Description

Spark Networks (LOV) continues to be attractive even after some recent run up (and fortunately pullback recently) for the following reasons:

• High ROIC, high margin business with a defensible moat
• Operates in a large target market with a long, predictable runway for growth
• Recurring revenue model with consistent and predictable revenue
• High likelihood of being acquired at a significant premium due to real cost synergies to a strategic acquirer
• Very reasonable growth assumptions get us to a potential double in 2-3 years

While Spark Networks (LOV) has been written up and presented on before, we feel we have some unique ways of looking at the thesis. There is also some opacity in the business model we will try to shed light on, as most people underestimate the margins in this business.

We will try and keep the majority of the write up to points about Spark we have not seen presented elsewhere, while still rehashing enough for those unfamiliar with the thesis. Spark Networks is a niche online dating business that has two key primary brands – JDate and Christian Mingle. JDate is a cash cow, 90% contribution margin (revenue-marketing expenses) business that generates cash to fuel growth in Christian Mingle – the high growth business segment. Christian Mingle grew 37% in Q2 2013. Christian Mingle is currently running at a negative contribution margin in order to fuel the rapid growth.

We believe LOV is misunderstood and improperly valued mainly due to the high margins the business can achieve at scale.  According to our discussions with management, a strategic acquirer would be able to buy Spark’s business and generate EBITDA based on Revenue – marketing expenses (contribution margin) – Credit card processing fees - customer service. So the primary line items that can be taken out by an acquirer would be R&D and G&A.

Downside

We believe the downside is well covered.  The lowest acquisition multiples we have seen are around $400/sub for People Media, a financially stressed dating business acquired in July 2009 (Russell up almost 100% since then). We believe JDate is the highest quality online dating business, generating roughly $160-$180 in EBITDA/sub.  Valuing Christian Mingle at People Media’s valuation of $400/sub and Jdate at 5x EBITDA or 800/Sub gets us to 68 (JDate)+80 (Christian Mingle)+18 (cash)+10 (other businesses and web properties) or $7.40/share.  This we view as a scenario where Christian Mingle turns out to be a disaster, and we don’t really view this as a possibility given that Christian Mingle grew 37% in the last quarter. We merely point this out to demonstrate the downside protection afforded at today’s prices and how draconian are assumptions could be and still breakeven.  Meetic, acquired by Match.com for 508/subscriber, is a closer comp to Christian Mingle, though it was stagnating and had essentially no growth when it was acquired.

Meetic does not nearly have the dominance that either JDate or Christian Mingle have in their segments, nor does it have anywhere near the growth potential of Christian Mingle or the operating margins of JDate.

When we think about the strategic value of JDate, we have a differentiated view as to their earnings power. 

JDate has roughly 90% contribution margins and the only additional fees to an acquirer would be credit card processing fees and customer service, which are approximately 8% of sales. That means the EBITDA margin for a strategic acquirer could be as high as 82% (90% contribution margin-8% for credit card processing and customer service). So 82% of JDate revenues is approximately 20M in JDate EBITDA to a strategic acquirer. A conservative 6x multiple on JDate implies 120M of value for Jdate.

This seems reasonable given a previous offer made for Spark Networks (include news article showing 185M offer). We believe 6x EBITDA is conservative because JDate has an incredibly entrenched moat in the Jewish community and is a fantastic business. JDate has a unique and defensible position in a business that lends itself to having a moat due to the network effects of the business model (winner take all model). We see how difficult it is to create a niche dating site in that Spark Networks has tried unsuccessfully in so many different verticals (Military singles, LDS singles, black singles, ETC). They have only managed to succeed in Christian Mingle and JDate. [Creating a niche site in an empty field (ie. LDS singles) is hard enough; imagine how hard it would be to create another niche site aimed at Jews. JDate should be in a strong position for years absent serious technological change creating an opportunity for someone new.]

When valuing Christian Mingle, we look at the takeout of eHarmony for $1,100/sub, IACI trading at about 9x EBITDA and that Match.com generates about $100 EBITDA/sub or a value of ~$900/Sub, as backing up our assumptions.  We would also note that not all of Match is the high quality match.com asset, but also has some lower quality dating businesses.

We believe Christian Mingle can generate at least $70-100 in EBITDA/sub or more at scale. We value Christian Mingle subs at least at $600-800/sub, which we feel is very cheap for a business growing ~40% annually with a long runway for growth. At the end of Q2, there were ~197,000 Christian Mingle subscribers, worth 138M, or $6/share in current value. More importantly, that value is growing by 40-60k subs/year, or at the midpoint 50k subs, which is 35M of annual value increase or ~$1.50/share/year. It is possible Christian Mingle continues to grow even faster, and adds intrinsic value of $2+/share per year.

An important data point divulged during the secondary roadshow was managements estimate for contribution margins for Christian Mingle, they estimated contribution margins at between 45-88%, and said they believed it would be towards the high end of that range. The 45% comes from the contribution margins that a low quality dating business such as one of Spark’s smaller businesses like LDSsingles.com or silversingles.com would garner. The 88% is just under what JDate generates, and is higher than we would expect for Christian Mingle.  We estimate Match.com generates 60% contribution margins, and we think this is a reasonable number for Christian Mingle. Given that, Spark is currently on a run rate excluding growth marketing spend of just under 30m of EBITDA. This means it is trading at 5x normalized EBITDA, which is extremely cheap given the high quality nature of the business, and also given the fact that a strategic acquirer can strip out so much cost when they acquire the business.

While it makes sense for a strategic acquirer to purchase Spark given there are real synergies, we need to first and foremost look at the business on a public company basis, excluding the idea of an acquisition. There is significant operating leverage in the business.

The actual EBITDA number will be lower than that because Christian Mingle will be reinvesting a significant amount of cash flow into continuing to grow the business. This assumption is based off of a more mature margin structure. At a 9x multiple of EBITDA (where IACI trades) Spark would be worth 360M or $16.70/share, roughly a double from today’s prices in 1.5 years.

One other point we do not see mentioned for Spark is the opportunity they have for advertising across their faith.com, believe.com, and dailybibleverse.com websites. Management stated their goal would be for advertising revenue to reach a double digit % of overall sales. While we do not factor this into our model at all, this would have dramatic upside in EBITDA growth because essentially all of the advertising growth falls to the bottom line. Dailybibleverse.com for example is an incredibly simple site that takes almost no capital to maintain/update. We estimate that advertising revenues are currently in the $2-4M dollar range. If advertising revenues were able to reach 10% of sales in 2014, or approximately $8.5M, assuming 90% GM’s that would increase EBITDA in the range of $4-6M.

You can follow the growth and success of Spark on compete.com and google trends: http://www.google.com/trends/explore?q=christian+mingle#q=christian%20mingle&cmpt=q

https://siteanalytics.compete.com/christianmingle.com/

Neither one of these is perfectly reliable, but they tend to be approximately correct in showing traffic count and search interest respectively.

Risks:

Spark does not break out the return on marketing spend that they achieve. They assure investors the number is high, but it is difficult to do anything other than look at competitors high return on marketing spend to know this.

A significant competitor enters their vertical, such as match.com entering the Christian Mingle vertical. For reasons already stated, we think it makes sense for match to buy vs build in this case, so we view this risk as mitigated.

Technology is always a concern here, but we think for serious daters looking for a long-term partner, online dating businesses are here to stay. That does not mean the market is not segmented – there is social media driven dating, free dating sites, mobile dating sites, and paid dating sites. That being said, we believe for the serious person looking to find the most well developed profile, a paid online dating site is the best option.

Great Hill Partners, a large private equity firm invested in Spark Networks, recently sold a part of their position. It is possible they know something we do not. More likely however, is anecdotally we have heard that Spark is the last position in their portfolio and they are trying to wind down this fund, which seems logical.

Other Things to incorporate:

Room for Upside

If we look at historical SAC for Spark they have paid roughly $500 per net sub -they spent 100M to acquire 200,000 subs. They are now spending over 50M/year, so if cost per sub stays stable, they will be adding 100k subs/year, which is meaningful upside from our estimates. 

Spark is penalized from a GAAP accounting standpoint in how they market to new customers. Many businesses are able to capitalize their advertising spend when they are getting customers over a long period of time. However, in the case of Spark, they are unable to do this because even though they are getting customers over a long period of time, they have an uncertain customer life – even though they know they are benefitting from one customer win over several years. For example, in year 1 the customer signs up, finds a girlfriend, and dates her for two years. In year 3, they break up, and he signs up again for another 6 months until he finds another girlfriend.

January 2008, NY Times said Spark is close to being sold for $185 million or $850 per subscriber - http://ca.reuters.com/article/technologyNews/idCAN0359774420080104

If you back out the low quality OAN subs of 113,000 at $300 sub you come up with 34M of value. 185M-34M puts 151M value on JDate or $1590/sub. At today’s levels, that would make JDate worth $135M, fairly close to my 120M estimate.   

Catalyst