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Thursday, July 30, 2009

eFax Still Alive – Short JCOM at Your Own Peril

Another long one, for those interested.... regarding an idea mentioned in a Barron's cover story a few weeks back that we happen to own.

The Saturday 7/04/09 Barron’s cover story, “Shorts Story” by Gene Epstein, highlighted five short ideas from Short Alert, a North Carolina-based research firm with respectable track record on the short side. Barron’s even took a victory lap on Monday 7/06/09, “Barron's Short Picks All Fall Down”, as the picks were down in “midday trading” while the overall market moved higher. In the cover story, Mr. Epstein wrote “that the firm … produced annual returns averaging 18.3% from 1999 through 2008.” The article also included commentary from a New York University professor about earnings manipulation and how ‘short sellers can make a positive contribution by trading against these subterfuges.’ We agree that uncovering companies using accounting shenanigans makes for great short candidates, as does finding firms with broken business models, unsustainably high leverage, and/or negative secular trends. However, we think at least one of Short Alert’s five short calls is off the mark: j2 Global Communications (JCOM, $24.20).

As background, j2 Global was founded in 1995 and provides fax, voicemail, email and call handling services to individuals and businesses worldwide. We’re long the stock (full disclosure) and believe the company is the exact opposite of each major short rationale noted above, with the possible exception of negative secular trends (the major knock on the stock). Yet, in this regard, the sky isn’t falling anytime soon.

j2 Global’s core, cash-cow, subscription-based eFax business keeps adding corporate customers while the company’s voice services business continues to scale. In addition, the company’s financial results, metrics, and position are strong:
  • In 2008, the company generated revenue of $242 million in 2008 (+9% Y/Y) with gross and operating margins of 81% and 41% (GAAP), respectively, earnings per share of $1.58 (GAAP), and free cash flow of $91 million (38% of revenue).
  • As of 3/30/09, the company had no debt and cash/investments of $179 million (17% of market capitalization), and consistently generates astoundingly high return metrics, including a return on net operating assets in excess of 60%. Few companies are capable of this feat, period. Year after year, j2’s management team runs the business to maximize margins, free cash flow, and returns on invested capital.
  • Finally, among category killer companies such as Cisco Systems, Digital River, eBay, Qualcomm, and Salesforce.com, j2 Global slightly edges Qualcomm for the highest profit per employee (measured by GAAP EBIT) and has the highest return on equity of the group (please see below table - click to enlarge). At present, the company also offers the highest FCF yield per share. j2 Global’s high profit per employee illustrates the quality of the company’s business model and extremely cost conscious management.

Detailed Analysis

Let’s take a closer look at the short thesis and why some investors might consider shorting j2 Global. For reference, here is the JCOM short thesis as reported in Barron’s:
  • J2 GLOBAL COMMUNICATIONS, the subject of a June 19, 2008, report by Short Alert, was down 14% a year later, but Guild sees far more downside. About 80% of the company's sales come from transmitting electronic faxes, a business that's in decline. Its growth in subscribers has come from acquiring other companies, he says. And 50% of its paid subscriber list turns over every year. Its stock is now hovering above 20 but could easily plunge below 10, asserts Guild, if it were hit with the one-two punch of no significant acquisitions and fewer paid subscribers. J2 President Scott Turicchi counters that "our short position has fallen to 1.7 million shares, less than 4% of outstanding shares of j2 Global and near an all-time low."
Let’s consider each point in the paragraph:

J2 GLOBAL COMMUNICATIONS, the subject of a June 19, 2008, report by Short Alert, was down 14% a year later, but Guild sees far more downside.
  • Given the market’s swoon over the past year, most stocks are lower than year ago levels. However, JCOM’s performance of down 14% compares favorably to the S&P 500 – down 31% – and the Nasdaq – down 26% – over the same period. Like many stocks, shares of j2 Global were thrown out with the bathwater and briefly touched an intraday low of $13.03 in November. Yet, the stock quickly recovered to near $20 per share and has largely been range bound between the mid/high-teens and mid-twenties over the past year. Investors likely jumped into JCOM because of the company’s high quality business model, not to mention better-than-expected earnings results in each of the last three quarters.
(1) About 80% of the company's sales come from transmitting electronic faxes, a business that's in decline.
  • Indeed, “eFax” is j2’s primary brand and fax services provided an estimated 90% of 2008’s $242 million in revenue. Approximately 79% of 2008 revenue was “fixed” (recurring) versus 76% in 2007 and 72% in 2006 as variable usage revenue declined along macroeconomic trends in recent years. The company had 11.6 total customers as of 3/30/09, including 1.3 million “paying” subscribers (+16% Y/Y including some small acquisitions) and 10.1 million “free” subscribers. The company had approximately 1.1 million paid fax customers and 200,000 voice subscribers at 3/30/09. Geographic revenue mix: 85% US / 15% International in 2008, versus 87% US / 13% International in 2007 and 89% US / 11% International in 2006.
  • We agree that fax is in secular decline as more persons/firms use email to transmit documents. And, j2 faces a double whammy in that the weak economy is negatively impacting usage. Still, as the market leader with perhaps one third of the market (hard to measure), j2 is gaining share as more individuals and corporations utilize digital fax services to reduce costs and improve security. j2’s corporate fax business actually accelerated in 2008 as large enterprises focused on reducing hardware footprints and operating expenses. This trend is continuing in 2009. Faxes are still widely used around the world, especially for business transactions in “FIRE” – finance, insurance, and real estate – industries.
  • Still, even if j2 can still grow in a declining market, an important question is the pace of decline for the sector at large – is the decline similar to rapid creative destruction impacting print media or more similar to the gradual demise of the paging industry? The nature of j2’s business suggests the latter, as numerous competitive advantages protect j2’s subscription-based, high margin/ROIC business model: brand, sticky customers, scale/scope, and intellectual property rights.
  • o Leading market share (brand) and loyalty (sticky customer relationships) lead to low cost, efficient customer acquisition and stability – only modest short-term increase in customer churn following 30% price increase effected in 2006-07 for core eFax service (acknowledge: pricing power not possible in current environment and loyalty also less evident). Viral marketing brings approximately 40%-50% of new paid subscribers directly to j2 Global’s various Web sites.
  • o Global telephony/IP network supports service in more than 3,200 cities in 46 countries across six continents (scope/scale).
  • o Intellectual property rights (IPR) with successful licensing efforts and proactive defense of rights – 59 issued patents.
  • o Recurring revenue model enables meaningful operating leverage and consistently high margins (>80% gross margin and 40% operating margin) and ROIC (31% including large cash position, 89% excluding cash/investments).
  • o Software based product offerings require no inventory – negative cash conversion cycle (negative ~100 days) yields positive carry.
  • o Result: strong, sustainable financial position: as noted previously, the company has no debt, cash and investments of $179 million (17% of j2’s market capitalization), and should again generate FCF north of $90 million this year (approximately 37% of 2009E consensus revenue of $246M).
  • The company’s voice service offerings are gaining traction and j2 Global is claiming a market leadership position in this space. Voice services include automated receptionist offerings (“virtual PBX”) for small/medium sized businesses that tie into email/messaging systems. As of 1Q09, run-rate voice services revenue could represent an estimated 15% of 2009E revenue, up from an estimated 10% in 2008, 4% in 2007 and 2% in 2006. j2’s voice business is achieving critical mass that could propel future growth when the core fax business begins to decline (under normal economic conditions).
(2) Its growth in subscribers has come from acquiring other companies, he says. And 50% of its paid subscriber list turns over every year.
  • Most of j2’s historic subscriber growth was organic, although it is true that small acquisitions over the past year boosted growth. Through the years, j2 Global closed 22 acquisitions across nine countries and different service offerings. The deals are usually small and, per management, contributed a low single digit percentage of average revenue growth in the year of acquisition (i.e. if top-line growth was 20%, acquisitions added perhaps 1% to 3% to that figure).
  • The economic downturn is leading to slower gross new customer additions and higher churn. Churn was 3.5% in 1Q09 versus 2.8% in 1Q08, implying that 42% of j2’s current subscriber base will churn away (disconnect) within one year (not the 50% mentioned in “Shorts Story”). The company’s historic target churn level was 2.50% - 2.75%.
  • The combination of slower additions and higher churn is leading to fewer net new customers. Management’s philosophy with respect to customer acquisition and retention in the current environment is very clear: the company is focused on maintaining/ improving margins and free cash flow, and not afraid to let some customers disconnect.
  • Admittedly, the impact of the recession on the customer base is hard to gauge and differentiate from the impact of the technological change (email substitution). The latter has long been the bear thesis on the stock, yet j2 continued to grow and prove skeptics wrong.
(3) Its stock is now hovering above 20 but could easily plunge below 10, asserts Guild, if it were hit with the one-two punch of no significant acquisitions and fewer paid subscribers.
  • Before directly addressing this point, let’s first address another important investor concern: lower reported average revenue per user. In recent years, j2 began to cannibalize higher ARPU offerings through increased corporate sales (1,000s of users per account, but lower ARPU) and a product/brand segmentation strategy driven by the acquisition of smaller, lower priced competitive fax services companies. Reported monthly ARPU was $14.85 in 1Q09 versus $16.30 in 1Q08 (down 9% Y/Y). In addition, ARPU for voice services is typically in the low-teens versus mid-teens for the core eFax business. At some point, the overall ARPU decline will stabilize, and, pricing power could even return.
  • Lower ARPU and slower subscriber growth are leading to flat organic revenue trends (not bad, all things considered) and valuation compression. But, a snapshot of j2 Global’s overall 1Q09 results suggest the company is far from unraveling:
  • Revenue grew 3% Y/Y to $60.4 million (including small acquisition).
  • Gross margin improved to 81.1% from 80.2% in 1Q08.
  • Operating margin was 43.8% versus 38.4% in the year ago period as the company shows continued operating leverage and scale.
  • Operating earnings of $26.5 million increased 18% Y/Y and net income was up 11% Y/Y (OE strength offset by much lower interest income Y/Y).
  • GAAP EPS of $0.42, up 20% Y/Y from $0.35 (helped by lower share count).
  • Quarterly free cash flow of $30.4 (March quarter is usually strong).
  • Management maintained guidance for modest revenue and earnings growth this year including acquisitions (which will likely be a small contributor).
  • j2 Global's return on net operating assets (RONA) remained extremely high.
  • In 2005 – 2007, with organic revenue growth of 20-30%, j2’s shares traded at a median TTM GAAP EPS multiple of 26 times. The stock is currently trading at 14.5 times TTM GAAP EPS and 11.8 times 2008 free cash flow (defined as CFO less capital expenditures) for an earnings yield of 6.9% and a FCF yield of 8.5% (*slightly below our preferred >10% buy threshold). Although shares are not the bargain they were last fall, the stock arguably could trade at 15 times free cash flow (7% yield) or $30 per share based on j2 Global’s established (but mature) eFax franchise and growing voice services business.
  • Given the strength of recent results and the company’s financial position, we are hard pressed to see how shares “could easily plunge below $10” or even return to the low teens in the near-term. At $10 per share, JCOM would trade at six times 2009E GAAP earnings (17% yield) and only five times 2009E free cash flow (20% yield), which would be an amazing entry point for a cash rich, growing, cash flowing company with shareholder friendly management.
J2 President Scott Turicchi counters that "our short position has fallen to 1.7 million shares, less than 4% of outstanding shares of j2 Global and near an all-time low."
  • Mr. Turicchi is correct that the short interest declined to 1.7 million at 6/30/09, down markedly from 5.0 million almost one year prior at 7/15/08. Short interest ticked slightly higher during the first half of July, to 2.3 million shares, perhaps as a result of Barron’s “Shorts Story”. Unlike last year, where some institutional investors correctly foresaw the impending banking crisis and wagered that j2 Global’s business would suffer, far fewer professionals are willing to make that bet today. The probable reason: j2 Global’s results and cash generation over the past year were very resilient, and 2009 should be no different.
Conclusion

Shares of j2 Global could certainly decline if the economy weakens further and/or the broader market again tumbles. Yet, aside from these scenarios, the short thesis appears fickle, particularly in the face of a high quality business model with numerous competitive advantages. Further, although the risk of technological change cannot be ignored, j2 Global should continue to generate significant excess cash that management can use to both further grow the business and return to shareholders through additional share buybacks. As the market leader with a large cash balance, j2 is well-placed to take advantage of incremental industry consolidation during the down economy. Finally, potential near-term positive catalysts include: (1) continued improvement in usage trends for credit-sensitive customers, (2) incremental M&A activity, and (3) renewed share buyback program (early 2010 seems likely as cash accumulates on the balance sheet, barring a major acquisition, which seems unlikely). The company reports June quarter results Wednesday 8/05/09.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long JCOM, EBAY.

© 2009 Jeffrey Walkenhorst
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