Description

I’m about to tell you the story of a formerly successful company, afraid it’s core business was getting too tough, that is burning an amazing amount of cash trying to launch a new business that doesn’t appear like it can ever succeed. You’ll probably be asking yourself why I’m recommending such a mess, well please hold on for the end of the tale and the value that’s buried within. Note that I hammered this out very quickly since it appears to be a short term opportunity, apologies in advance for any errors and/or poor grammer.

Metro One Communications (MTON) is a company that provides directory services to phone companies, the simple description is they are the people who answer the phone when you call 411. This service is very important to your typical phone company, since 411 is one of their cash cows. The phone company pays MTON 46-47 cents to handle each call and typically charges $1-$1.25 cents to the user, so it’s almost pure profit for them. And it was a great deal for MTON, which ran revenues up to $257M two years ago with $26M in profit ($1.04 per diluted share) and AT&T, Sprint, and Nextel as key customers.

Well, those days are over. They lost Sprint last year and AT&T is leaving them this quarter. Their revenue run rate will be about $100M after AT&T leaves. It’s apparent they felt they would have trouble retaining contracts as early as last year, so they developed a new product called InFone to try to take the place of their deteriorating core business and launched it about a year ago. InFone is basically a 411 service with many additional features (including 15 minutes of free long distance), but accessed through a 1-800 number, and charged to your credit card at a discount rate of only 89 cents per call. In what some would call a very aggressive rollout (others may call it a ludicrously bad waste of shareholder resources) they spent $50M on a massive national ad campaign, and from the results it appeared they launched without any testing. That $50M netted a total of 58,000 InFone users as of February or a customer acquisition cost of $850 each.

This wouldn’t be so bad if each individual InFone user was likely to generate a great deal of revenue, but they aren’t. The company spent another $6M marketing InFone in Q1 to end up with 70,000 clients (bringing acquisition cost is down to $500 each!). During their Q1 conference call they stated that 30% of those customers were using the service an average of 8 times per month. Let’s call this segment “power users” and my estimate is that they are worth about $40 per year in gross profit before marketing costs. I’m basing this by pegging their costs at the same 47 cents per call, assuming their 411 profit margins were roughly equal to long distance costs on the InFone service. This provides 42 cents in gross profit per call, or $40 per year per “power user”. As for the 70% non-power users, a conversation with the CFO confirmed my assumption that many are one-time users, so they are basically worthless. If one makes reasonable assumptions about the turnover rate for power users, say assuming they have a three-year membership on average, which would make their total present day value at around $100 each.

So the math on InFone is pretty simple, and simply awful. The company is now spending about $6M per quarter on marketing, or $24M per year. To generate a gross profit of $24M per year requires about 600k power users. Right now they have about 21 thousand. So to make this business a success, they’ll need about 30 times the number of users, after they’ve already burned through about $60M in marketing costs. And they’ll have to find a way to sign up these large volumes of InFone “power users” for less than $100 each, hopefully substantially less since they don’t have another $60M to throw at this. And last quarters $500 per user acquisition cost actually works out to $1600 per “power user”, so they are about as close as NASA’s Manned Mission to Mars is right now. And not only is InFone unlikely to ever turn a profit in time, but it’s very existence is probably an irritant to existing clients and a barrier to signing new clients.

So why am I recommending this position? It’s not because I think InFone will be a success, just the contrary. It’s because I think InFone has been such a terrible failure that it’s very likely to be canceled or scaled back significantly within the next two quarters. And I think that at current prices ($1.50 or a $40M market cap) MTON is priced as if it is heading for bankruptcy, while it still possess substantial assets.

Let’s go to the balance sheet and see what the company is worth. Current book value is $135M, or a little more than $5 per share. Much of this is telephone equipment (partially depreciated), but they do have $54M in cash ($4M restricted). Running a liquidation scenario gives me a valuation range of $1.71-$2.66 based on what I hope are conservative assumptions that the equipment is worth between 25-50% of book value, that future burn until a restructuring will be reasonable, and that $30M in future lease commitments can be renegotiated or subleased to provide savings.

Worse Best
Shareholder equity $134,489 $134,489

Prepaid Costs $ (6,914) $ (6,914)
Equipment $ (44,009) $ (29,340)
Intangibles/Others $(5,522) $ (5,522)
2 Quarters burn $ (20,000) $ (10,000)
Option Exercise $ 4,500 $ 2,250
Operating Leases $(15,000) $ (15,000)
Net $ 47,544 $ 69,964
Shares 27775 26275
Per Share $ 1.71 $ 2.66

But along with liquidation value, you are also left with a $100M run-rate business that they’ve been (in the past) able to generate over a 10% after tax profit from. Assuming that on their smaller scale they’ll have less operating leverage and will need to discount more to keep 411 clients, I’m targeting a 5% after tax margin. At today’s run rate that would generate $5M in profit, which should justify a valuation of near $50M on it’s own..

So looking at this position you are left with three possible outcomes.

1) InFone is a success. This would make an investment at todays’ prices a huge home run, but is, to say the least, a big long shot.
2) They continue to burn shareholder equity. Under this scenario I think there is at least 9-12 months before their liquidation value drops below todays prices.
3) They cancel or curtail InFone to focus on their old business. This should cause an immediate pop in the stock, and should put them closer to a $3-$5 valuation. And if the stock doesn’t respond strongly, the company has plenty of cash for a one time dividend or share buybacks.

So what are the chances that management comes to their senses? Based on my call with the CFO, I felt like it sounded like they had started the journey. I emphasized to him that I could see no way InFone making money and that they are well undervalued at today’s prices. But obviously, no announcement has been made yet. My gut tells me this quarter is too soon, but that we’re getting close. Of course my gut also told me that the Arizona Diamondbacks were set for another World Series run, so it’s accuracy is not 100%.

Risks:
The biggest risk is of course continuing to throw money at the InFone effort. But I’ve identified several other pertinent risks.

Operational – To demonstrate value in their 411 business, they have to retain their last large client (Nextel) which is around 70% of their remaining 411 business. And they have to be able to scale down to a profitable size and compete effectively for new 411 business. I think they can since this isn’t a business that’s likely to be heavily outsourced overseas. Quality is what counts here, companies are willing to outsource costs such as customer service to the cheapest vendor to save money, but 411 is a profit center and they want to promote heavy use by providing good service and an American accent. But if I’m wrong they are at heavy risk of overseas-outsourced competitors. I believe this whole InFone mess just distracted management and am betting that with a suitable focus on the 411 business that they should be able to stabilize it. And if they can regain some old clients, there is even bigger upside in the model.

Enterprise Market – The CFO mentioned to me that they are looking at entering the enterprise market to sell 411 services directly to large corporations (reprogram your PBX to point your employee 411 calls to MTON, get much better/cheaper 411 service). Going after large company PBX market may not be taken well by existing and potential 411 clients. I’m withholding judgment here since I think it’s probably going to be a small enough effort it won’t raise too many red flags, at first. And it’s interesting upside if it works, but is probably not enough revenue and may have it’s own customer acquisition cost issues, to make much of any upside here.

Oregon Based – As a former Oregon resident, it’s not a surprise to me that Oregon apparently has some stricter anti-takeover laws that make it more difficult to replace boards, so the influence of a larger shareholder here may be limited.

Personal Disclosure: I’ve bought put around 3-4% of my portfolio in MTON between $1.52 & $1.62.

Catalyst

Canceling or scaling back their InFone service before they burn through a significant amount of shareholder equity