Description

Recommend long Consensus Cloud Solutions. CCSI is the unwanted fax business from the J2 (now Ziff-Davis) spinoff in late 2021. The stock has performed poorly since the spin, down ~65%; however, the combination of a change in capital allocation policy and an abandoned stock creates the potential for attractive returns over the next few years. The business currently trades for ~5x EV/Ebitda and ~20% fcf yield (~$375mn market cap & ~$1bln EV).

The Situation

CCSI provides cloud fax solutions to ~900k customers across multiple industries, primarily healthcare, government, legal, and financial services. The business has shifted focus to healthcare over the last half decade, providing a cost-efficient way for healthcare providers to ditch their physical on-prem fax equipment. The business has two core revenue streams:

Corporate (est. ~$200mn in 2023 revenue) – ~55% of total revenue – serves SMBs (~$120mn) and large enterprise customers (~$80mn). This business has grown over the last decade as CCSI switched focus to larger customers in the healthcare industry; >50% of corporate revenue comes from healthcare.

CCSI has ~53k SMBs customers, which are smaller business accounts with a short sales cycle (1-3 days) and month-to-month or annual plans; ~65% of this revenue comes from fixed subscription fees, with the remaining 35% made up of variable payments based on volume. CCSI has ~700 Enterprise customers, they typically sign 3-year contracts with rolling 1-year auto renewals. ~70% of revenue comes from variable payments based on volume, with only ~30% from fixed subscription fees.

Management reports combined metrics for SMB and enterprise, with ARPA of ~$310, and monthly churn of ~1.5% (enterprise has higher ARPA and lower churn).

Small Office/Home Office – SoHo (est. ~$165mn in 2023 revenue) – makes up ~45% of revenue and serves ~850k small customers. A customer will buy a subscription online without any interaction with the company (month-to-month contracts). This business is declining as demand for individual fax solutions slows. Customer count is down ~20% from 2020 (revenue down ~10% due to price increases). ARPA is ~$15, monthly churn is ~3.6%, and >90% of revenue is made up of fixed subscription fees.

Ebitda margins for the overall business are >50% but have declined post-spin as management invested in healthcare interoperability solutions.

Original Plan

In April 2021, J2 Global announced plans to spin-off the legacy fax part of their business in a classic good co/bad co split. The split occurred in Q4 21, with J2 CFO Scott Turicchi becoming the CEO of Consensus. J2 loaded up CCSI with ~$800mn of debt and spun-off 80% to J2 shareholders. J2 planned to sell down their remaining 20% stake within 12 months of the spin (they own <10% as of Q3 23).

The stock traded at ~10x EV/Ebitda (~$60 a share) based on management’s long-term guidance of ~5-9% topline growth, ~50-55% Ebitda margins, and aggressive investment in healthcare related solutions.

Since the spin, Consensus has encountered multiple issues:

• Identified additional tax exposure of ~$8mn related to unpaid state sales tax – occurred over 5-year period.
• Failed to file their 2022 10-K on time, and when they did it resulted in a restatement and the disclosure of a material weakness over internal controls, specifically related to revenue. The first related to the SoHo business (pre-spin accounting practice), which had grossed up revenue by ~$7.3mn; the offset was bad debt expense, so the error had no impact on net income or Ebitda. The second was ~$2.5mn for the sale of a perpetual license, revenue was recognized upfront, but should have been recognized over multiple years – this incorrectly increased reported revenue (~$2.5mn) and Ebitda (~$2mn).
• A significant slowdown in corporate revenue growth in late 2023 (decreased from ~13% to ~3% in Q3 23 vs Q3 22) due to a slowdown in decision making from potential healthcare customers; management pointed to a tight labor market as the key factor causing the slowdown in bookings. This meant flat revenue vs the 5-9% long-term management guidance. Management now expects little to no revenue growth in 2024.
• COO, John Nebergall, quit and left the company at the end of 2023; Mr. Nebergall had been hired in 2018 and was key to the push into the healthcare sector.
• The SoHo fax business lost ~12% of its customer base in 2023 (thru Q3) and revenue dropped ~6% YoY (Q3 23 vs Q3 22).

During the Q3 23 conference call, Scott Turicchi, CEO, announced a change in priorities. The company would switch focus to Ebtida/cash flow and reduce capex investments in healthcare interoperability solutions. Additionally, they’d begin to repurchase their debt (~$800mn principal) and buyback stock on the open market – they’d been restricted from buying back their debt as part of the spin-off. Management has a $300mn debt buyback authorization from the board and their debt currently trades at ~85-95% of par (two tranches due 2026 & 2028). Management has stated a goal of ~2-3x leverage.

They expect to generate ~$80-85mn of free cash flow in 2024, driven by a decrease in capex spend of ~$7mn (less capitalized labor). This is >20% free cash flow yield, and ~8% of the total EV.

The stock has been abandoned; the narrative has changed from a growing business with plans for aggressive investment in the healthcare space and opportunistic acquisitions (the first question at their initial investor day was about acquisitions from Dan Ives...). The growth story is now gone, and Mr. Turicchi has switched focus to lowering debt and returning capital to shareholders.

Given the low multiple and expectations embedded in the stock, if management holds revenue even close to flat, increases margins and free cash flow with less aggressive hiring, all while reducing debt and buying back stock, this will produce solid returns over the next few years.

The Fax

Time to address the elephant in the room. Pitching an investment where fax is the core business and projecting flat revenue over the next few years… Skepticism is obviously warranted, but the fax is still a surprisingly popular way to send information where data security is key. Cloud fax is also growing off a smaller base and offers a way to keep the security, simplicity, and convenience of fax, without having to maintain and operate a physical fax machine (or undergo a major IT overhaul).

Why fax is still used in healthcare

The best place to start is the HITECH Act, signed in 2009. The Act invested ~$30bln to of incentivize medical businesses to digitize their records. The Act was a success in this regard, hospitals using electronic records increased from ~8% in 2008, to ~83% in 2015. However, the standard didn’t incentivize medical institutions to share data. Turns out both doctors and IT companies are incentivized to make data sharing difficult and inefficient... Doctors don’t want to lose patients, and EHR providers want doctors locked into their platforms. Unsurprisingly, this led to digitized records (collect incentives), but with no easy way for different systems to send data or communicate. The one thing all hospitals had in common was a phone line, so fax continued to be a popular way to send data and meet data security requirements (email is not HIPAA compliant).

This led to Congress passing the 21^st Century Cure Act in 2016 (compliance was required by 2021). The Act prohibited information blocking, which is defined as “a practice that…is likely to interfere with, prevent, or materially discourage access, exchange, or use of electronic health information.” Fax is still an acceptable way to send data under the Act, so not too much has changed.

There’s also been attempts to set up standardized information exchange. HL7 is an international standard for the exchange of healthcare data, FHIR is an open standard for the creation of new applications to transfer data, and Direct Secure Messaging allows for data to be exchanged within a trusted network. These are all growing, and will continue to, but significant hurdles remain; the fax isn’t going anywhere fast.

The healthcare industry requires communication with lots of different businesses within many different segments of the healthcare space. Smaller players are less likely to invest in new IT systems, and larger players are required to accept fax as a secure form of data transmission. There’s little incentive for small providers to change: cash investment, train staff, risk of violation etc., and large players don’t have much leverage to push smaller players to change.

Cloud fax offers a way to digitize the process without changing the method. It reduces maintenance and downtime, removes printer and ink costs, and doesn’t require someone to physically retrieve or send faxes. Fax still makes up ~70% of health data transmission volumes, and only ~35% of fax volume is sent via cloud fax.

I am not arguing that fax is going to grow, but cloud fax has a little more runway than I think the market realizes. Their legacy SoHo business will continue bleeding, but Consensus has growth potential on the corporate side. They’ve signed some large contracts which offer some evidence of this. One with the VA which continues to ramp up (could be ~$10mn in annual revenue at full runrate and could lead to other government business); this contract has been significantly delayed but should start generating revenue in 2024. In Q3 they also announced the signing of 2 large hospital systems (60 hospitals, 400 clinics and 100 skilled nursing facilities).

Interoperability Solutions

Coming out of the spin, the focus was on developing healthcare interoperability solutions. Despite management slowing investment in this area, they do have some products that offer potential upside (could make them a takeover candidate down the road). It’s not key to this thesis but adds some potential upside.

The solutions range from Consensus Unite, which helps customers manage patient data, make queries, request records, and send data using their preferred method (e.g., fax or direct message). jSign is an electronic signature technology (similar to DocuSign). Clarity is an extractive AI technology that takes unstructured data (e.g., fax) and transforms it into a structured format for more efficient entry into a customers’ records system. These solutions haven’t grown as management predicted but given the current price, they can be viewed as a free option.

Valuation

Assumptions through 2027:

• Roughly flat revenue with corporate revenue growth offset by SoHo declines.
• Rise in Ebitda towards the upper end of managements’ 55% target.
• Increased Ebitda to free cash flow conversion due to less investment (~40-45%).
• Total share dilution of ~3% (~600k shares).  

This gets us ~$340mn in cumulative free cash flow through 2027. If we assume management uses ~$180mn to repay ~$200mn of principal debt (¢90 of par), and ~$125mn on buybacks at ~$30 a share (remaining ~$35mn of fcf goes to closing tax issues and margin of safety). Slight increase in multiple to ~5.5x as leverage decreases. This gets us ~$40 share price and IRR of ~20%. 

The key is flat revenue and management executing their new capital allocation strategy. If that happens, this works.  

Risks

Fax declines accelerate

I’ve put why I don’t think this will happen above but if fax declines faster than expected and revenue sees significant declines, this won’t work. I think risk of significant loss from this is pretty low given the low multiple and steady cash flow generation.

Accounting issues

Management has reported a material weakness and 2 misstatements related to revenue (they reported 1 the first year related to controls around the spin-off). I don’t believe the errors point to a deceptive management team. The $7.5mn error had no impact on Ebitda or net income and related to a legacy accounting practice from prior to the spin. The $2.5mn adjustment that did impact profitability is more of a concern, but GAAP accounting does allow for upfront revenue recognition from perpetual license sales. I’m not sure of the specifics of this instance but it appears a reasonable mistake to make on a small amount of revenue.

They have also changed auditors from BDO to Deloitte; a change in auditors is usually seen as a red flag, especially after a material weakness, but switching to a big four firm makes this less of a risk imo. There were no disagreements referenced in the 8K filed by CCSI, and BDO signed off on filed 8K with no issues. 

Sales tax issues

CCSI hadn’t historically collected sales tax where it was unable to quantify the correct rate. It has since created a way to estimate sales tax and entered into a VDA with impacted tax jurisdictions. The company reported the process was substantially complete in Q3 23, but there’s risk of additional exposure if CCSI underserved or tax authorities disagree with CCSI’s assessment (I’ve assumed full payment in the valuation above).

Management & Stock Comp

I’m accounting for a reasonable amount of dilution to account for stock comp, but a significant portion of management’s comp package was tied to long-term performance options that are now significantly underwater (stock has to be between $60-90 for them to vest); the COO forfeited these options by retiring. There might need to be a recut option package to reincentivize management, causing additional dilution.

There’s some hair on this idea but we’re getting ~20% fcf yield from a steady business and sensible capital allocation (reduce debt and buyback stock). I like the bet.

Catalyst

• Business shows stabalization in revenue
• cash flow generation jumps as management slows aggressive interoperability investments