Description

Conclusion:

A discounted cash flow valuation implies a base case value of $30.01 per share.

Business Model:

Constant Contact is a leading provider of online marketing tools that are designed for small organizations and delivered via software as a service. These tools enable customers to easily launch and monitor marketing campaigns across multiple channels in order to better create and grow their client footprints. The Company is best known for its standalone email marketing product, which represented ~80% of 2014 revenue. More recently, however, Constant Contact has launched a series of additional products designed to enhance the marketing opportunity of its users, such as social media campaigns, surveys, event coordinating, and local deals. In 2014, Constant Contact launched Constant Contact Toolkit, which incorporates all of its products into a single integrated online marketing platform. The Company views its Toolkit offering as one of its key competitive advantages, along with its high level of brand recognition and high touch customer care and coaching. Constant Contact focuses primarily on small businesses in the United States, with 80% of its 635,000 customers employing 25 or fewer employees, and generates new customers primarily through online advertising, partner relationships, customer referrals, and footer click-throughs on the bottom of customer emails. While Constant Contact continues to grow its installed base of recurring revenue, given the small size of its customers and highly competitive nature of the industry (discussed below), Constant Contact’s customer churn is higher than that of a typical SaaS business. Over the past 5 years, the Company’s annual retention rate has been in the low to mid-70% range while monthly average revenue per user (ARPU), a key driver of revenue growth, has increased from $36.99 to $44.94.

Although growing rapidly and largely underpenetrated, the small business online and email marketing industry is highly fragmented, with many players competing for market share in a space where it is increasingly difficult to differentiate technology or create any competitive moat, outside of just brand awareness. With more than 7 million users, MailChimp is the largest competitor to Constant Contact on the email marketing side, with Campaigner, iContact, MyEmma, and Vistaprint, among others, serving as other well-known players. Additionally, the Company admits that the competitive landscape is constantly evolving and much more dynamic than it’s ever been, and with barriers to entry almost non-existent, many new upstart companies are now coming to market, while website players, such as GoDaddy, and online search companies are spending money to offer their own platforms. Outside of email marketing, Constant Contact competes with large and well known incumbent players in its various online marketing products, such as Hootsuite for social media, SurveyMonkey for surveys, and Groupon for local deals. Price competition is fierce in the industry, with many competitors offering free or low priced options to users in an effort to gain market share and build brand awareness, largely commoditizing the industry.

Customers typically choose an online marketing provider based on a few key attributes: cost, ease of use, integration with customer relationship management software, reputation/brand awareness, and customer care. In speaking with a handful of online marketing customers (of both Constant Contact and its competitors), the reviews across providers were generally positive, with every customer noting the ease of use of their respective platform. It became clear, though, that users have a difficult time differentiating the offerings from various providers as many highlighted platform aspects that are largely uniform across providers (ability to monitor marketing campaign results, ability to create and edit email lists, ability to preview emails). In addition to email marketing, roughly half of the customers also used additional forms of online marketing, including surveys, events, and social media. While these customers noted that a single integrated platform for all their online marketing needs, similar to that offered by Toolkit, would be of interest to them and could make their marketing simpler, almost no one was willing to pay more for such an offering given the availability of these services individually for free. Most notably, customer stickiness and brand loyalty is incredibly low in the online marketing industry. When asked how they would react to a price increase on their existing services, many customers responded that they would likely just switch providers to maintain their low costs.

Management:

Gail Goodman, President, Chief Executive Officer, and Chairman, has served as CEO at Constant Contact since 1999, during which time the Company has successfully expanded both its customer count and product portfolio beyond email marketing to a suite of online marketing offerings. Prior to joining Constant Contact, Ms. Goodman served as Vice President of the Commerce Products Group at Open Market from 1996 to 1998 and Vice President of Marketing at Progress Software Corporation from 1994 to 1996. Before Progress Software Corporation, she worked at Dun & Bradstreet Software and Bain & Company. Ms. Goodman currently owns 563,768 shares of CTCT, equivalent to $22.0 million. In 2013, she received $877,474 in cash compensation, resulting in a 25.1x ownership to salary ratio. Ms. Goodman’s 2015 incentive compensation is dependent on quarterly revenue growth (75%) and adjusted EBITDA margin (25%). Ms. Goodman has been an active seller in the open market, selling 200,000 shares over the last 24 months.

Investment Thesis:

The Constant Contact investment thesis is predicated on a re-rating in the multiple back to more normalized levels based on the value of future free cash flows as the beneficial impact from the transition to Toolkit passes while, longer term, revenue growth subsides as the ultra-competitive landscape causes declines in both ARPU and customer retention rate.

The bull thesis embraced by the market is largely predicated on the Company’s transition to its integrated marketing offering, Toolkit, which the Company believes will drive ARPU growth (average monthly ARPU of Toolkit users is ~$10 higher than core a-la-cart offerings) while increasing customer retention and gross new customers added, ultimately driving sustainable revenue growth north of 20%. The near term results largely support this view, as the offering of Toolkit to new customers (Constant Contact plans to transition existing customers to Toolkit in 2H 2015 through 2016) drove ARPU growth of 8.7% in 2014 (versus 4.2% and 3.8% in 2012 and 2013, respectively) and gross new customer adds exceeded 200,000 for the first time in the Company’s history (gross adds had oscillated between 170,000 and 195,000 for the previous 5 years). Customer retention was flat in 2014, though the Company blames that largely on increased credit card failure rates that resulted from data breaches at large retail companies.

However, extrapolating this growth beyond a near term jump, which the market appears to be doing currently, does not make sense. The commodity-like nature of the industry, the vast and increasing number of providers, and the unwillingness of customers to pay more for an integrated offering given their awareness of free or low-cost versions available elsewhere should cap the ultimate upside potential of ARPU and make growth beyond the 2016 transition significantly more difficult. Similarly, as the novelty of Toolkit wears off and competitors continue to refine their offerings (MailChimp already offers a variety of similar third-party services, such as surveys, linked to its website) and reduce any early mover integrated advantage that Constant Contact currently enjoys, churn should revert to higher levels while acceleration in gross new customers slows and pricing comes under pressure.

Longer term, the Company points to potential international expansion as a key driver for growth, but this, too, appears to be a lofty goal. As noted above, reputation and brand awareness are key factors in a customer’s decision in choosing an online marketing provider. Given Constant Contact currently does very little business internationally (the Company is currently in a testing phase in Mexico and does a limited amount of revenue in Canada), it will be starting from a brand awareness level of close to zero, while it competes against local incumbents and MailChimp, which currently has roughly 50% of its users coming from outside the United States. Unless the Company plans on aggressively undercutting local pricing, which would negatively impact Company-wide ARPU, international growth will likely be very difficult. As a result, rather than accelerating to the Company’s stated 20% goal in the near future, Constant Contact’s rate of revenue growth will likely slow from 17% in 2015 to 11% in 2017, and into the low-single digits by 2020.

On the margin side, Constant Contact should see some operating leverage over time from R&D and G&A expenses, as both grow more slowly than revenue. Sales and marketing expenses should provide attractive near term operating leverage as customer acquisition costs increase more slowly than ARPU over the next couple years, but this benefit should reverse beyond 2018 as ARPU growth slows and the Company needs to continue to spend more to win the incremental customer in an increasingly competitive environment. Notably, even if Constant Contact were to achieve the mid-point of its long-term adjusted EBITDA margin goal of 30-33%, which seems unlikely given headwinds in S&M costs and the need to continue to spend on R&D to maintain technological adequacy, the stock would be fairly priced today using my base case revenue assumptions outlined below.

Valuation:

On a trailing basis, Constant Contact currently trades at multiples of 3.4x EV/sales, 18.7x EV/EBITDA (adjusted for stock based compensation), and 36.2x P/E (adjusted for stock based compensation and cash taxes). The below scenarios assume the Company’s current $30 million buyback authorization is completed in Q2 of this year, with no additional buyback being implemented thereafter.

Base: The base case scenario incorporates the poor competitive and consumer landscape outlined above, which should impact both revenue growth and margin expansion opportunities. I assume that significant Toolkit-related ARPU growth is largely contained to 2015 and 2016, while customer retention and gross customer additions are slightly elevated. After 2016, ARPU growth rapidly declines, before turning slightly negative in 2021 as a result of pricing pressure from competitors. The rates of gross new customer additions and customer retention both decline as well, but only moderately from current levels (a potentially optimistic assumption). As a result, revenue grows at an annualized rate of 6.4% for the next 10 years before growing at 3% in perpetuity. Adjusted EBITDA margin increases through 2019, but given headwinds in ARPU and the ongoing need to spend more to acquire the incremental customer, declines back to 20% by 2024. The resulting cash flows discounted at a WACC of 8.9% imply a base case price target of $30.01, 23% below where the stock trades today. At $30.01, Constant Contact would trade at a 2015 multiple of 2.1x EV/sales, roughly in line with its average forward multiple over the last 3 and 5 years.

Upside: In an upside scenario, I assume that after 2016, the Company is able to withstand the competitive pressures outlined above and ARPU growth declines to 2% per year before stabilizing, while customer retention rate increases to 76% as a result of increased stickiness from the Toolkit platform. As a result, revenue grows at an annualized rate of 11.3% for the next 10 years, before growing at 3% in perpetuity, with a resulting 2024 adjusted EBITDA margin of 26%. The resulting discounted cash flows imply an upside price target of $50.46, 29% above where the stock trades today. At $50.46, Constant Contact would trade at a 2015 EV/sales multiple of 3.9x, roughly equivalent to its peak multiple over the last 5 years. Alternatively, the Street applies a forward EV/sales multiple to value Constant Contact’s shares. Applying the Street’s preferred EV/sales multiple of 3.5x (in line with the SaaS comp group) to 2015 expected sales implies a stock price of $45.97.

Divergent View:

Market commentary and the price of the stock currently appear to imply that Constant Contact’s new Toolkit offering is a complete game changer for the Company and will be able to materially increase ARPU and decrease customer churn over the long term, creating a sustainably elevated revenue growth profile. While Constant Contact did benefit during its initial rollout of the platform in 2014 and I credit the Company with a continued tailwind in 2015 and 2016 as it transitions its current customer base onto the platform, any benefit beyond 2016 is improbable. Rather, the Company’s ARPU growth and customer retention profiles are likely to revert to pre-Toolkit levels before continuing to decline in the future given the commoditized nature of the industry and vast number of existing and incoming competitors, combined with how price-sensitive the customer base is.

In addition, in valuing the Company, the majority of the Street justifies the current stock price by applying an elevated EV/sales multiple based on where SaaS comps currently trade. Notably, while Constant Contact has a growth profile similar to this peer set, its customer retention rate is roughly 25% lower than that of the typical SaaS company, which should result in a discounted multiple to the peer group.

Similarly, at least one prominent sell-side firm uses a DCF methodology to calculate the fair value of Constant Contact. Interestingly, however, the revenue growth and margin profiles applied in the DCF are materially higher than those that the Firm calculates in its bottoms-up income statement analysis. As a result, the price target from the DCF is materially higher than what would be generated were the Firm to use its more realistic bottom-up assumptions.

Investment Risks/Considerations:

Competitor risk: As outlined in detail above, the email marketing and online marketing industries are fragmented and highly competitive, with little ability for companies to differentiate their products, almost zero moat preventing additional players from entering the market, and customers with very low tolerance for price increases. Looking forward, this combination likely results in lower ARPU and customer retention over time, especially given many competitors offer free entry-level marketing tools. While the Company claims the transition to Toolkit should mitigate this risk, any sustained benefit from a Toolkit offering is unlikely given rapid and constant evolution in the industry. Should future ARPU or customer retention be lower than the base case assumptions, Constant Contact would likely have drastically lower revenue growth.

Contract risk: Constant Contact does not sign long-term contracts, instead only requiring that customers prepay for one month of service at a time. For customers, switching providers is simple, quick, and essentially zero cost (in fact, the customer likely sees a cost benefit as most companies offer a free trial to start a new service). As a result, should Constant Contact’s competitors develop a more innovative or easier to use online marketing solution, or should a new technology be introduced into the space that Constant Contact misses, the Company’s revenues could decline significantly as customers quickly change providers.

Economic risk: Any economic slowdown would likely impact Constant Contact to an outsized degree given its focus primarily on small businesses, which are typically impacted more significantly by economic downturns than their larger counterparts.

Acquisition risk: Should a larger company decide it wants to improve its offering or enter the online marketing industry, Constant Contact’s market cap is small enough that it could be an easy acquisition candidate. Additionally, the Company’s brand recognition among consumers appears to lead the pack alongside MailChimp, increasing its appeal as a way for a larger company to quickly scale into the market. Framing the potential upside risk, Constant Contact’s peak forward EV/sales multiple over the last 5 years has been 4x. Applying this 4x multiple (a 0.5x premium to a SaaS group that arguably has a more attractive business profile) to 2015 estimated base case sales results in a stock price of $51.84, or 32.5% higher than the current level.

Roll up risk: Constant Contact currently has $163 million and growing of net cash on its balance sheet and the Company has noted that it would be interested in making acquisitions to help catalyze growth going forward. Particularly, management has pointed to a potential international acquisition to help its international expansion or a consolidation roll up of email marketing competitors. Should the Company be able to find potential uses of this cash that immediately increase its subscriber count, revenue growth is likely to be higher than is currently predicted by the fundamentals of the business. However, should Constant Contact decide to deploy the cash into its third area of focus, technology tuck-in acquisitions to broaden its platform offering, revenue would likely be impacted to a lesser degree given the hesitation of customers to pay for additional services.

Catalyst

Catalysts:

In the near term, no pure catalyst exists for Constant Contact. However, given the recent run in the stock (+60% over the last 1 year and +214% over the last 2 years) and the elevated multiple, any disappointment in earnings results would likely lead to a rapid re-rating in its price. Investors saw this occur in both 2011 and 2012 when the Company missed on earnings and customer retention, ultimately driving the stock lower by 58% and 62%, respectively. Interestingly, over the last few months, Google searches for “Constant Contact” have accelerated downward, implying new potential customers may be gravitating towards the Company less than they had been a year ago. While Constant Contact claims this decline is misleading due to the Company moving away from traditional marketing for its email product combined with various other Constant Contact-related search terms that are making up the search difference, should new subscriber demand decline, the Company would certainly struggle to meet its revenue goal for the year. Additionally, should the Company find that few of its customers are interested in migrating from their current email marketing service to the significantly higher priced Toolkit (per the customer commentary above), both ARPU and customer retention would likely come under pressure versus Company commentary.

Longer term, the completion of Constant Contact’s transition of its current user base to Toolkit at the end of 2016 should cause the Company’s growth profile to revert from high-teens to high-single digits as ARPU growth slows.