Description

CafePress, an online customizable gift retailer, is a small-cap turnaround situation that was written up 3 years ago. The previous thread chronicles a worse-than-expected outcome, followed by the announcement of an explicit turnaround plan: the CEO was fired, the founders returned, sold non-core divisions and announced a buyback. But after these low-hanging fruits were picked the thread died off. In the 18 months since, the stock gave back most of its turnaround bump even though management has delivered on all intermediate-term targets, achieved financial stabilization, improved many metrics, launched a remodeled website, purchased more shares for themselves and added notable names to the board. PRSS's expenses have gotten to the point of being predictable enough and the company is now turning the corner on revenue growth, poised to benefit from operating leverage. Under my base case, EV/EBITDA is 4.8x for 2018. With substantial NOLs, minimal fixed assets/expenses required and above-average growth, a good portion of EBITDA translates to free cash flow that can be reinvested attractively.

History Up To and Including Previous Thread

First, a quick summary of all historical events up to the previous write-up's thread's end: PRSS was founded in 1999 by Fred Durham and Maheesh Jain (respectively, CEO and CMO) and they served until 2011. At that time, PRSS was profitable and readied itself for an IPO. It appointed as CEO Bob Marino, who had already been high up in the ranks. Durham stayed on the board and Jain left. The IPO was in 2012. Looking back at the 2008-2013 period, two bad trends grew under the surface: (i) perhaps thinking of synergies or just empire-building, the company acquired other tangential online businesses that were distracting (ii) under Marino, margins deteriorated and the company generated a loss due to sloppy execution on every facet: adding unprofitable revenue, inefficient marketing and technology spend, loss of customer focus, etc'.

In early 2014 PRSS decided to fix their broken IPO and retained Raymond James to review strategic alternatives; in August 2014 the turnaround plan was announced:
- Marino fired, Durham and Jain returned as CEO and CMO
- Discontinued guidance yet started giving useful and detailed explanations of their plans
- Divested all acquired divisions, which represented half of revenue at that time, generating a huge cash hoard and announcing a buyback for a portion of that cash.
- Decided to focus on B2C (namely, the cafepress.com website) rather than the B2B partnerships, because that's where their circle of competence was.
- Backed off a lot of unnecessary marketing/discounting that was bringing unprofitable revenue
- Cut the 10% most unprofitable base products
- Improved customer satisfaction: fewer delayed orders and service requests
- Improved factory processes
- Started experimenting with new marketing and pricing techniques

During that time Lloyd Miller accumulated most of his current position and Durham added too. The stock peaked at $5 in mid-2015 as the market lost interest in the higher-hanging fruits of the  turnaround.

Events Since the Previous Thread

The stock has gradually declined back to $3 but it has done so despite good execution. The company has broken down its turnaround plan into 3 phases it calls “stabilizing, optimizing and energizing”: stabilizing is the urgent stuff; optimizing is a collection of special projects designed to make them better in every way and able to handle future revenue growth; energizing is pushing that growth forward. They consider the stabilization to have ended roughly at the end of 2015 and now we're in the middle of the optimization.

Here's what they've now achieved:
- Eliminated remaining low-ROI marketing and then ramped up high-ROI opportunities
- Eliminated low-margin partnerships
- Eliminated all international websites except Canada, Australia and U.K.
- Eliminated more base products: kept 400 out of 650 originally
- Continued tweaking the pricing strategy
- Gross margin gains: from mid-30s to low-40s
- Contribution margin, a modified gross margin metric that also includes variable sales and marketing expenses, was increased from mid-teens to 29% and has remained very stable in the 27-29% region.
- More margin gains further down the income statement: manufacturing and operations, closure of California offices, SG&A reduced to a now stable level
- For 2015, got a positive $3.9mm adjusted EBITDA on $104.5mm of revenues
- Q3 2016 brought the first YoY increase in total orders since the turnaround began (9%) and revenue was only down 2% YoY. They expect revenue growth in 2017. Gross margin in the quarter was 41.5%, the highest level yet. [ The main reason revenue had been declining that long was they were gradually shedding unprofitable revenue ]
- Customer relationships: continued increasing customer satisfaction and implemented CRM database to improve customer lifetime value, convert more visitors and otherwise gain better understanding of customers.
- Built tool that generates a multitude of e-mail versions when doing a marketing blast vs. only 2 versions before.
- Launched new website with better interface + more search-engine friendly (allow better indexing of product pages).
- Increased IR activity; attending conferences

It's important to note that many of these improvements were foreseen in conference call answers and press releases, and have generally occurred on schedule.

Ongoing projects are aimed at developing even more efficient back-end tools, notably for customer segmentation and customer acquisition. There are also a lot of marketing initiatives and they think another significant round of margin improvements will occur in the future. Two examples: (i) mobile is around 20% to 25% of revenue and gaining ground as the turnaround advances - they want to address mobile even better (ii) The average customer makes 1.4 lifetime purchases and one of their goals is to increase that.

Overview of Remaining Business

With all kinds of divisions/revenue having been shed, it's useful to go over what the company still does today. PRSS's main business is retailing personalized products: mainly gifts, accessories and home goods. Apparel represents half of that. Also among the larger categories are drinkware and bed accessories. There are 400 base products and a billion SKUs. A base product for PRSS could be “shower curtains”; a SKU would be the white shower curtain with Snoopy printed on it.

The designs in their catalog come from crowd-sourced content, stock art, and licensed content from large entertainment companies and brands. In addition to these designs, users can upload anything else they like and keep the image privately in their account without having it crowd-sourced. For the crowd-sourced portion, users who create a SKU are 'Shopkeepers', which means they get paid for the content in either of two ways: commission, or determining their own markup but doing their own marketing. As part of the turnaround, management has decided to hide the origin of a design from customers. In other words, you can still go and sign up to be a shopkeeper but the idea of a crowd-sourced marketplace is no longer an explicit part of the company's customer-facing branding when you shop around.

PRSS's sales occur through:
A) [85% of revenue] Their own domains: cafepress.com + .ca + .co.uk + .com.au
B) [15% of revenue] Retail partners, which comprises of: (i) CafePress branded 'stores' or 'feeds' on other sites like Amazon where they sell about a million out of their billion SKUs and (ii) corporate shops: for example, CBS would have its own branded online souvenir shop but it's in fact powered by, and connected to, CafePress systems. The vast majority of the 15% is from feeds.

Production is in their Kentucky-owned facility and sometimes outsourced overseas. There is a certain level of sophistication in that they have such broad array of items yet production is not scaled at all and the orders are prepared on-demand; this business model can perhaps be replicated, but not overnight.

Competition

PRSS has competition from various companies but the only one that is as large, with the same breadth of products, consisting mainly of gifts that appeal to the average American and addressing the core low-mid level budget, is privately-owned Zazzle. Breadth of product works on two dimensions: # of base products and # of different designs.

PRSS and Zazzle are also protected by:
- their brands
- patents, proprietary technology and processes for fulfilling all these different orders that they receive with a quantity of 1 for most orders.
- cost advantages
- budget for complex marketing projects and for upgrading technology, something which should make their site even more user-friendly in the future, thus increasing their competitive advantage.

Other competitors include:
- Redbubble (uncommon designs by independent artists, so not mainstream stuff)
- Society6 (less breadth, more artsy as well)
- CustomInk, Spreadshirt, Threadless.com, TeeSpring (apparel only, although apparel is still half of PRSS revenue and more sensitive to competition. It is useful to point out, though, that PRSS says there's not a lot of price shopping as a general rule)
- Etsy (not really the same type of brand nor market segment)
- Amazon (as someone mentioned in the previous thread, if anything it would make more sense for them to acquire PRSS than to build a copy)
- Things Remembered, Uncommon Goods (more sophisticated, special items - but both very impressive!)

Back to the 2 large ones. On Facebook CafePress hs over 600k likes vs. 100k for Zazzle, but more importantly, PRSS's facebook game seems way better. Not only do they post a bit more often but viewers' engagement is multiples of what it is at Zazzle. On Twitter, Zazzle is more active but PRSS has more likes. On Pinterest, PRSS has half the followers Zazzle does, however PRSS has way more likes and boards/pins. This seems to be due to a much larger community of people who have created designs for sale on PRSS, so that's a good thing. The fact that they have less followers on the highest-growing social platform for women who want to express creativity is probably explained by the sloppiness of previous management while Pinterest was growing.

In terms of search traffic for the keywords zazzle and cafepress, below is a graph of the two since the turnaround began, restricted to the U.S. because PRSS has said specifically that taking care of international is not a priority right now:
https://www.google.com/trends/explore?date=2014-08-05%202016-11-30&geo=US&q=zazzle,cafepress
Both declined in line with the economy but… in 2016 PRSS kind of stabilized whereas Zazzle did not. It remains to be seen how these numbers will look like during the holidays.

But much more important is where PRSS and Zazzle rank on search results and how they flow customers through their sites (enticing the visitor to buy certain things, customizing the experience etc'). I poked around and I have many thoughts about how the websites compare. I can go into detail upon request but it suffices to say that I believe that PRSS has not yet made all kinds of inroads that it can easily make. The turnaround will probably continue gradually and search engines also need to adapt to the new website. Also, PRSS tries to make navigation useful in terms of specific occasions and specific gift recipients rather than just product browsing, which I think is way better. There's a lot of potential...

Zazzle has around $300mm in revenue, so almost triple what PRSS has. We don't know how profitable these revenues are but we do know that there's a lot of discounting because some of the top searches related to Zazzle involve terms like 'zazzle' and 'coupon'. Either way, at least we know there are only two dominant players in this space.

Management

Durham clearly has a passion for serving customers as well as possible. Not only did he make customer service improvements a priority right from the start of the turnaround, but he also analyzes their behavior in a very detailed way, including inspecting individual orders to understand why someone bought a specific gift with a specific uploaded design, for whom, for what occasion etc'.

In terms of financial conservatism, he has said on a recent conference call that their contribution margins have remained too *high* at 28-29% as opposed to their target of 25% because they couldn't find enough marketing spend that would provide attractive returns; they don't want to just spend for the sake of increasing revenue.

Durham owns 13% of the shares, Jain 11%, Sequoia 17% and Llyod Miller 17%. There's been steady insider buying this year.

Since the turnaround began, the BOD has changed quite a bit. Notable new additions include Zappos founder Nick Swinmurn as well as Ken McBride, Chairman & CEO of stamps.com (where Lloyd Miller is a long-time director). Also, Patrick Connolly, Chief Marketing Officer at Williams-Sonoma, is on the BOD since 2007

Valuation

With revenues and expenses having been stabilized by a detail-oriented management team, PRSS will start growing revenue and benefiting from operating leverage. In 2017 more turnaround-related investments are necessary (both expensed and capitalized) but in 2018 there should be a reversion to the mean and FCF generation.

The ROIC here is very attractive as PRSS prints on demand and there's no inventory. With only $10mm of PP&E, no long-term liabilities and negative WC (ignoring the extra cash), we have smart passionate and capable management with a good board who in the future will have the opportunity to make intelligent investments and further dominate on search engines, establish relationships with customers so that they buy more than once, and perform advanced analytics. The opportunities abound in this space, there's still lots of juice left to squeeze in the data-mining world.

Assumptions for valuation:

Revenue growth: For 2016 I'm assuming this Q4 will have equal revenue to last Q4 so revenue would be $97mm. For growth, their base-case is low-teens but they're confident in their ability to outperform and get mid-teens. I've used a low number for 2017 and different numbers in the low/base/high cases.

Contribution margins (what they essentially define as gross margins less the variable portion of marketing spend): into 2017, given it's a year investments, they're expecting a decline toward 25%. They should return to normal after that. Variable marketing can probably be pushed down to around 12% of revenue and GM might settle at 43%, leaving a 31% contribution margin. I'll assume 30%/31%/32% for low/base/high.

Fixed expenses: The fixed portion of sales and marketing is currently running at $1.5mm quarterly. I'm assuming this as a base for 2017. Technology expense should return to 2015 levels after the big investments, so $3mm quarterly for 2017. SG&A should be around $2.8mm quarterly.

Maintenance cap-ex: In 2018 cap-ex should decline from 2016-2017 levels, where the new website and turnaround-related software investments are leading to an increase. Assuming 2018 looks more like 2015, and considering that in 2015 cap-ex consisted primarily of the building they purchased + $1.9mm software and website development costs + and $1.5mm for the purchase of production and computer equipment, we have $3.4mm + a bit for the building. Perhaps $3mm of that is maintenance. As a percentage of TTM revenue that's roughly 3%. To 2017 I'm assigning the current guidance of 5%, and then 3% thereafter.

NOLs: (from 10-K): At December 31, 2015, the Company had approximately $18.4 million of Federal and $34.5 million of State operating loss carryforwards available to reduce future taxable income. The federal net operating loss carryforwards begin to expire in 2034 and the various state net operating loss carryforwards begin to expire in 2022. The company has federal AMT credits of approximately $0.2 million.

Excess cash and EV: in the latest Q3 they burned $2mm net of buybacks, in Q2 it was $3mm. In Q4 they will have net inflows like last year. I assume they'll make $2mm vs. $1.3mm last year. Then in 2017 they'll still burn cash for the first 3 quarters - I'm assuming $2mm in each. Then we've got to account for additional burn because the contribution margin will be compressed by increased marketing spend. I'm assuming $4mm, $3mm, $2mm for the first three quarters. Q4 2017 would be positive again and the end of cash burn. That leaves them with about $20mm of extra cash that they can return to shareholders and therefore a year-end-2017 EV of around $30mm assuming the current stock price. [ Note on options: there are about 300k options outstanding; i.e. 2% of the shares outstanding ]

This all gives the following numbers:

Catalyst

- Q4 results may help a bit because revenue growth is at an inflection point. Then, as 2017 progresses, lower expenses will reveal a profitable model.
- CEO keeps buying on the open market
- Maybe Lloyd Miller presses them to return capital more quickly
- Good execution: excellent management at the helm of one of the top 2 players in a business that requires minimal capital and is still somewhat hard to re-create