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:

• Its CEO, Daniel Borislow, seemed straight out of central casting for “penny stock promoter / manipulator” rather than business executive.  Borislow had a reputation from before CALL and lived up to it while at CALL.
• There appeared to be almost no company underneath Borislow, i.e., no “real” senior management.
• According to most reviews, the product was terrible.  VOiP call quality was poor, it dropped calls, it didn’t work for a number of expected functions (inbound calls, conference calls, caller ID on call waiting, faxing, porting your existing phone number), and customer service was non-existent.
• The business model appeared to be a product pump-and-dump: a blitz of TV advertising on late-night reruns that would get product out the door, and if the product didn’t work, oh well.
• Their product cycle of a new product launch + advertising blitz created predictable growth spikes followed by fall-offs, which would spike and tank the stock.
• Earnings-related press releases were laughable, with selective disclosures, unrealistic and ever-changing guidance, made-up earnings metrics, selective pre-releases clearly designed to spike the stock temporarily, and earnings calls with Borislow rambling and no questions taken apart from perhaps one pet sell-side analyst.
• CALL was making large chunks of its net income by trading its own stock rather than selling product.  Because CALL became a favorite short target, borrow cost and put premiums were very high.  CALL sold mountains of puts on its own stock and, over one six-month trading period, booked roughly $10m in trading profits compared to $20m in EBIT.  (The next quarter it booked a $3m loss on that trading as the stock price declined.)
• The stock valuation was at high multiples that made no sense unless the growth would sustain, which it didn’t.

Almost all of that has now changed:

• Borislow stepped down as CEO in December.  (Even CALL’s own press release quotes him saying, “So the Dan Borislow show is coming to an end.”)
• They have a new CEO and CFO who sound reasonable on the earnings calls.  They also appointed a new “real” board member in April.
• The product has improved.  Shockingly (at least to me), in January magicJack received Frost & Sullivan’s award for “Overall Best VoIP Service Provider,” winning the highest score in all five ratings categories.  (Here is the press release.)  Frankly, I still don’t quite believe the Frost & Sullivan award, but if their findings are even half true it is a remarkable improvement.  Based on my own searches, recent consumer reviews are still very mixed – some still very negative but some positive – rather than universally terrible as they were before.  Many recent Amazon reviews are still one-star, but there are an equal number of 4-5 star reviews saying “it works fine.”  (The ratio is literally 234 with 4 or 5 stars and 233 with 1 star.)  Clearly magicJack works for some but not all people, and if it doesn’t work for you, you might as well just throw it away, because customer service is still virtually non-existent.  But many customers appear to understand that “you get what you pay for,” as even Amazon’s #2 “most-helpful” positive reviewer says.  Some people are willing to trade off very cheap pricing for a lack of support.  (Service with free calls to U.S. numbers costs $19.95/year, which is $1.66/month.  That is stunningly cheap even for someone like me who has been involved in telecom and specifically in VoIP for almost 15 years.)
• The business model has evolved.  An initial magicJack purchase has always included the physical equipment plus a one-year subscription of free calls.  CALL has been selling less new physical product recently, but as the existing customer base has grown and matured, CALL is getting more recurring revenue as customers’ initial periods expire and they pay to renew their subscriptions.  Revenue growth is smoothing out, and margins are rising as the mix shifts from hardware to services.
• Earnings releases and earnings calls are much better.  They are more professional, and they now spend most of the earnings call talking about the recurring nature of their revenues and the strong free cash flow characteristics (which is accurate).
• They stopped selling puts on their own stock.
• 3Q12 was their peak revenue quarter after the last new product launch in 3Q11.  Revenue predictably declined in the following quarters.  3Q13 was their latest product launch, which should get them back to flattish revenue growth in 3Q13 and positive growth in 4Q13.
• The stock is very, very cheap.  (Valuation below.)

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:

• Sales of magicJack and magicJack Plus – the initial hardware plus a 1-year subscription for “free” calls in the U.S. & Canada
• License renewals – people buying another years’ subscription for “free” calls
• Shipping and handling – varies with the initial magicJack purchases
• Sale of magicJack-related products – largely the purchase of Canadian, vanity, or custom phone numbers.  (E.g., if you port your old phone number to magicJack, that costs $9.95 per year.)
• Prepaid minutes – customers buying minutes for international calls
• Access and termination charges – paid by other carriers to CALL for inbound calls

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:

• Each round of new product doesn’t sell as well as hoped.  In particular, the 2011 upgrade from the original magicJack to the magicJack Plus was significant, because the original needed to be plugged into a running computer while the Plus could be plugged directly into a router.  The latest upgrade appears much less significant, so it probably won’t generate anywhere near as large of a sales bump.  (That is factored into my numbers.)  I fully admit that 3Q sales of the new magicJack could have been disappointing, and the stock could fall further in the short term.  Similar risks exist for later iterations.  However, it is hard for lower product sales to generate true longer-term downside for the stock at this valuation when half the revenues are now recurring rather than product sales.
• Over time, technological changes could reduce the overall demand for VoIP services.  Some new innovation could move everyone off paid voice altogether.  Or VoIP pricing could collapse.  That risk seems remote in the near term.  Services like Skype and Google Chat/Hangout have ramped fairly far up their adoption curves.  Across its different interations, VoIP pricing has been stable for quite a while, and the prices of other paid services are multiples of CALL’s price. 

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.