I've been shorting shares of JCOM, which have recently been levitating along with the market and are up 35% this year and near a 3-year high.  The company essentially has one product - which is commoditized and its competitors sell at far lower prices - and it participates in a declining industry: sending & receiving faxes over the internet.

JCOM turned up in one of my screens for long investment ideas.   And at first glance it has a bunch of attractive attributes - stable recurring revenue, high & rising margins, throws off lots of free cash flow, high return on capital, no debt, a big cash balance, and at the time it traded at a below-market multiple.  On closer inspection, JCOM actually looks really interesting as a short:  (1) its "recurring" revenues are coming from a subscriber base that churns 30-50% annually (I'd call that "non-recurring"), (2) its apparently stable revenue is almost certainly in perpetual decline but is being masked and propped up by serial acquisitions that add customers, (3) margins have almost certainly peaked as JCOM sells a commodity product with numerous competitors undercutting them on price by 50%, so ARPU has fallen 5% annually for three years straight, and finally, (4) JCOM's current market-average P/E or P/FCF multiple starts to look really expensive considering the product accounting for nearly all its revenue & earnings is in decline and might not exist in a few years.

The quick take on JCOM is as follows: if its eFax service exists at all in 5-10 years, it will be at much lower volume, lower price and lower profitability.  While we wait for the residual stub of faxing activity to be fully replaced by email, the competitors selling JCOM's service at half price will erode its subscriber base and bring down its ARPU.  Management can paste over the cracks for a while by spending shareholders' cash on acquisitions (whose financials are never disclosed) but the bottom line is that the market is valuing JCOM's business like a stable one when its free cash flow stream is in terminal decline.  JCOM appears to trade at a Price (ex-cash) / FCF multiple of 13.5x.  Adjusting FCF for the cash M&A spend that JCOM uses just to keep revenue & earnings/FCF flat, the multiple rises to 21.6x.  I think JCOM is worth about $17, 38% below its current price.

JCOM's flagship product, eFax, provides customers with a virtualized fax machine service using a customer's computer and the internet.  This is often called "eFax", "online fax", "virtual fax" and "internet fax".  JCOM provides customers with a phone number for their virtual fax and allows them to send and receive faxes.  JCOM's eFax product provides a fax gateway to customers.  It takes the place of a fax machine and telephone line, allowing a customer to use their computer and internet connection to send faxes to a fax machine and receive faxes through a dedicated phone number provided by eFax.  Another JCOM product, eVoice, provides a customer with a toll-free or local phone number, an automated receptionist / menu tree, and voicemail.  JCOM also provides email hosting services, mainly to small business customers.  JCOM's faxing service provides 70-80% of revenue.  These other businesses are just as undifferentiated and intensely competitive as JCOM's core eFax business.

JCOM measures its customers in terms of DIDs or phone numbers assigned - this captures eFax, eVoice and other products.  Across all of its products JCOM claims to have 11.2MM customers but only 1.4MM are paying customers, the other 10 million are "30 day free trial" customers who never seems to convert into paying customers.

JCOM's customers are individuals and small businesses.  Any business requiring frequent use of a fax machine is likely to actually own one, as the cost is de minimus.  Individuals requiring only occasional use of a fax are unlikely to pay $16.95 per month to access one.  There are many free or low-cost internet options for occasional faxers, including JCOM's own 30-day free trial.  It's somewhat telling that JCOM has 1.4 million paying subscribers and 11.1 million subscribers taking advantage of JCOM's 30-day free trial who never convert into paid subscribers.  JCOM's free trial user base has been over 10 million since 2005 but annual net paying subscriber additions peaked at 186,000 in 2005 and now are virtually zero (ex-M&A activity).  Also, for customers who don't need a dedicated phone number as an "address" for incoming faxes, simple to use software programs provide all the other functionality of JCOM's service for a much lower one-time price.

JCOM prices eFax as a monthly subscription service.  The monthly cost is $16.95 (or a "two month free" discount to $14.13 if a customer commits to an annual membership).  The customer then may receive 130 pages per month and send 30 pages per month.  Any page amounts over these allotments cost $0.15 per page received and $0.10 per page sent.  Current ARPU of $14.21 indicates some discounting off the advertised price and lower prices for corporate customers.  Also eFax has several "secondary brands" (for example, RapidFAX) with monthly pricing around $10.  Not surprisingly, the secondary brands are growing faster than eFax.

Before we go through how JCOM's business is unlikely to exist in 5-10 years, let's first cover how they're masking their declining user base through acquisitions and how intense price competition has pushed down ARPU by 5% annually for three years straight.

JCOM's high profit margin and return on capital indicate that it currently has a great business.  Unfortunately it is also one with low barriers to entry, low start up costs (JCOM's net PP&E is all of $12 million), and essentially no differentiation between competitors.  If I remember my competitive strategy class, this tends to end badly.  Many competitors see JCOM's profits and high margins and are aggressively coming after its customers.

A comparison of identical services offered by numerous competitors indicates that JCOM's pricing is being undercut by an enormous 25-50%... and the competitors actually offer higher monthly page allotments before per-page fees kick in.  See www.faxcompare.com for details.  A company providing a commodity product or service that is being undercut on price by 50% by a range of near-identical competitors is in enormous amounts of trouble.  In theory, this will manifest itself in high subscriber churn and intense pricing pressure.  Let's take a look.

JCOM adds new subscribers primarily through online advertising and marketing.  Recently it has also been using M&A to make up for its inability to add subscribers organically.  Under the company's definition of churn, which excludes customers who churn within 4 months (huh?), average monthly churn has been 2.75% over the past 12 months.  That translates to annual churn of 33%, or an average customer life of 3 years.  But its arbitrary decision to exclude customers who only last four months or less (to make the number look better) suggests they may be playing other games.  In any case, if 33% of the customers who used the product for more than 4 months cancel their service each year, properly measured churn is probably closer to 50%.

JCOM is spending $44MM annually on sales and marketing to replace its churning customers (17% of sales).  But that's not the whole picture.  JCOM has been serially acquiring customers by spending cash to acquire companies.  Over the past 3 years JCOM has spent $92MM on M&A but provides little detail on the acquired companies as they are individually "not material" to its financial condition.  Of course, in the aggregate, they make a structurally declining business look like a sustainable one - at least for a while.  Comparing the change in the customer base with cash spent on M&A over the past 7 quarters reveals an unsurprising pattern.  No M&A, no new customers.  Spend cash on M&A, new customers.

Faxes are still required in a small number of situations.  Most of these are required by government regulations, including HIPAA (health care privacy) and the Gramm-Leach-Bliley Financial Services Modernization Act.  Email or secure internet transmission methods aren't considered secure enough to constitute executing legal contracts via signature.  Once regulations are update to accept the fact that internet transmissions can be just as secure as a fax (how many millions of secure e-commerce transactions occur daily?), JCOM's business will deteriorate.  Of course, regulators move fairly slowly.  But as JCOM's 10-K admits: "We believe that one of the attractions to fax versus alternatives, such as email, is that fax signatures are a generally accepted method of executing contracts. There are on-going efforts by governmental and non-governmental entities, many of which possess greater resources than we do, to create a universally accepted method for electronically signing documents.  Widespread adoption of so-called "digital signatures" could reduce demand for our fax services and, as a result, could have a material adverse effect on our business, prospects, financial condition, operating results and cash flows."

So will JCOM still have its current level of business in 5 years?  Maybe.  In 10 years?  I wouldn't bet on it.    And while we wait, JCOM's competitors are undercutting it on price by 50%, putting intense pressure on its subscriber base and pricing.  Even if the market for fax service remains at the current level, these competitive forces will wreak havoc on JCOM's sales volume and profitability.

I project JCOM will generate free cash flow of $80 million in 2011 (using GAAP definition less $12 million of stock comp. expense).  If we want to value JCOM using a multiple, I believe that subtracting M&A spend from FCF is mandatory, since this cash is required to sustain the customer base and offset pricing declines.  Subtracting average M&A spend over the past 3 years of $30 million from FCF yields adjusted free cash flow of $52 million.  On this basis JCOM's Price (ex cash) / FCF multiple is 21.6x.

JCOM's quarterly revenue has been stuck around $60 million for almost 3 years.  Acquired subscribers can make this revenue level seem sustainable and keep profit margin high, but declining prices eat away at per-subscriber profitability.  JCOM's per-subscriber EBIT ex-SAC (operating profit plus Sales & Marketing expense divided by average paying subscribers) has been falling since 2007, from $135 to an annualized $119 in 3Q10.  If the subscriber base isn't growing and per-subscriber profit is dropping, JCOM is in trouble.

I should note that the internet is littered with customer complaints about JCOM's eFax service.  These are easy to find via search, but to summarize the main themes are: service is very difficult to cancel, improper billing, improper conversion of free trial to paid service and very poor customer service.  The Better Business Bureau's website also lists numerous complaints and gives the company a grade of "F".  All of this reminds me of AOL back in its early stages of decline.

JCOM's current share price is $27.47.  There are 48.9 million diluted shares outstanding so the company's market cap is $1.34 billion.  JCOM's cash balance of $272 million reduces its enterprise value to $1.07 billion.

JCOM trades at a Price (ex-cash) /2011 FCF multiple  of 13.5x.  I realize that JCOM's valuation multiple doesn't suggest overvaluation, but it does assume a sustainable business with stable or growing earnings, and I'm pretty sure that's not the case here.  And when adjusted for M&A activity needed to keep up the current level of sales & FCF, the multiple is 21.6x.  Now I'm not usually a relative value guy, but I really like the pair trade of shorting JCOM against cheaper tech stocks with far stronger and actually sustainable businesses.  Using a quick screen of Bloomberg's Price/forward consensus EPS, I find many great businesses trading at a discount to JCOM.  On this basis JCOM's P/E is 14x and the following companies trade at a big discount (below 12x, I picked the big ones but there's 20-30): CSCO, HPQ, IBM, MSFT, T, XRX.

I look at downside this way: if FCF is somehow 10% above my $1.68 2011 estimate and the market continues to mis-value the company as a sustainable business (say a 15x FCF multiple), that's $27.75 plus $5.57 cash so the stock price rises to $33.30.  That's 20% appreciation.  But I honestly can't see how JCOM's revenue or free cash flow can grow from here without JCOM spending shareholders' cash on buying more customers.  If these acquired customers churn off at the same rate as existing customers - within 2-3 years - I'd say this is a very poor use of capital.  So I'm confident that we're looking at peak earnings power right now.

On the other hand, to get a sense for how the market values a dying technology, let's look at the dial-up internet access companies.  ELNK and UNTD trade at 8.3x and 6.3x current EPS.  Applying a 7x multiple to my JCOM 2011 FCF estimate of $1.68 (which has nowhere to go but down) yields a price of $17.33, or 37% downside.  JCOM's 52-week low is $18.79 so I think it can get there.

A quick DCF using the NPV=CF/(r-g) formula is helpful for assessing fair value too.  CF is $1.68 and I like to use 8% as my discount rate for valuing shorts (10% for longs).  In a highly competitive, dying business with a flat to declining subscriber base, prices falling 5% annually and magnification of revenue loss from operating leverage, I think assuming a 7-10% perpetual decline in profit is conservative.  This yields an NPV of $14.90 - $18.50, or 33-45% downside. The midpoint of that range is $16.70.

So I think $17/share is a reasonable target price and the 38% implied downside looks pretty good, especially given the risk to the upside feels very limited.

Short interest has ranged from 2-5 million shares and is currently 3.1 million.  A check of IBKR shows millions of shares available for shorting with a -0.7% borrow rate.

Risks:

Management does the right thing to maximize value for shareholders.  I think this means paying out 100% of the cash on the balance sheet and paying out 100% of annual free cash flow as a dividend.  I think this is unlikely to happen since without cash to spend on acquisitions it will quickly be revealed that JCOM is a declining business.  Again, a Price/FCF multiple of 13x means it takes 13 years to get your investment back.  I don't see 13 years worth of a sustainable business here.

Despite the competition selling its product at half price and the inevitable long-term demise of its business, JCOM's business turns around, prices stabilize, and revenue & earnings grow for a while.

JCOM executes large-scale M&A that gives the appearance of growth & sustainability for a while.