Blucora, Inc. is a massively profitable business that will be its own catalyst for appreciation due to the combination of incredible cash flow, a low valuation, good growth and a conservative balance sheet.  When all of those factors are present at the same time, good things usually happen.  Few investors know what this Company is and are more familiar with the Company’s old name, InfoSpace Inc.  (InfoSpace changed its name to Blucora on June 7, 2012).  When I found out that this was the old InfoSpace, I initially lost interest in what I had always thought was a mediocre internet business sitting on a massive pile of cash awaiting to be deployed into value destroying acquisitions.  Nothing could be further from the truth:  in late 2011 BCOR completed a perfect acquisition of “2^nd Story Software”, which is better known to the layman as TaxACT, the maverick of the online tax preparation world, which is taking market share from just about everyone in the tax prep business.  The acquisition of TaxACT was a beautiful deal for Blucora because well, first off – it’s just a great asset, but also because they bought it at a very compelling price and Blucora has a massive tax shield in the form of $700mm + of NOLs.  The Blucora investment thesis rests on the combination of 1) TaxACT, which I view as a clearly excellent business, 2) the legacy search business, which I refer to as “legacy”, yet it is firing on all cylinders and performing fantastically and is underappreciated and 3) tying all of these massive cash flow generating assets up under the umbrella of $700mm+ in NOLs.  As a side note, I’m not usually too big on ascribing value to NOLs, but this is a case where the value is clearly playing out and I think it’s justifiable to place a conservative value on that tax shield.

Let me walk through the three components of value in BCOR:

TaxACT

TaxACT is a wonderful business.  They are a fast growing provider of online tax preparation software, having completed over 5 million tax filings in the 2012 tax season (out of about 142mm total filings with the IRS in 2011).  The business model for TaxACT consists of offering a free federal filing and then upselling additional services such as state tax filings, data archive services, refund payment transfers, phone support and stored value card solutions.  TaxACT charges an average price of $13 per filing across its user base.

The overall tax preparation market consists of the following segments:

Paid Preparer:  60% of tax returns prepared in 2011; this segment is generally stable but slowly shrinking over time due to the increasingly easy to use DIY options.  This is the highest price part of the tax preparation market and is dominated by the tax store chains (H&R Block, Jackson Hewitt and Liberty Tax) as well as independent tax preparers.

Do it Yourself:  DIY makes up 40% of the tax prep market and consists of the following components: Paper & Pencil (a small part of the market and rapidly converting to digital), software based (TurboTax) and online.  The online segment of the industry is dominated by three players: TaxACT, H&R Block Online and TurboTax Online.

TaxACT is playing in the best part of the market, as DIY is taking share from Paid Preparer, and then online is the fastest growing part of the DIY segment.  The overall tax preparation market is a very stable one, and the trend towards online tax preparation is an obvious long term consistent trend.  TaxACT has the wind at their back in that regard.

From a pricing perspective, TaxACT is a highly disruptive player.  Everyone knows that consumers are highly price sensitive when it comes to tax preparation, so it’s good news that TaxACT is positioned as the lowest price option, offering a free federal return and then an upselling various services for an average price per filing of $13.  On the other end of the spectrum, the paid prep players like Block, Jackson Hewitt and Liberty typically charge in the $180 range while professional accounts will charge considerably more than that.  The other key digital players are TurboTax at $54 and H&R Block Online at $33.  TaxACT is clearly playing in the right part of the market – the fastest growing segment and the most competitively priced option.  While the tax stores (H&R Block, Hewitt etc.) are constantly struggling to hold pricing with a stingy consumer, TaxACT is already priced at $0 for a federal filing while they build their user base and figure out ways to upsell useful services to their customers, such as state tax filings.

Within the online tax prep space, a simple Google search will reveal dozens of competitors offering seemingly similar services.  None of these competitors is a meaningful challenger to TaxACT with the exception of TaxSlayer.com, but even TaxSlayer is a small fraction of TaxACT’s size.  One industry player who works for a competitor noted to me “TaxSlayer is just noise, the fly on the wall…it just doesn’t go beyond TaxACT in terms of the competitive set (in the online category)”.  The pricing landscape is less clear in the online tax preparation world, as some players will offer a “Free” federal filing, but it will be subject to certain restrictions and then the price levels for various upsell services will vary by competitor.  It is very clear however that TaxACT plays it straight up with its customers and offers the free federal filing without exception and has incredibly high customer satisfaction levels.  TaxACT has never played with its pricing model, and while some might see an opportunity for them to raise their prices to juice profitability, I think it is more likely that they choose to stick with the pricing model, grow their user base, and continue to add new services and ways to monetize their loyal customer base.

It is worth noting and intuitive by the way, that there is a lot of repeat business in the online tax preparation world: if you file your 2012 return on TaxACT, you are likely to file it on TaxACT in 2013 as well since you are familiar with the process, have your information stored with TaxACT already etc.  While the Company does not disclose the level of repeat business, my conversations with folks in the industry lead me to believe that customer retention from one year to the next is in excess of 80%.

Here are a few articles and online resources that discuss TaxACT and illustrate the favorable position they are in from a pricing and overall competitive standpoint:

http://tax-software-review.toptenreviews.com/taxact-review.html

http://www.nextadvisor.com/online_tax_preparation_services/compare.php

http://www.pcmag.com/article2/0,2817,2376880,00.asp

So with that background behind us, let’s take a look at the actual financial performance of this so-called “wonderful business”:

Holy Cr&p!!  This looks like a 1st year analyst at Goldman Sachs got assigned to make a pitchbook for a sell side M&A deal …except these are actual historical results!!!  And recent guidance projects more of the same growth for the 2013 tax season as TaxACT continues to innovate and invest in incremental product enhancements and functionality.   In addition, while I don’t have the historical capex numbers, they are immaterial – this is a well-oiled growing cash flow machine.

It is interesting to note the background on the TaxACT acquisition as a historical point of reference.  H&R Block had initially tried to buy TaxACT in 2010, but the transaction was scuttled by the DoJ on antitrust grounds with the Justice Dept. noting that TaxACT “disrupted” the tax preparation market with “low prices and product innovation”.  The H&R Block acquisition of TaxACT was negotiated in 2010 based on TaxACT’s performance in the 2009 tax season; when the deal was finally blocked in late 2011, BCOR was there waiting for the rebound and managed to snap up TaxACT just before the 2011 tax season, but based on a price that was negotiated on the 2009 tax season.  Anecdotally, I have also heard that Intuit became concerned about TaxACT as well and was interested in acquiring them, but determined that they too would be prohibited from such an acquisition on antitrust grounds.

See the link below for an interesting article about the antitrust case findings, which I will print out a short exerpt from as well:

The [antitrust] complaint quotes internal communications showing that TaxACT views itself as a maverick and a “catalyst for change.” It also cites to H&R Block’s awareness of TaxACT’s aggressive competitive strategy and success in getting a competitive response from its rivals. For example, incumbents were forced to match competitive offerings and lower their own prices as a result of TaxACT’s disruptive presence in the market. Internal company documents cite to the need to “stem” online market share loss to TaxACT and preserve “at risk” sales. More important, communications reveal that the merger was motivated by H&R Block’s strategy to “…eliminate the [TaxACT] brand to regain control of industry pricing and avoid further price erosion.”

http://www.antitrustinstitute.org/~antitrust/content/aai-says-doj-complaint-hr-blocktaxact-merger-provides-transparency-maverick-firms

OK, so you’ve heard the business description, you’ve seen the financial results, so what would you pay for this asset light, high ROE, 50% margin business?  10x EBITDA, how about 15-20x, anyone?  Nope, you can buy it right here on Wall Street for a high 4’s multiple of EBITDA.  Or if you want you could go out and pay a higher multiple for a chemical company or a perpetually declining landline telecom business, or maybe pay twice as much for a radio stock…but I’ll stick with investing in Blucora. 

Hyperbole aside, I think it should be clear to anyone that this business has fantastic characteristics and deserves a high multiple, probably in the double digits of EBITDA.  Wait to see what happens when you pair up the financials shown above with $700mm+ of NOLs.  Really good things start to happen.

Search

This is the business that most people think of when they hear the name InfoSpace.  It’s a business that has produced solid profit and cash flow for years but doesn’t get the respect it deserves.  And, it happens to be flat out on fire right now in terms of growth.

The business model is simple: Blucora has agreements with Google and Yahoo to syndicate out search results to third party websites.  Let me explain that a little better:  BCOR goes out to a third party website like windstream.com as an example (BCOR would call this a “Search Distribution Partner”).  Windstream.com wants to be able to provide search results on its homepage but doesn’t have the technology to do so – BCOR has agreements with YHOO and GOOG to “syndicate” out their search results (BCOR refers to GOOG/YHOO as “Search Customers”).  BCOR has technology and services that combine YHOO and GOOG’s results and present those search results in a format that is determined by the customer (in many cases BCOR will build out entire portals for their Distribution Partners).  In essence, BCOR is a value added reseller of GOOG/YHOO search results…they add some value and customer service and tailor the offering to what the Search Distribution Partner needs (including building out portals).  When consumers click on a paid ad at windstream.com, GOOG gets a cut, windstream.com gets a cut and of course BCOR gets a cut of that revenue. 

“Distributed search”, as the Company calls this business has been growing rapidly in the past few years and has only accelerated its growth in recent quarters.  This growth is being driven by increasingly diverse ways that people are accessing search – through social platforms, mobile, apps on tablet devices and desktop utilities.  BCOR has executed on this opportunity very well, adding significant new distribution partners and participating in growth with existing partners.

BCOR’s relationships with GOOG and YHOO go back for over 10 years and are highly stable.  BCOR just recently renewed these agreements in 2011 and have visibility under the current terms that extend out to the end of 2013 in the case of YHOO and 3/31/2014 in the case of GOOG.  The business relationship is locked in through 2013 and there is no indication that it is likely to change in 2014.  It’s also worth noting that the Company recently added Yandex to its list of Search customers, sitting alongside GOOG/YHOO.  Yandex is the leading Russian search engine, is growing very quickly and serves to diversify the Company’s search offering.

You might be asking why this business exists and the answer is simply that Google does not want to be in the business of reselling its own search results, building portals and providing services to all of these little third party sites.  There are obviously bigger players who can go directly to Google, but everyone who is big enough to do so already does.  BCOR does a good job tailoring the offering on a distribution partner by distribution partner basis and has also built a good reputation over time of only dealing with high quality sites that deliver high quality traffic to GOOG’s advertisers.  All of this plays well with GOOG/YHOO and helps to reinforce the long term relationship with BCOR.

Interestingly one piece of color on the relationship with Google is that GOOG doesn’t want to be seen as a monopolist.  BCOR is technically a competitor to GOOG/YHOO in the search business (albeit one that they have some control over), and as such it is actually useful to GOOG from a regulatory standpoint to have a few competitors out there who are making a little (or ridiculously little compared to GOOG) money.

In addition, BCOR has a few O&O sites such as Dogpile.com and MetaCrawler.com and believe it or not, people still actually use these sites.  This was 12% of Search revenue in the most recent quarter and remarkably it grew slightly over the prior year, but safe to assume this is flat at best and more likely a slow decline.

Let’s take a look at the recent financial performance of this business:

Hmm, not so shabby.  In fact, pretty darn good.  Q4 is projected to look like Q3 and management sees continued opportunities in this business going into 2013. However, given the step function of growth in F2012, management sees things flattening out a little bit.  The margin decline that you see reflects a mix shift from O&O business that is stagnating to the lower margin but high growth distribution business. Like tax, search is also a business with minimal capital requirements.

Overall, this is a business that has performed really quite well over time – its been a consistent grower, earns high margins and requires little to no capital to grow.  They have been very successful recently in winning new Distribution Partners and they participate in a growing industry.  Actually, to be quite blunt, this business has been “en fuego” of late.  The trends that have driven growth over the past few years are continuing and have only recently accelerated.  The key relationships with YHOO/GOOG were just recently renewed, so all is fine from that perspective.  This business just doesn’t get the respect it deserves.  Id give it a 7x EBITDA multiple given the high margins, good growth prospects and minimal capital requirements.  I would actually argue that’s probably a bargain for a high growth, high margin, high ROE business.

NOL

As noted earlier, Im not one to bet on NOLs actually being realized in terms of valuation, but this is an outlier case given the extremely high level of profitability.  This business has minimal CapEx and also is not going to pay any taxes for 10 years -it’s going to free cash flow like crazy.

In the analysis above I assume the current income stream grows a measly 3% per year off the current base, and pick your discount rate, but I’ll take a 12.5% return over the next decade.  This shows you’ve got $148.1mm of value here with a few NOLs to spare come 2022. 

I note that there is optionality in the NOL value in the event that 1) the business grows faster than 3% (very likely that will happen) or 2) they do another acquisition to speed up the realization of the tax benefits.  I note that the NOLs quickly approach $200mm in value to the extent that the Company acquires another cash flowing asset (which is the crux of their M&A strategy).

Valuation

To me, the valuation here passes the “idiot test”, so put away your TI-82s, put in your pocket protector and let’s just think like plain old bean counters.

OK, so $645 market cap, $572mm EV…how much cash flow are they going to generate based on LTM EBITDA?  Hmm, probably a little more than $80mm or about a 14% free cash flow yield, unlevered.  Oh and by the way, mgmt. just gave guidance for TaxAct to keep growing 8-10% in 2013 off of the LTM number, so that $80mm estimate is probably a little bit low.    

That’s basically good enough for me from a valuation perspective, but for those of you who like their steak served sum’of’the’partes, lets run the numbers that way, just for “ha-ha’s”.

And at this juncture I will make the controversial yet totally valid assumption that all corporate expenses are allocated to search, which is totally justified.  Why?  Because TaxACT is a completely separate entity and was acquired and financed with debt that it non-recourse BCOR.  If the banks are OK with it, I am too.

For those of you who prefer to play, “figure out the implied value of the Search segment”, I will offer up the analysis in that format as well:

I do take requests, and if you would like me to perform any other acts of valuation, please refer to the Q&A.

Management

The last CEO at InfoSpace made some pretty questionable acquisitions, but it seems that we’ve got the right crew in place this time around with Ruckelshaus and co.  Ruckelshaus and Andrew Snyder (who represents 7% holder Cambridge Information Group) both have backgrounds in investment banking, and these guys are discounting cash flows and monetizing NOLs in a no holds barred manner.  It’s Investment Bankers Gone Wild, so to speak, and spring break is approaching, so get your DVDs now.

Summary and Other Factors

The stock dropped about 17% on Friday for totally nonsensical reasons, but providing us with a great buying opportunity.  Apparently the guidance for Q4 was viewed as a miss, but that is complete “malarkey” as our vice president might say.  I would note that TaxACT due to seasonality is really not even in business in Q4 (they do about $2mm in rev. in Q4) and there is a $0.7mm write off of deferred revenue in Q4 (purchase accounting adjustment from the acquisition) that wasn’t in the analyst numbers, and I think that accounts for basically the entire “miss” – who cares.  Let’s think about this rationally for a second: the businesses are doing great, cash flowing like crazy and growing, and you’ve got a rock solid balance sheet on top of that.

Ive never been good at playing the guessing game of actual results vs. analyst expectations, I just think this is a situation where the businesses are flat out too cheap, are high quality and with every quarter that goes by cash continues to just pile up on the balance sheet.  There isn’t a whole lot of macro risk here, I think it’s just a great way to make some money.  The obvious catalyst is simple cash flow generation - if you agree that this stock looks cheap now, wait till there’s another $80mm of cash on the balance sheet in a few quarters – I encourage you to take a look at the valuation with that amount of additional cash, because it won’t be long until it finds its way onto the balance sheet.

Thanks for reading, and I look forward to discussion.