Value Investors Club / SPARK NETWORKS INC (LOV)

Description

Spark Networks (LOV): LONG, $3.81

Spark Networks—the owner of online dating platforms JDate and Christian Mingle-- has been written up

5 times on VIC (most recently by RJM59 in October, 2013), so I’ll minimize the overview/ background

information and get straight to the point. A good bit of the logic of RJM’s write-up still applies

(particularly with respect to potential exits)— I recommend it—meanwhile, the stock price has fallen

more than 50% and there’s now clear evidence of renewed profitability following last Thursday’s results.

Synopsis

o 2014 proxy battle resulted in new Board with significant share ownership

o BOD has replaced CEO Liberman—an internal hire with a legal background and visions of sugar

plums dancing in his head—with Michael Egan, formerly an exec with Internet Brands, Inc. and

Yahoo. Egan has brought in a new CFO (formerly with Square).

o New BOD and management team have drastically reduced marketing expenses and eliminated

land-grab, pie-in-the-sky growth strategy. New focus on profitability, maintaining/ polishing the

key asset (JDate).

o Reduction of marketing blitz expenditures uncovers the attractive economics of the core

dating business: 25 – 30% EBITDA margins.

o 4Q14 earnings show early results: $3.2 million in EBIT for the quarter.

o $82MM EV implies ~8X 2015E EV/ EBIT multiple assuming continued modest contraction in

subscriber base & increased non-marketing cash opex

o Upside tied to possible renewed growth in subscribers in 2H15 as the company enhances long-

neglected products and introduces high-margin add-ons tied to JDate and Christian Mingle

(“Mingle”).

Proxy Battle

In 2014, long term shareholder Osmium Partners (~14% ownership as of most recent disclosure), along

with 402 Capital (~5%), led a successful effort to replace Spark’s BOD with its own slate. The new BOD

includes Osmium, 402, new CEO Egan and 4 outside directors. By virtue of Osmium and 402’s presence,

an owner’s mentality has clearly been installed at the Board level—a breath of fresh air after the

extremely light outright share ownership of the previous Board and management team.

New Management Team / New Game Plan

Previous management, in the estimation of many, had pie-in-the-sky notions with respect to the Mingle

segment (c. 57% of total revenue, with 141k members in 4Q2014). Management enunciated a top-

down vision of a future Mingle encompassing millions of members, based on shaky (crazy?)

assumptions:

(spurious adoption rate) X (total # of Christians in US) = thriving, 7-figure subscriber base

In an attempt to realize that vision, management poured over $120 million (again, significantly more

than the current enterprise value of the company…) into marketing expenses from 2011 to mid-2014,

relying heavily on direct advertising. Net earnings plummeted from c.$9 million in 2007 to a loss of $15

million in 2012, and a loss of $12 million in 2013. They raised equity to the tune of 7% dilution in 2013

to continue to feed the marketing beast.

Ultimately, the result was a very heavy cash burn, extremely high Mingle subscriber acquisition cost, and

a revolving door in much of its membership, due primarily to churn in Mingle. Continued marketing

expenditures were mandatory to bring new feet through the door, and despite the untimely equity

raise, cash dipped to a level where the business plan was seriously called into question. Personally, I

have long felt (see 2013 discussion board) that Mingle is a product that will appeal to a niche audience;

the geographic density advantages inherent in the JDate model will prove elusive in Mingle’s case.

New leadership, led by the BOD, CEO Michael Egan (hired 4Q14), and CFO Robert O’Hare (1Q15), has

begun to implement the overhaul laid out by Osmium and 402 in the proxy contest. Egan brings

relevant experience as former senior executive at Internet Brands, Inc. and as a former manager at

Yahoo; O’Hare previously served as Corporate Finance and Investor Relations Lead at Square, Inc., as

well as Director of Financial Planning at Pandora.

The new plan is music to the ears of a value investor:

o Drastically reduce marketing spend, and increase efficacy of future spending

o Minimize distractions and re-focus efforts on 2 core brands: JDate and Christian Mingle

o Protect and reinforce the moat of the key asset, JDate

o Emphasize profitability instead of land-grab subscriber growth (25 – 30% EBITDA margin

target mentioned in proxy materials)

o Bring products into the 21st century (e.g., no viable mobile platform until ~6 months ago…)

o Raise ARPU with product add-ons and enhancements

o From the proxy materials: “Once back-to-basics plan is executed, explore all

opportunities to maximize the value of the platform”

The early impact is apparent in 4Q14 year-over-year results (emphasis is mine):

	4Q2014	4Q2013
Revenue	14.3	17.2
Cost of Revenue	6.1	13.9
Total Costs & Expenses	11.0	20.7
EBIT	3.2	(3.5)
EBT	3.0	(3.4)
Net Income	3.9	(3.5)

What we see is a drastic reduction in marketing spend, which predictably results in a hit to the top line

(given the churn at Mingle in particular), along with a disproportionate positive bump to EBIT. In effect,

the underlying profitability of the business—obscured in past years by Mingle’s out-sized marketing

spend—has been uncovered. For what it’s worth, “bulls__t earnings” (Munger’s term), otherwise

known as Adjusted EBITDA, were $4.1 million for the quarter—the highest since 3Q2008.

Balance Sheet

At 12/31/14, the company had $11.7 million of unrestricted cash (note: up $2.4 million sequentially),

$1.0 million of restricted cash, and no debt. With an untapped $15 million line of credit with BOA, the

company had ~$27 million of liquidity at 12/31. The company carried about $3 million of operating

leases as of the 9/30/14 10-Q.

Valuation

At $3.81 (Friday’s close), the company’s diluted market cap is ~$94 million. Subtracting unrestricted

cash leaves an Enterprise Value of ~$82 million. I’ll ignore Adjusted EBITDA and EBITDA, despite the fact

that such figures would undoubtedly weigh heavily in a corporate sale. I’ll also ignore net income, which

includes a favorable tax benefit. The company generated $3.2 million of EBIT in 4Q2014 (4Q capex has not

been released as of this writing; for reference, YTD 9/30/14 it was $1.6 million, equal to D&A). The art

here is to determine the low point of subscriber base and ARPU, now that the company has slashed its

direct marketing spend.

After factoring in modest continued declines in membership, assuming relatively flat ARPU, and

assuming some investment in product and beefing up the management team (note that CFO said he

expects “double digit increase” in cash operating costs outside of direct marketing)-- I believe the

company will generate a minimum of $10 million of EBIT in 2015. I think that’s pretty attractive in light

of LOV’s $82 million enterprise value.

For a more aggressive take on valuation and exit multiples, as A) a function of EBITDA contribution

margin to a potential acquirer; and B) a function of subscriber headcount vs. market comps, I refer you

to RJM’s write-up from October 2013.

Potential upsides

1) Reinvigorated subscriber growth, 2H15 as the company’s product enhancements take root, and

marketing efficacy improves;

2) Enhanced ARPU through add-ons to JDate and Mingle: security features, event revenue,

additional services related to core business (featured profiles, gift cards, premium

matchmaking)

Risks and concerns

The market has clearly been spooked by the overall declines in revenue (-17% vs 4Q2013) and subscriber

base (-22% vs. 4Q13) as the company has shifted its game plan and slashed its direct marketing expense.

Spark failed to invest in its key asset, and in addition to its other missteps under previous management,

the company suffered from a faulty e-mail marketing partnership which resulted in additional

membership attrition.

I’m personally more concerned with the drop in subscriber count (-12% yoy) and ARPU (-4%) specifically

at JDate.

Fundamental to the thesis here is that JDate—which has generated a contribution margin of 90%+ in the

past, and 80%+ in the recent past—will stabilize with the introduction of new products (e.g., JDate

mobile app finally released in 2014) and with renewed focus from the management team. JDate has

very attractive economics, with high returns on capital, and average ARPU that is among the highest in

the industry. Moreover, the strength of this mini-franchise is such that it continued to produce

attractive margins despite the fact that by its own admission, Spark had not launched a major new

business initiative in JDate in more than a decade prior to 2014. That negligence, along with the

aforementioned flawed e-mail partnership, is reflected in the segment’s results.

Moreover, to what extent will Christian Mingle collapse as the marketing engine is vastly reduced in

size? On a personal level, I waited to invest in Spark until I felt the market value of JDate alone in a

private sale would exceed the Enterprise Value of the company.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Visibility of earnings power of JDate via elimination of excessive direct marketing spend

2 show sort by

			2015	2016
Price:	3.81	EPS	0	0
Shares Out. (in M):	25	P/E	0	0
Market Cap (in $M):	94	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	82	TEV/EBIT	0	0