Description

Incredimail (MAIL), founded in 1999, is an Israeli software and Internet media company which apparently lives below the radar. With a share count of 9.5mm and a recent share price of $9.00, the company has an approximate market capitalization of $85.5 mm. The balance sheet sports $30mm in cash and marketable securities (approximately $3.16 per share), no debt, deferred revenue of $7.5 mm and, with the exception of an accrued dividend, only minor liabilities. Total enterprise value amounts to $55.5mm and TLM EBITDA is $11.2mm, putting the TEV/Adjusted EBITDA multiple in the range of 5.0x. On TTM EPS of $1.10, the company trades at a P/E of 8.2x.

Considering the strong top line growth (greater than 30% CAGR since 2005), huge cash balance, absence of meaningful liabilities, and the fact that the R&D and advertising/marketing spend associated with new products recently launched is now behind it, I think the stock is trading cheap. I recommend a long position in the shares and expect a total return of greater than 100% in the next two years.

Returns on this investment will come from the combination of growth (both organic and through acquisitions), dividends, and an expanding multiple. The downside quotational risk could be meaningful given the small market capitalization, heavy insider and limited institutional ownership. The 52 week range is $2.10 - $10.89. Nonetheless I'd argue that major dips are aggressive buying opportunities as the value and its growth is there, management has exhibited discipline in capital allocation and expense management, and institutional investors will eventually move more aggressively into the name.

THE INCREDIMAIL BUSINESS MODEL

Incredimail develops customized, downloadable graphic consumer applications used to generate keyword based search revenue and sells desktop software and services. The three primary product lines include:

Incredimail XE (approximately 70% of monthly search queries in Q2 2009). This product, offered free of charge,  and is an email client add-on that includes creative features directly into email messages, including: backgrounds and letterheads, animated notifiers indicating the receipt of new mail, emoticons (icons used to convey emotions), handwritten signatures, a library of animations, sound effects, and virtual e-cards. The company reports that its 7 million global active users generate over 300 million emails monthly. More than 1 million downloads are registered every month. The demographics of the user base are attractive with 69% over the age of 32 and disproportionately female. A new version of this product, Incredimail II, is currently being beta tested in the market. Premium offerings are available for direct purchase, offering users an upgrade opportunity with more functionality.

Hi-Yo (approximately 20% of monthly search queries). This product, offered free of charge, is an add-on to existing instant messaging applications, including the following platforms: MSN, Yahoo! and AIM. Features include animations, sound effects, winks, nudges, and emoticons. The user is, on average, younger  and more tech savvy than an Incredimail user. The product launched in April 2008.

Magentic (approximately 10% of monthly search queries). This product, offered free of charge, provides a broad selection of desktop wallpaper and screensaver images and also enables users to creatively render personal digital photos.

Several other products are either in development or are available but not significant revenue generators as yet.

Each product is targeted to the consumer marketplace and intended to evoke a sense of fun as well as improved client and desktop usability. The company claims possess in total:

• Over 11 million active users in over 100 countries
• Over 1.7 million monthly new downloads
• Over 100 million monthly search

The email and instant messaging suite of products are extremely viral. With each communication recipients are offered, either directly or indirectly, the opportunity to add the free application. In my opinion, this is the genius behind the company's success in search as it provides for low cost user acquisition.

Incredimail did experiment with traditional marketing and advertising strategies to support the Hi-Yo launch and witnessed a substantial spike in monthly downloads as a result. In fact, monthly downloads nearly doubled during the July-December period of that year. Corresponding selling and Marketing spend were as follows:

                                                                                Average

                                                                               Q3-Q4                   Q3

                                                                               2008                     2009                 % Change

                Revenue ($mm)                                         5,963                  6,608                    10.8%  

                Selling and Marketing ($mm)                       2,282                  1,182                    (48.2%)

                  Selling and Marketing/Revenue                  38.3%                 17.9%                   (53.5%)

Estimated Monthly Downloads (mm)                                                        % Change

                July 08                                                                1.25                          

                August 08                                                            1.30                          4%

                September 08                                                      1.60                        23%

                October 08                                                           1.90                        19%

                November 08                                                        2.30                        21%

                December 08                                                        2.40                        4%

                July 09 (latest available)                                        2.20                        (8%)

(See Investor Presentation here: http://www.incredimail-corp.com/relations/presentations)

Despite slashing Selling and Marketing spend, total monthly downloads appear to have held up at quite well at July 2009 relative to the seasonal peak reached in December 2008. The seasonal factor at work here deserves emphasis. In reviewing the monthly download chart (which I believe represents new and subsequent downloads) you will see a noteworthy pattern of downloads trailing off during the late spring and summer months and increasing through the fall. The cause of this pattern can is not certain to me (less Internet usage during the summer months is cited by management). Despite this historical pattern (established during a period where the company spend little on traditional marketing and advertising) monthly downloads since December 2008 have continued to exceed 2 million. This indicates the strength underlying the viral nature of the applications offered. Advertising successfully attracted a significant number of new monthly downloads but the viral qualities of email and instant messaging sustained downloads at the higher level established by that ad spend, even in the face of seasonal factors from which one might anticipate otherwise.

There are four primary revenue streams: 1) search queries, monetized on a cost-per-click basis 2) software purchases and upgrades 3) banner adds on company websites and in its free software, and 4) brand licensing and promotion arrangements with operators of third party websites.

The company has direct partnerships with search providers Google and Info Space. The Google relationship goes back to 2006, but the company entered a new direct AdSense Agreement in July 2009 which has a two year term. Google represented 70% of total revenue in 2008 (judging from the table below, a portion of product revenue were also attributable to Google), and that number is likely to have increased since. The split of search revenue between Google and Info Space is roughly 87%/13%.

SUNDRY CURVE BALLS

Incredimail has batted a series of curve balls out of the park. Several unexpected events caused immediate damage leading investors to flee the stock during 2009.  The long term results of the adjustments made by management, however, have been extremely positive to the value of the business and shareholder confidence.

Curve Ball #1: In late 2007 Incredimail wrote-off auction rate securities purchased from a swindler employed by Credit Suisse who was later convicted of fraud. Credit Suisse, after being sued by Incredimail, agreed to buy the securities back at par in October 2008 and the company reversed the prior write-off.

Curve Ball #2: In January 2008 the company was dropped from Google's AdSense program. I'm not sure what transpired but here's what the then CEO, Yaron Adler had to say about being reinstated within a month: "We are pleased to be able to resolve this setback so quickly and in such a positive way. Google's co-operation in re-instating our account, together with the feedback we've received from other search engine companies, makes us more optimistic than ever regarding the potential of the search business to drive our results, validating our long-term growth strategies." Regardless of the cause, the cousins Adler shuffled roles, Incredimail proclaimed a redoubling of its focus on search revenue, and the ship seemed to readily right itself (see Jeff Holzmann's commentary below).

Curve Ball #3: The shift in the mix of revenues from software sales toward an increasing reliance on search revenues also proved disruptive, particularly considering the hiccup with Google. A recounting of the shift in the business mix is presented below:

During the Q3 2009 earnings conference call the company reported that search represented 77% of total revenue.

This transition drives an improvement in gross margin. Gross margins have increased by 200 bps since 2006, from 92% to 94% in Q3 2009. I believe a further 50-100 bps of improvement is possible as the mix shifts further toward search.  Additionally, this ongoing shift has enabled Incredimail to more intensively monetize each user across product category.

Perhaps the best way to tell this story is to quote the EVP and GM of Incredimail USA, Jeff Holzmann. The entire interview can be found here:

http://www.envoyglobalresearch.com/incredimail-mail-may-continue-to-surprise-investors-in-the-year-ahead/

Envoy Global Research: Can you please describe the major transitions that Incredimail has gone through over the last few years?

JH: There have been two major shifts, one involving management and the other being a big change in our revenue strategy.

First, with regards to management, the reins were passed from Yaron Adler to his cousin and co-founder Ofer Adler in early 2008. Whereas Yaron was interest[ed] in pursuing several new growth areas, Ofer has refocused on the core opportunity of driving search revenue via our free software offerings. This has allowed the company to reduce headcount, discontinue less promising business efforts, and really hone in on our fastest-growing source of revenue.

On the strategy front, our sales efforts used to focus primarily on upgrading our users from the free products to the premium offerings. Perhaps 2% of users would upgrade, and 98% would stick with the free software. Not the best model, perhaps, but it's the one we IPO'd with, and we did generate nice profits from that business. In late 2006 though, the company began experimenting with Google's AdSense program to try and monetize those other 98% of our users. Google quickly became a very important partner for us, and their AdSense program has been the main revenue driver for our company ever since.

EGR: So your search business has been growing fast, with this cheap viral marketing driving downloads. Why, then, did the company's operating profits stay relatively flat until just recently?

JH: This is a function of a few factors. First, as I mentioned, the company was chasing several different market opportunities under the former CEO, and the related expenses have only recently dropped away. Second, the search monetization process takes time to fine tune. The more time we spend working with partners like Google, the better we get at maximizing search revenues from our free software downloads. Third, as I mentioned, we chose to do some media buying to support the HiYo launch last year. That marketing spend saw no offsetting revenue initially, as we didn't begin monetizing the program immediately. However, since the beginning of 2009, we've significantly reduced the media buying and let the viral marketing take over. Now that HiYo has this momentum in place, we are able to start ramping revenue from the product without much additional expense.

Basically, the dramatic growth in profits we recently reported is the result of a transition to a new cost structure, a new revenue model, and the monetization of a new product. The results of these changes are reflected in recent financial results, but the success didn't happen overnight.

These transitions and challenges were responded to in a fashion that displayed a level of maturity unusual for such a young company and management team. Essentially MAIL commenced to showering investors with cash, first in the form of a buyback and later with the institution of dividend program whereby 50% of profits are distributed annually.

This year the company declared two dividends totaling $0.90 per. The first dividend, which took place mid-year, represented an amount in excess of earnings for 2008 and was, in my mind, atonement for the ARS mishap. The 2009 "interim dividend", representing a down payment on the 50% of 2009 earnings pledged to be distributed, is $0.40 per share and has a record date of 12/21 and a payable date of 12/30. Subsequent amounts will presumably be paid should actual earnings for the year exceed $0.80. I think Incredimail is likely to earn approximately $0.90 this year and that a subsequent small dividend might be paid early next year.

FINANCIAL FOOTPRINT

This is a business has produced significant revenue growth at high margins and with little capital investment. My earnings projections for 2010-2011 are included:

OWNERSHIP

Ownership above 5% according to the proxy was concentrated in the hands of the Adler cousins and a few institutions, as shown:

 Ofer Adler, CEO            1,794,771              18.9%

Yaron Adler, Director      1,416,933              14.9%

Alpha Capital Anstalt        545,073               5.8%

Sprott Asset Mgmt           462,912               4.9%

Both Adler's have sold shares within the past year but maintain significant positions.

COMPARABLES

I present comparables for several of the largest Internet related companies and suggest that a discount be applied to account for differences in liquidity, size, customer concentration, and management depth. A discount of 30% for these factors suggests that MAIL is incredibly cheap, as shown:

SUMMARY

I think Incredimail possesses a very attractive business and will experience continued growth, driven by the viral nature of its offerings and new product launches. There is quotational risk in owning the shares of a company of this size but those who ride out the bumps are likely to be handsomely rewarded.

Catalyst

Success with new products, Hi-Yo and Incredimail II and contunued growth

Analyst coverage

Increasing institutional ownership