|Shares Out. (in M):||18||P/E||6.9x||6.2x|
|Market Cap (in $M):||231||P/FCF||7.0x||5.4x|
|Net Debt (in $M):||-50||EBIT||52||54|
I expect this write-up to get a low rating as some of my former fellow shorts in this name reflexively ding it. To them I say, you have been warned; the market just gave you 14 points of alpha in a week, get out now.
magicJack VocalTec Ltd. (CALL) sells very-low-end voice-over-IP (VoIP) service to consumers under the brand name magicJack. We were short CALL’s stock on-and-off throughout 2012 and 2013 as it gyrated from $28 to $11 to $28 to $11 to $19 to $13. Indeed, it was one of the stocks we most loved to hate, for reasons explained below. But now, with the business changed significantly and the stock at a six-month low below $13, it has become a compelling long. Adjusting for CALL’s $50m cash balance, the stock is trading at 4.9x 2014 EPS, 4.3x 2014 FCF, and 3.3x 2014 EV/EBIT, with the company buying back cheap stock at the rate of about 10% per year. I see roughly 100% upside (10x earnings ex-cash versus 14x for the S&P 500). The path to that upside is clear: most of the shorts have not yet realized the changes, and 25% of total shares are still shorted (which is 20 days to cover and 35-40% of the float, depending on which source you look at). CALL’s reported results are about to improve, starting with 3Q earnings in a week or two, which should spark a short-covering rally.
To summarize the summary, this stock has morphed into a surprisingly safe and perfectly legitimate unloved and underfollowed small-cap that any fundamentals-based value investor could buy and own for several years. In addition, it seems perfectly set up for a sizeable short squeeze that should get you your returns sooner rather than later.
For background, I urge you to read Tyler’s excellent February 1, 2012, write-up of CALL as a short, which is what originally sparked our involvement on the short side. The comments thread is also informative; it eventually became mostly a dialogue between Tyler and me.
CALL was an easy stock to hate for the following reasons:
Almost all of that has now changed:
DIGGING INTO THE NUMBERS
There is little more to say, other than to provide the numbers backing up the story. The earnings releases are still not great, but the SEC filings do a good job of breaking down the revenues into meaningful segments. Those segments are:
Here are the recent quarterly numbers by segment (in thousands):
The first two segments are the important ones – sale of magicJacks and license renewals. magicJack sales growth peaked at 108% during their last product launch, and lately it has fallen off a cliff. But license renewal growth has been strong and accelerating.
Management has guided to $155-160m revenue for 2013, which is -2% to +1% growth, but – they say – +3-7% growth if one excludes $8m in “one-time and discontinued revenue” from 2012. Unlike a few quarters ago, I believe this guidance. They also guide to $52-55m “adjusted EBITDA,” which is 10-17% growth. From the EBIT line, “adjusted EBITDA” will exclude roughly $5m in D&A and make another ~$2m of bogus adjustments. Call it $45-48m EBIT. I think that number is too low. They gave the guidance with 1Q results, and based on 2Q actuals and their revenue guidance, I have trouble getting below $52m EBIT for the year. With a 34.6% tax rate (guidance) and an average share count of 18.4m for the year (assumes modest buybacks since 2Q), that’s 1.83 of EPS. The one published sell-side estimate, from Oppenheimer’s report after 2Q earnings, is $35m net income and $1.87 EPS. I think that is a bit high, but no one trades this stock off that published estimate. With another $8m in cash generated during 3Q, as of today the company has roughly $50.6m in cash and no debt, or $2.78 per share. The stock is trading at $9.88 ex-cash, which is 5.4x 2013 earnings ex-cash.
Who knows what 2014 will bring, but it seems reasonable to assume CALL can get back to modest revenue growth. With 5% growth, flat margins, a flat tax rate, and no buybacks, they will earn $2.04 and are currently at 4.9x excluding today’s cash. (Oppenheimer also estimates $2.04.) In real life, they will probably do more buybacks, which will boost the EPS number and further reduce the earnings multiple; they will have less cash but will shrink the share count by more than enough to compensate.
As a cross-check on the reasonableness of the guidance and full-year numbers, here are my more detailed estimates for 3Q results, which are based solely on three items: (1) the historical line-by-line quarterly results, (2) the June 24 launch of the next magicJack and an accompanying boost in marketing, and (3) the assumption that revenue guidance is solid. Of course these will end up being wrong, but they still give a good sense of that range of possibilities:
$18m sale of magicJacks – that is still down 13% YoY but up significantly QoQ
$15m license renewals – this number should climb another ~$1m from last quarter, as it has been doing
$1.2m shipping and handling – rises in line with magicJack sales
$2m magicJack-related products - steady
$3.2m prepaid minutes – steady
$1.5m access and termination charges – steady
$41m total revenue – 0% YoY growth
$16.4m cost of revenue – 60% gross margin, well below recent quarters due to mix shift back to hardware
$4.5m advertising – well above recent quarters but slightly down year-over-year
$6.9m G&A – steady
$0.8m R&D – steady excluding the 2Q spike
$12.4m EBIT – that is 11% year-over-year growth
$0 other income – compared to 4m profit from selling puts in 3Q12
$4.4m taxes at 35% rate
$8.1m net income
18.3m share count – modestly down from last quarter due to continued buybacks
$0.44 EPS – down year-over-year only because of last year’s profits from selling all those puts
DID I MENTION THAT FREE CASH FLOW IS MUCH BETTER THAN GAAP EARNINGS?
CALL has excellent cash-flow characteristics. When it sells a new magicJack, it is paid for the equipment and a year’s worth of call subscription. The call subscription portion of the payment is booked as deferred revenue and converted into revenues on the operating statement over the course of the year. The same thing happens when someone renews their subscription; most renewals pay for a full year up front. Thus, when the business is growing at all, cash flow exceeds the stated revenue growth. For example, I am assuming 5% revenue growth in 2014; if that ends up being right, I see $2.04 in earnings per share but $2.33 in FCF per share.
TWO UPSIDE WILD CARDS THAT I AM NOT INCLUDING IN THE NUMBERS
CALL has been offering an app for smartphones, which as of June 30 already had 4.4m users versus 3.4m equipment-based subscribers. They have not done much yet to monetize the app, and management says it will not contribute materially to revenues in 2013. But that could change, either through new subscription fees or more display advertising.
Also, management says they intend to expand internationally. On the one hand, by far the majority of VoIP usage takes place outside the U.S. On the other hand, there is plenty of competition outside the U.S., and far more people have made the shift to Skype/Google than in the U.S. Given CALL’s ultra-low pricing, international expansion could be a nice growth driver for them, or it could be a bust.
VALUATION AND RISKS
If I assume 5% annual revenue growth each year, flat margins, a 3.5% terminal growth rate, and a 10% discount rate, my standard DCF model spits out a value of $43 per share. There is no way I would own this stock at $43. It is a small-cap stock (verging on micro-cap) with a terrible reputation among investors and, I still believe, a mediocre product. It faces two obvious risks:
So what is a fair stock price? I will stick my thumb in the air and say a 30% discount to the S&P 500, 10x 2014 earnings instead of 14x. That would yield $2.04 x 10 = $20.40. Assuming $8m in 3Q earnings, they should have $50.6m in cash today, which is $2.77 per share, yielding a target price of $23.17, for a minimum 80% upside. The upside increases either if you assume the company continues buying back stock at anywhere near the recent pace (which seems likely), or if you are willing to give a multiple of (higher) FCF rather than GAAP earnings. If you do both, you get closer to $2.50 per share of FCF in 2014. $2.50 x 10 = $25.00 + $2.77 = $27.77 = 120% upside. Remember, this stock actually hit $28 twice last year. During that period, Borislow offered 2013 EPS guidance of 2.00-2.50, which seemed ridiculous at the time and in fact was way off for 2013; I would not be surprised if he was assuming $0.50 in profits from put-selling. Waddayaknow, 2.00-2.50 is now precisely the right range for 2014 EPS and FCF/share.
If a real short squeeze gets going and the day-trading momo muppets pick up the story again (as they have several times before), the multiple could move a lot higher than 10x.