NYSE: GPS) Old Navy stores, soon-to-be public upstarts Bolt.com (Proposed ticker: BOLT, profile) and Snowball.com (Proposed ticker: SNOW, profile), and content providers such as iVillage (Nasdaq: IVIL).

Meanwhile, Alloy languishes not far from its May IPO price of 15 despite what analysts believe is a clear roadmap to profits. Shares closed at 18 1/4 on Thursday. Analysts contend Alloy won't stay down much longer. Derek Brown, an analyst with W.R. Hambrecht & Co., said Alloy is one his firm's "best small cap Internet investment ideas."

Brown used to work for Prudential Volpe Brown, which had underwriting ties to Alloy. W.R. Hambrecht doesn't have underwriting ties to Alloy.

"A big part of the problem is investors haven't gotten their arms around the convergence story yet," said Brown, who rates Alloy a "market outperform" with a price target of $30. Brown said Alloy's combination of commerce, content and community is hard to match by the competition. Alloy also has a catalog business that drives traffic and revenue and keeps marketing costs low.

The bottom line: It's hard to categorize Alloy. Jeffrey Klinefelter, an analyst with USB Piper Jaffray, said investors aren't sure what to make of Alloy because it straddles categories. USB Piper Jaffray doesn't have underwriting ties to Alloy.

Once you get comfortable with the Alloy business model, you'll be hard-pressed to get shares. About 70 percent of Alloy's 6.8 million-share float is held by institutions. And big shareholders aren't selling, said Brown. The lack of liquidity is both good and bad -- Alloy shares have remained stable, but there haven't been any big runs either.

Despite the lack of liquidity and definition problems, the Alloy story is about to gain steam. Klinefelter said the company will gain momentum with some help of Liberty Digital (Nasdaq: LDIG).

Earlier this week, Liberty Digital invested $56 million in Alloy. The companies will also work together to target Alloy's teen demographic through Liberty Digital's interactive-TV commerce initiative. Liberty Digital will receive about 2.9 million shares of newly issued Alloy common stock for $19 per share. In exchange, Alloy will receive $10 million in cash and 837,740 shares of Liberty Digital common stock.

"I'm bullish on the concept," said Klinefelter. "The Liberty Digital deal positions them well for multimedia."

Alloy is also likely to get a boost from the next round of IPOs. Snowball.com, which will make its market debut next week, has Goldman Sachs as a lead underwriter, and Bolt.com is in the Morgan Stanley camp. Wall Street is going to hear a lot about the Web-centric teen demographic in upcoming weeks.

Alloy, like many of the upcoming IPOs, is focused on the biggest group of people since the Baby Boomers. And this group has lots of money to spend. According to the U.S. Census Bureau, 15- to 24-year-olds have disposable income of $302.4 billion.

If Snowball.com and Bolt.com make a strong market splash, investors are likely to look for other companies targeting the teen set. That search can only benefit Alloy, which is expected to turn a profit this time next year.

The network question

One question Alloy is likely to face is whether it should create a network. Alloy currently drives all its traffic into Alloy.com. Other Gen Y players -- eUniverse (OTC: EUNI), Snowball.com and UGO Networks -- have formed networks and diverse properties to target different groups.

So far, the lack of a network strategy hasn't hurt the company, but it's something to watch in the future.

Alloy has marketing pacts with Yahoo! (Nasdaq: YHOO), Excite@Home (Nasdaq: ATHM) and Microsoft Hotmail (Nasdaq: MSFT). The company will also have $85 million in cash after the Liberty Digital deal closes.