Description

FriendFinder Networks (FFN) finally IPO'd last Wednesday at the low end of its expected range. The parent of Penthouse Magazine and the AdultFriendFinder sold 5 million shares at $10 per share. This was it's third attempt to go public and the third time was the charm for the company, but not for the lucky buyers who have seen FFN shares fall almost thirty percent in under a week.

FriendFinder trades around 20x TEV/FCF, has huge debt maturities coming due in the next two years, is rife with serious legal risks, and will possibly default on its debt in the next two months.  As such it looks like a very compelling short.

A quick background on its IPO attempts:

• December 2008 - despite its auditor raising "going concern" risk in the audited statements, FriendFinder tried to raise $460 million during the depths of the financial crisis. The investment bank running the IPO was the Cyprus branch of the Russian firm Renaissance Capital.
• February 2010 - With the economy improving and the "going concern" problem cured, FriendFinder tried again - this time to raise only $200 million. Renaissance, which at the time had never brought a U.S. based company public, again failed to complete the offering.
• May 2011 - Switching to Imperial Capital and Ladenburg Thalmann as the underwriters and reducing the size to $50 million, FriendFinder finally succeeded with their IPO.

What is FriendFinder?

FriendFinder's various websites are among the most visited properties on the web. In the month of December 2010 alone they had almost 200 million site visits. They claim they are the 20^th most visited site on the internet.

FriendFinder is a compendium of sites like ItalianFriendFinder.com, AsiaFriendFinder.com, KoreanFriendFinder.com, SeniorFriendFinder.com, IndianFriendFinder.com....you get the idea. They also own Penthouse Magazine and derive about $25 million in revenue per year from the magazine, films, and licensing of the name. However, the real driver of the business and the focus of the rest of this discussion will be AdultFriendFinder which generates around 70% of FriendFinder's revenues.

AdultFriendFinder is a site where both men and women can meet each other, chat and arrange sexual encounters. On the surface, it appears to be an adult social networking site-- think Craigslist's casual encounters meets Facebook. However, as often is the case, the reality is far different.

It doesn't take long to figure out how AdultFriendFinder generates their tremendous traffic. They have two sources, the first is Google keywords and the second is referrals from 250,000 affiliate sites. You won't read this in the S-1, but these affiliates are pornography sites across the web that put up banner ads directing their own visitors to visit AdultFriendFinder. AdultFriendFinder has one of the most generous affiliate programs on the web with reimbursements over $1 per unique click. The number of affiliates has grown dramatically over the last few years from 100,000 in 2008 to 200,000 in 2010 and 250,000 today.

I found it instructional to watch what happens to this traffic once it gets to their site. Of all the traffic to the site, they are able to get about 3.9 million people to sign up for a free registration and submission of an email address. Of those 3.9 million people, about 1 million become paid subscribers, a slightly better than 25% conversion rate.

How they turn this traffic into paid subscriptions is as fascinating as it is disingenuous. Once directed to the AdultFriendFinder website, the slogan "meet real sex partners tonight" appears and a handful of pictures of beautiful women in various stages of undress are all over the website. These women are all listed as being located in your geographic area (software determines your IP address location and tailors the ads to match where you live). The homepage encourages you to create a profile for free and this free membership allows you to receive messages from other members, but doesn't allow you to respond. Almost immediately after setting up a free account, messages start appearing from beautiful women requesting trysts with "you tonight." The only way to respond is to pay for a membership, which explains the 25% conversion rate.

What was clear to the 75% that didn't bite on the bait, becomes clear to these paid-up subscribers rather quickly after they respond to the original messages. The original messages were from bots designed to entice paid subscriptions and any messages to the bots receive automated messages along the lines of "sorry I am out of town now, but let's meet up when I am back." There are some amusing anecdotes on the various consumer affairs message boards of subscribers who sent an angry, profanity laced email to one of these bots only to be answered with the same form-message. It is clear these "girls" are unmonitored accounts with auto-responses designed to convert free registrations into paid subscriptions.

The average paid subscriber remains on the site for 4.4 months based on 2010 data. This was a surprising number to me after reading about the "bot" tricks employed to drive subscriptions. I believe there are two things going on that explain this. The first, is that some people are actually finding success through the site. Based on a number of site reviews and message board commentary it appears there are a large number of prostitutes working on the site as well as a small number of swingers. The second reason that the average subscriber remains on the site for as long as they do appears to be the result of a number of dirty tricks. Subscription renewals are set to "auto-renew" automatically and there have been reports that despite being shifted to "off", renewals were still charged. One can also infer that this is happening from some statistics derived from the S-1. The average length of subscription has been growing from 3.47 months in 2008 to 4.13 months in 2009 and 4.39 months in 2010. At the same time, credit card charge-backs have grown from 0.7% of sales in 2008 to 1.2% in 2009 and 1.4% in 2010. If you include refunds with charge-backs the percentages of sales have from 3.6% in 2008 to 4.7% in 2009 and 6% in 2010. These numbers suggest that FriendFinder is becoming more aggressive with their renewal tricks.

 Balance sheet

The desire to go public is rooted in FriendFinder's balance sheet. AdultFriendFinder was previously named Various Inc. and was sold to the owners of Penthouse magazine in December, 2007 for $401 million. The deal had a very small cash component and was effectively an LBO with the previous owner acting as the lender as well as the seller because financing fell through for Penthouse. The rush to go public in 2008 was an effort to replace the high debt load with equity and thus cash out the seller. They missed their window when the market went into free-fall and had to cure a number of defaults on the debt in the intervening years.  Some of the technical defaults include one in June 2009 when they failed to meet their EBITDA covenants and as recently as February of this year when they "inadvertently" applied the wrong amount of excess cash flow to principal payments. The equity has nine lives because the debt holder also happens to be one of the largest equity holders.

FriendFinder has been paying down debt with cash flow and will also use the net IPO proceeds to continue to pay down debt. Including that paydown and the excess cash flow sweeps that occurred in 1Q11, FriendFinder has $491 million in debt of which $232 million is non-cash pay and convertible into equity. The bulk of the non-convertible debt is $305 million worth of 14% notes due in 2013. For my enterprise value calculation, I counted the convertible debt as debt rather than equity because it has an 11.5% interest rate and can be converted at anytime. It doesn't make any sense to convert early when he can collect 11.5% PIK coupons.

Valuation

FriendFinder is at the nexus of "the oldest profession" and "there is a sucker born every minute" so I don't expect their business to go away anytime soon. That being said, they aren't growing very much. Revenue actually fell 1% from 2008 to 2009 and grew only 5% from 2009 to 2010. Revenue in 2007, the year it was sold, was $284 million vs $309 million today (for just the FriendFinder side of the business), an 8% increase. Margins were higher then so its hard to make a case that intrinsic value has grown much since 2007 when it was sold for $401 million. I calculate Total Enterprise Value to be roughly $750 million so either it was sold at a very favorable price in 2007 or it is highly overvalued today.  

FriendFinder has been losing money on a GAAP basis since it was sold, including a $43 million loss in 2010. They do appear to be generating free cash flow, though, as they have large depreciation and amortization charges. In 2010, FriendFinder generated roughly $39 million in free cash flow. Based on this figure, FriendFinder trades at 19.2 times TEV/FCF before the additional expenses they will incur due to Sarbanes Oxley and other public company requirements. While this isn't a "silly" multiple, it seems way too high for a company that isn't growing and has following risk profile:

Risks

In 2008, when they first tried to go public, there was commentary that the reason their underwriter was a Russian bank that had never taken a U.S. based company public was because domestic banks were afraid of being linked to a company that facilitated prostitution. The saga of the online poker companies is an interesting parallel. The poker companies were very profitable entities for a number of years and were allowed to exist until one day the government pulled the plug. I think that is a distinct risk for FriendFinder - it could bump along for a number of years and then one morning it could be gone because it is blatantly facilitating prostitution. FriendFinder also may have some liability based on the activities of its affiliates depending on how these sites are generating traffic. For example if they are using mal-ware to drive traffic to FriendFinder, FriendFinder may be found complicit. Having exposure to the behavior of 250,000 independent pornographic websites is generally not a good place to be.

Friendfinder could also find itself the subject of a class-action lawsuit due to its credit card shenanigans although they are probably somewhat insulated from this by virtue of the fact that most of its subscribers would prefer to remain private. As a public company they do become a bigger target for lawsuits though. In addition, American Express already stopped accepting credit cards for pornography sites and the other cards already require FriendFinder to maintain $7 to $8 million in restricted cash to cover charge-backs and the S-1's risk factors lists losing the ability to accept credit cards if chargebacks grow too high as a percentage of sales.

While number of subscribers has been growing in each of the last three years for the adult side of the business and churn is declining, the trends under the surface are suggesting some trouble. Subscriber growth appears to be a result of the increased number of affiliates pushing traffic to them and the reduced churn may be a result of more aggressive credit card renewal shenanigans. ARPU fell 7% in 2009 and another 1.2% in 2010 while cost per customer acquisition rose 11% in 2009 before ticking down slightly in 2010. Falling margin per subscriber may be the reason they are becoming more aggressive with the credit card shenanigans.

Friendfinder is the subject of a lawsuit by the merchant bank, Broadstream Capital Partners. Evidently, Broadstream had an agreement to purchase Various Inc as a joint venture with Penthouse. Penthouse then went ahead and did the deal without Broadstream and Broadstream sued for $557 million. In July 2009, they came to an agreement whereby FriendFinder paid Broadstream $3 million and agreed to go to arbitration where Broadstream could receive anywhere from $10 million to $47 million in a judgment. FriendFinder has disclosed that if the judgement is for $15 million or more (beyond the $3 million already paid), they will be in default of their Notes.  Given that $15 million is at the low end of the range, it seems like a distinct possibility that FriendFinder could default. The first arbitration meeting already happened and the next round is scheduled for late July.  This item is extremely buried in the S-1 and it is likely that most shareholders are not yet aware of it. 

Management is a disaster. There are too many related party transactions to name and it appears that management has been using FriendFinder as their own piggybank. A few choice examples are: top managers increased their salaries and bonuses as part of the IPO, Marc Bell and Daniel Staton, the CEO and Chairmen of the board, respectively control a blank check public company called ARMOUR which they are contractually entitled to spend 10% of their time working on, they own one of the buildings that FriendFinder leases space from, and the kicker is that they added a clause into their contracts before the previous attempt to go public which entitled them to receive cash payments of almost $10 million dollars contingent on a successful IPO. There are plenty of others and I recommend a good reading of the S-1. These are very shady operators.

By virtue of the fact that they want to pay down their debt and once tried to sell over $400 million worth of stock, it is highly likely that there will be secondary offerings in this name. Its also likely that these will be priced below market to entice buyers. I also anticipate insider dumping shares along with these offerings as soon as they can. I think there is a huge supply of stock that will be constantly dumped on the market if the stock price rallies. As a short, this is a nice margin of safety - we can count on the greed of insiders to keep the stock price from rising.  

Enterprise Value Calculation - TEV is a bit confusing with a lot of moving parts so I am summarizing below.

• 26.3mm shares "outstanding" plus another 4.7mm shares from the various warrants and notes that will convert to common now that they went public. Note that I am counting the "Non-cash pay" 11.5% notes as debt, but they may be converted to common at some point.  At $7.20, FFN has a market cap of $223.2mm
  
• $550.8mm in debt less amount paid off from IPO proceeds of $44.75m (net), less $15mm principal payment in January 2011 = $491.05mm
  
• Broadstream litigation - between $10mm and $47mm liability
• VAT back taxes liability - likely around $30mm. Various Inc did not collect VAT taxes prior and FriendFinder retains some liability to this.
• Sweetheart payouts to top management after IPO - $10mm
  
• $41mm cash as of Dec 31, 2010 less $15mm principal payment in 2011 = $26mm
  
• TEV is $738mm to $768mm depending on Broadstream liability

Catalyst