J2 Communications (JCOM) - $50/share, $1.5B mkt cap, trading $12m/day

Short.  Believe it should be a $20-25 stock (8-10x real earnings), down roughly 50%.

Unfortunately, this write up comes 2 years after a March ’12 writeup on JCOM short at $30. (Note EPS above is EPS incl. stock comp & amort)

Thesis in a nutshell:

• 87% of profit comes from what management calls “cloud services”, of which 75% of rev and probably 90% of profit is a business where users pay to send/receive faxes as pdf email attachments.  This business is in permanent, slow secular decline, I believe 3-6% topline decline with faster profit declines as the revs fall off with exceptionally high incremental margins.  Mgmt tries to obscure the decline with acquisitions and refuses to discuss organic growth, while playing small scale acquisition accounting games to artificially create profit. 
• 13% of profit comes from recently acquired “digital media” businesses (PCMag and IGN.com).  These are also poor quality businesses, and from independent work I believe they are organically declining, at best flat.  However management vaguely implies to investors they should be high teens growth, with huge incremental margins (again, liberally making use of the assertion that they “do not distinguish between organic growth and acquisitions”). 
• JCOM needs to reinvest >100% of their cash flow just to keep earnings stable.  So this can be viewed either as a zero cash flow business that doesn’t grow earnings, or a cash generative business with profit in permanent decline.  But it is NOT cash generative AND stable. 
• Somehow this business manages to get a big multiple – 15x earnings on management’s inflated numbers, or ~20x real economic earnings including stock comp and amort (to be discussed), realistically I think the multiple looks even worse if the true cost of churn/acquisitions was allowed to hit the income statement. 

Quick update on the last 2yrs:

The core company is still the same low quality send faxes-via-email attachment, this is 87% of EBITDA. 

But JCOM has now layered on a new, and equally low quality, search-engine-optimization-driven web product review business (PCmag.com and IGN.com).  They refer to this as “digital media”.  It is indisputable these business have seen tremendous declines over the past decade, yet JCOM now pitches them to investors as fast growers with huge incremental margins.  That doesn’t appear to be true based on our research. 

The new digital media businesses were acquired for $230m, yet the market has doubled JCOM’s TEV to $2.4B since those acquisitions.  Nothing has gotten better about JCOM’s core business, now there is just a new unrelated story to tell about digital media growth that I believe is not only misleading, but also not very material at only 13% of EBITDA. 

To put this all in perspective, since I posted in March ’12:

• Earnings per share in ’12 was $2.69, they just guided 2014 to $2.67-2.87, so little to no earnings growth (on apples to apples basis, discussed below)
• Net cash has declined $100m, now stands at $100m instead of $207m.  JCOM consumed 3 years of cash flow over 2 years on acquisitions and buybacks in order to prevent earnings from falling. 
• To be clear, this is not a cash generator with minimal growth.  Cash generation and stability are an either/or decision for JCOM.  If JCOM didn’t spend 3 years of cash flow over 2 years to support EPS, earnings would have declined quite a bit. 

I think JCOM continues to use aggressive accounting and acquisitions to confuse investors and obscure what is a poor business in terminal secular decline.  I believe JCOM has fooled investors into believing that its “digital media” assets, are somehow super high growth and super high incremental margin businesses -- despite these assets a) having declined 90% in the past decade, b) having been acquired for ~5.7x EBITDA, and c) all independent info I can gather on the businesses which suggest they are declining, not growing. 

I think JCOM stock should be worth 8-10x GAAP earnings, or $20-25, ~50% downside from the current price. 

Core business -- Fax by email attachment – 87% of EBITDA

This business still continues to be in slow, permanent secular decline.  Fax lines are eroding, slowly.  Fax usage is eroding much faster.  Fax line switchoffs lag usage declines because a) people forget they are being charged, b) business slow to cut the fax line even when it is unused, just in case someone does want to send a fax, c) fax is still utilized in some verticals that are paper based (like healthcare), or accustomed to using faxed signatures (some law, real estate).  Declines in fax usage will continue, and will likely hit some acceleration points going forward as there tends to be a tipping point where people turn off an unutilized technology like fax, and things such as e-records in healthcare, and adoption of electronic signatures (or at the very least emailing pdfs) in law and real estate.  The business is also chipped away by Unified messaging / digital communications offerings from phone / cable companies, apps which provide this service free, etc.

I don’t think it is controversial to say with reasonable certainty this business will slowly decline to zero, I don’t see any realistic prospect for it to organically stabilize or begin to grow. 

This “send/receive faxes as email attachments” business is the lion’s share (~75% of revs, probably ~90% of profits) of JCOM’s “cloud” business.  In addition JCOM has some side businesses – automated telephone menus (“press 1 for Sandy”), email marketing, online computer storage/backup.  The common thread amongst the “cloud” businesses is they are extremely cheap services to provide with zero barriers to entry, and crowded competition.  JCOM’s strategy is to purchase companies, increase prices, slash spending on growth, and maximize short term profit while causing the business to decline. JCOM will do some limited investment in customer acquisition (adwords etc.) to try and grab customers where they can, but they generally have a poor product offering that is way overpriced vs. competition (often free), and don’t spend enough to organically add enough customers to replace churn losses.  JCOM is making rapid acquisitions, most are in these ancillary businesses at this point b/c there just aren’t more sizeable fax targets left.

So that’s what “cloud” is, it’s certainly a very low value, low multiple business.  Against the backdrop of this bad business, JCOM’s management team runs a few small time acquisition tricks to try and convince investors its better than it is. 

Acquisition tricks – the biggest lever

• First, mask declines– acquisitions are used cover organic decline.  JCOM repeatedly tells people the business is not declining, but with one occasional and incredible caveat -- mgmt doesn’t distinguish between organic and acquisition revenue.  JCOM never discloses the contributions from acquisitions.
  • Every once in a while you get a glimpse of what they are doing. 
    • For instance in 1Q12, they just managed to meet consensus revenue (0.5% ahead of consensus).  There were four acquisitions that quarter, mentioned in passing, as always of undisclosed size.  Mgmt didn’t highlight it, but one acquisition, Zintel, was actually a piece of a tiny New Zealand public company.  From the New Zealand public filings we can see that it added US$10m of revenue, or 3% to JCOM’s revenue base.  That’s just one random acquisition out of 4 that quarter, and a relentless stream of ongoing acquisitions.  Mgmt purchased it at 1x revenue, vs. JCOM which is valued at 4.4x revenue.  It’s not a good business, but it helps cover up revenue decline. 
    • 2013 10-K sheds some light on declines. 
      • Demonstrates 2013 organic rev decline was something greater than 3.9%
        • JCOM’s reported revenue increased $147.3m y-o-y – yet we can piece together at least $161.2m of non-organic rev additions below. 
          • 2013 K discloses that acquisitions made in ’13 added $98.1m of rev.
          • Mgmt said Ziff Davis acquisition (done 4Q12) totaled $60m of rev in ’13, only contributed $9.7m last year, so that ZD added $50.3m in y-o-y rev. 
          • A one time IP settlement increased revenue $12.8m y-o-y
          • So this means cloud organically declined by something worse than 3.9%
            • >>Note I say at least 3.9% because there are still $31m purchase price of acquisitons made in ’12 that are being lapped y-o-y for which we have no way to estimate the size of revenues. 
        • And 4Q13 organic rev declined 19% ?!?!?!
          • Y-o-y 4Q reported revenue increased $36m – yet we can piece together $53.6m in y-o-y revenue increases from acquisitions
            • 3Q13 10Q said acquisitions closed in ’13 contributed $50.3m YTD revenue.  In the 10-K it said they contributed $98.1m full year revenue – so ’13 acquisitions added $47.8m revenue in 4Q13. 
            • Ziff Davis contributed $9.7m in 4Q12.  It was owned for about half a quarter since 11/4/12.  Because it peaks in holiday-season, I assume only $6m of y-o-y 4Q revenue increase from a full quarter of Ziff Davis in 2013 (inline with half a quarter of 1Q13’s offpeak $11.8m revenue)
            • Y-o-y IP licensing declined $200k, so I add that back to give the base business more credit
            • This means “cloud” revenue organically declined 19% in 4Q13
            • I find 19% shockingly high, think normalized declines more modest.  But 4Q should show more accurate decline since it has less benefit from lapping the other $31m of non-ZD acquisitions in ’12 we can’t account for
        • I estimate organic EBITDA declined 6-7% in ‘13
          • Cloud EBITDA (ex-IP one time) was flat y-o-y at $158m, despite ~$107m in cloud acquisitions over the two years.  If acquisitions were 4-5x EBITDA which I think is fair/generous, and a half year exposure on average, this implies a 6-7% rate of organic EBITDA decline.  This makes sense vs. a 4% organic rev decline since the fax declines should happen at ~70-80% incremental margin vs. 46% margin on the base business. 
        • Note: unfortunately this method can’t be applied consistently, was only made possible by an unusual amount of pro forma info in the ’13 10-K, I think due to the size of the acquisitions.

• Second, boost profit with a Tyco-esque subscriber acquisition accounting game – acquisition accounting shifts the cash spend required to prevent the business from declining from operating expense into goodwill on the balance sheet. 
  • The core of the “cloud” business is subscriber relationships which churn off.  To maintain a steady state, you need to spend cash on customer acquisition costs – advertising, adwords etc – to attract customers to replace the ones you have lost. 
  • JCOM’s trick is that instead of organically finding replacement subs, they acquireother companies that have subs.  This means no subscriber acquisition cost is expensed. 
    • In cloud acquisitions, JCOM really acquired nothing more than subscribers.  They take those subs, operate them through JCOM’s existing fax, or online storage, or online PBX platforms. 
    • As such, you’d think JCOM would allocate close to 100% of the purchase price to customer relationships, amortize them over the average sub life (about 3 yrs given ~30% annual churn), and that is how GAAP accounting is meant to deal with situations like this, (but this would mean JCOM would only have a fraction of the earnings they report)
    • Instead, JCOM stuffs the acquisition price into goodwill so the cost of acquiring those customer relationships never hits earnings. 
    • Look at the 7yrs from 2005-2012 so we can focus on “cloud” subscriber-based acquisitions (post-2012 numbers mix in digital media acquisitions into the accounting which we can’t seperate)
      • 80% of the $340m spent on acquisitions was stuffed into goodwill.
      • Most of the remaining 20% was put on customer relationships, where incredibly it is amortized over 7-8 years (which makes no sense on a business with 30% churn). 
      • In other words – roughly 100% of the purchase price of cloud acquisitions should be acquired customer relationships which should churn off as income statement expense at ~30% of purchase price each year.  Instead, JCOM’s aggressive accounting assumes only 20% is customer relationships, and amortizes them over 7-8 years, so really only ~3% of purchase price hits the income statement instead of 30%!
      • By doing acquisitions to offset a declining business instead of replacing churn organically, JCOM is able to boost earnings (or more accurately said – to show the higher earnings of a business that is not replacing its churn, while still trying to tell investors it is not declining). 
        • The fact they are now trying to add back the tiny bit of understated amort that does touch their income statement is pretty ridiculous (discussed below)

Other tricks

• Report metrics in unusual, flattering ways – JCOM’s “churn” only looks at customers 4mo out.  Churn is incredibly high in the first 4mo, they just choose to exclude it so that reported churn can be “only” 30% a year. 
  • JCOM also “reserves” for churn when making acquisitions, I understand the “reserves” can in some cases be up to 20-30% of customer base acquired.  Then, as customers leave they aren’t reported as churn, and later JCOM at their discretion can decide the reserve was too high and reverse it, artificially increasing subscriber count and reducing reported churn. 
  • Notably churn came down abruptly 2yrs ago.  Mgmt cites a number of reasons about running the business better, then says under their breath they also paid credit card co’s to transfer their billing to new cards (so now if your card expires and you get a new one JCOM can just keep on charging, which speaks to how little customers want this service). 
• During 1Q12, JCOM “discovered” they accidentally had realized $10m too much revenue that should have been deferred as pure profit.  They brushed it off as a minor counting error on a small part of revenue, but of course $10m of pure profit is very meaningful for this company, and the counting error was pretty material – deferred revenue was $12m when it should have been $22m.  Of course they didn’t restate prior periods, they just took the hit to GAAP and got people to add it back. 
• And sometimes, JCOM would just stop letting customers cancel their accounts.  Think this was used more aggressively in the past around quarter closes, but some great youtubes out there (search “efax cancel” or “efax fraud”). 

Digital Media

So what are these new businesses?  The core is Ziff Davis (PCMag.com) – yes PC, Mag, perhaps the universal nexus of secular decline – and IGN.com, a website that reviews video games and some movies.  Pretty far out of JCOM’s expertise area, but I think they were running out of enough “cloud” acquisition targets to play the acquisition accounting games, so the mgmt team needed to buy something big enough to prevent investors from getting a clean look at JCOM’s business. 

Low quality sites

• Mostly product review – zero barriers to entry, proliferation of competing sites and fragmentation of traffic
• Business is simply about search engine optimization.  Try to get to the top of the search lists so someone looks at your site quickly and you can display an ad.  I don’t think many people are typing “pcmag.com” into their computers every morning to see what PCMag has to say about the world. 
• Follows the same JCOM playbook – cut out all costs to maximize today’s reported profit, but at the expense of future revenue declines (then maintain it’s not declining because you refuse to recognize the difference between organic revenue and acquisitions)
  • Switch from staff writers to freelance, lower content quality at lower cost, which causes traffic loss, hurts your search rankings over time as you get high rates of bounce back (Pcmag.com currently has 58% bounce rate, IGN has 47%)
  • Search linkedin or Monster for former IGN.com employees – you can see how JCOM cleared the decks.  If you speak with these people they’ll also probably have interesting insight about how fast IGN’s revs were declining before the acquisition.

The long term trajectory of these businesses is pretty clear – both down 90% over the last 10-15 years. 

• Ziff Davis / PCMag – JCOM purchased for $167m.  Mgmt said $60m of revs in FY13. In June 2000 the business was public and had $600m rev and $100m EBITDA.  So a 90% decline over 15yrs
• IGN.com – Purchased for $50m, Mgmt said >$60m of revs.  Newscorp bought this business for $650m in 2005, so 93% value decline in less than 10 years. 

Yet management gives investors the impression this is a high growth business:

• At digital media day, in conversations with investors JCOM gives the following impression –
  • Digital advertising industry is growing midteens, our traffic is through the roof, our assets undermonetized – investors come away with it implied that the businesses should organically grow midteens or faster.
  • Mgmt says incredibly high incremental margins when it grows.

You can now hear analysts ask about digital media on calls in the context of high teens / low twenties growth and huge incremental margins, so it seems they believe this.  But this just doesn’t seem accurate to me. 

• JCOM’s reported traffic stats seem directionally wrong compared to the independent data we can find.  JCOM reports huge traffic growth, but I think traffic is really declining or flattish (look at Comscore, googletrends, Alexa)
  • When JCOM bought Ziff Davis – they showed a slide showing ZD’s traffic growing 230% in FY11, 50% in FY12.  But with a little investigation you could figure out that a) the 2010 traffic base shown was only 7mo, so of course traffic about doubled off of only a half year base when they were coming out of bankruptcy, b) deep in the ZD financials filed later in an 8-K you can see ZD made a large acquisition in the period before JCOM bought them, which of course inflates the growth. 
  • Now, mgmt is playing the misleading acquisition metric game again – Reported traffic growth looks like it is exploding up 600%, which is just clearly due to comparing periods with acquisitions vs. periods without acquisitions, mgmt of course refuses to discuss in anyway the organic growth ex-acquistions
    • In contrast, Comscore says for the last 3 months PCMag.com’s traffic was +3%, +0.4%, -12.5%, and that IGN.com’s traffic was -4.1%, -8.1%, -14% (despite the new console cycle which would be a huge benefit to a website that focuses on console-gaming)
• On top of which think I think digital media’s ad rates decline
  • Total digital ad spending is growing yes, but proliferation & fragmentation of content is growing too, pressuring like for like CPM
  • Traffic continues to shift desktop to mobile, pressuring CPM (harder to show effective ad on small screen)
  • PCMag/IGN are “endemic” sites, which sees the fastest erosion – endemic means content specific.  Used to be that in order to advertise to someone shopping for a smartphone you’d have to advertise on a page about smartphone comparisons etc.  So those “endemic” sites would get huge adrates (PCmag for consumer electronics, IGN for console games).  Now Google knows who goes where, so they can target the customer looking for smartphones not just when he/she is on the product review site, but later when they go read Ladies Home Journal online.  This is rapidly compressing “endemic” rate premiums, which is a big headwind to PCmag/IGN rates
• I think mgmt is leading investors to believe a very innacurate picture of this business using a few tricks
  • Never says outright that it grows at those rates organically, just implies this.  Will once in a while slip in the term “including acquisitions” when discussing growth prospects
  • Plan to juice reported revenue with low margin businesses to give the appearance of growth
    • Buying lower quality revenue already – e.g. the Netshelter acquisition.  Netshelter does not own any sites with traffic, its merely a me-too niche advertising network – so has a small community of sites that sell adds through Netshelter, so JCOM recognizes full ad revenue (and counts the traffic of these other sites in its stats), but pays out most of that rev to the sites where the ad is actually displayed
    • Plan to enter the low-value wholesale traffic “targeting” business.  This is like what Google/Facebook do where they know everything about you, so they follow you around the web and serve you with ads for bonobos for a month after you look at pants. But the large networks have real data on you and can effectively target customers and sell targeted non-endemic ads at scale.  JCOM will just have this tiny glimpse that you fell on a page about smartphones (GOOG will already know this too b/c you like got there through a google search). 
      • Speaking with ad buyers, they can’t imagine why they’d buy wholesale-targeted ad space through ZiffDavis/IGN.  They’d buy it through real people with scale.  Much more importantly they don’t see how IGN could make a profit here.  Margins are thin to begin with, JCOM would be operating with much worse targeting data, and much smaller scale. 
      • I believe the plan for wholesale is really just a tool JCOM can lean on whenever they need to come up with revenue to show a little growth or at least offset declines in core digital media.  This won’t come with profit, but can fill revenue holes
      • Lastly the “high incremental margins” are true, for organic growth.  If you get more traffic & ad revs on existing site, that’s high margin.  But if you grow by acquiring new sites that come with their own expenses, I don’t think that is margin accretive.  If you grow revenue wholesaling traffic/ads, that hurts margin.  And importantly, if revenue organically declines, that high incremental margin works against you. 

So in summary – I think the “digital media” business is just another extension this management team has made to seek out acquisitions so they can keep running on the hamster wheel of buying very bad businesses very cheaply, to fill the holes caused by organic decline in their core business.  And as you can see recently, it requires >100% of JCOM’s cash flow to keep earnings from falling, so maybe the hamster wheel is starting to spin faster on them. 

Management’s 4Q game

I thought 4Q13 would mark the unravelling of mgmt’s digital media charade with 2014 guidance.  Up until that point, the media businesses were less than a year old, there weren’t historical financials, no one knew how to model them etc.  But given my views of the business I expected mgmt would struggle to guide to earnings growth in ‘14. 

What happened?  Instead of guiding below the $2.97 consensus, JCOM simply changed their definition of EPS so they could guide higher. 

• Old methodology was EPS ex stock comp. That was the basis for $2.97 consensus.  An on that constant definition of EPS, JCOM’s guidance would have been 3-10% below consensus and flat to down 6% y-o-y. 
• But instead, mgmt just changed the definition of EPS to now exclude stock comp and amort – on this new basis guided $3.27 - $3.47 (mgmt still hasn’t acknowledged what guidance would have been on apples-apples basis)
  • At the time of guidance, they told investors amort was 42c in ’13.  So if you assumed amort was flat, apples to apples guidance would have been $2.85-3.05, encapsulating the $2.97 consensus
  • But when the K was published – you could see that amort will be significantly higher at $34.7m next year based on acquisitions through 12/31.  This is equivalent to 54c of earnings.  And guided EPS included the large Feb ’14 acquisition, which I estimate adds another 6c of amort that wasn’t in the K’s numbers.
    • So really, that $3.27 - $3.47 guidance included ~60c of amort, and would be $2.67 - $2.87 apples to apples versus consensus expectations of $2.97
      • So guidance was really 3-10% below consensus, and flat to down 6% y-o-y 
      • Guidance also included a very large acquisition in FY14 completed a week before the earnings release, that would materially benefit the $2.67 – 2.87 earnings guidance but was not anticipated in $2.97 consensus. 
        • As always JCOM won’t discuss any metrics about how big the acquisition is, but we can infer it is about $28m of revenue
          • on 4Q call mgmt said backup storage revenue was “currently” runrate $40m, which they pointed out meant storage revenue was growing ~900% (ha!).  So last year’s rev was ~$4.4m, it would have grown 272% ex live drive which implies Livedrive is something like ~$28m of acquired revenue.
        • This would be the 5^thlargest acquisition the company has ever made -- $28m is a 7% increase in revenue
          • That 272% backup storage “growth” they quote also neglects to mention what we can impute about a Nov acquisition, which added at least $3.4m of online backup rev.
      • It’s easy to get bogged down trying to track this with almost no information – but right there we can show $31.5m of acquired “cloud” revenue that will benefit ‘14, which compares to guidance for cloud to increase revs $28-$53m.  And that $31.5m is just what we happen to be able to see from 2 acquisitions, there are multiples others already completed (e.g. metrofax), and management’s assumption of “ordinary course” acquisitions in the guidance which benefit the numbers as well. 
      • Aside from JCOM management’s little magic show changing the definition of earnings, it is clear guidance was materially below consensus.  3-10% below consensus just on the definition change, guidance might really be 10-17% below consensus if they didn’t include that huge acquisition made in ’14 that wasn’t contemplated by consensus. 
      • Yet with a little earnings definition sleight of hand, JCOM’s stock rallied 12.5% in the following week.  Maybe as an encore next year they will start adding back COGS to show earnings growth. 

Why amort isn’t an appropriate addback for this company. 

• I often find amort an appropriate addback. If the acquired business is stable and investing the necessary cash expense to sustain the business, there is no real cash cost behind amortization of customer relationships, brand equity etc. etc.
  • But, when a business is in organic decline, and the business model is to keep acquiring declining businsess, amort is a very real cash expense.  The cost to keep earnings flat means you need to spend cash to acquire more businesses, so the amortization of that purchase price on a declining business is representative of a very real cost.  It’s similar to the Tyco-scam on acquiring subs to hide the expense of replacing churn.  As discussed in the cloud section, I think amort in this case actually understates the true expense since so much is shoved into goodwill the income statement is not being hit with the full cash expense to maintain this business. 
  • Big picture, the realness of this cash cost becomes apparent when you are spending >100% of your free cash flow on acquisitions just to keep earnings flat. 

How I look at >100% of cash required to keep EPS flat

• Over the last 2 yrs – FCF generation was $300.4m(and $14m of that was cash from a one time patent settlement)
  • Note: mgmts’ “free cash flow” calculation sums to $340m over the 2 years, but includes $19m of stock comp which is real expense for equity owners, and excludes $21m of intangible spending which is a very real, and recurring expense
  • Spending to boost guided earnings was ~$450m-- $324.7m of acquisitions over 2 years plus I est. at least $50m for the large acquisition closed in Feb that was included in ’14 guidance, plus $64.9m of stock buyback.
    • JCOM also paid out $85m of divs over this period, or a 1.8% avg. yield. 
    • Side note - since they are spending more cash than they can generate, they did a bond issuance.  The company had $208m net cash when they issued and still have $100m net cash today, yet are still paying an 8.5% coupon on the $250m bond, which speaks to the low quality of the business model. 
    • And earnings were $2.69 in FY12, vs. guidance of $2.67 - $2.87 for FY14 on an apples to apples basis
    • So, JCOM spent 1.5x its cash generation to buttress EPS, and EPS was only flat over 2yrs.  Pretty weak. 

Other?

• Management continues to sell stock aggressively.  CEO owns a total of 194k shares, has sold 281k in the past 3 yrs.  Management now takes ALL their stock comp in restricted stock instead of options.