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United Online Inc. (UNTD)

Overview

United Online (“UNTD” or the “Company”) is a compelling long opportunity with upside of 60% – 120% and a multitude of catalysts in the next three months, most notably the spin-off of the Company’s FTD segment which will force investors to value the business more appropriately.  United Online consists of two primary business units:  the FTD.com online florist business (“FTD”), purchased in 2008, and the Company’s legacy Communications and Content & Media segments (“Legacy” or “Legacy UNTD”), which are what UNTD is more commonly known for.  While most investors still think of UNTD as a legacy dial-up internet business, the real gem and the greatest source of value lies in the FTD segment.  FTD is a high quality business with large barriers to entry, a network effect which strengthens the business over time, and little chance of technological obsolescence.  The business generates strong free cash flow and requires very little capital to grow, yielding high ROEs that should drive a premium valuation.  An expected spin-off of FTD in the third quarter of 2013 should unlock significant value for UNTD.  At the current price of $7.83/share for UNTD, I believe investors are getting the FTD segment at a discount and are getting a completely free option on the legacy business (If you don’t care at all about the legacy businesses, skip further below in this write-up.  I think the legacy businesses have a sneaky amount of value though.)  Most importantly, as I will discuss later, based on both conservative absolute valuations and the most obvious publicly-traded comparable, the case for significant upside hardly requires heroic assumptions or multiples.  Finally, given the ~9% current free cash flow yield, I believe UNTD provides solid down-side protection.

Why Does the Opportunity Exist?

Before I detail why UNTD is so undervalued, I think it is valuable to understand why the opportunity exists.  The situation presents a compelling spin-off opportunity because many of the reasons value is being obscured will quickly be rectified:

• The Company trades at an LTM P/E multiple of roughly 71x.  As a result, it shows up on few “value” screens.  In fact, 71x earnings coupled with a top-line that actually declined 3% last year on a consolidated basis likely makes UNTD scream “short” much more than it does a value long.  What investors may be missing is that the business has significant intangible amortization that obscures the true free cash flow or cash earnings of the business.  Additionally, while the consolidated business has been shrinking its top-line slightly, this is actually the combination of growth at the FTD subsidiary and large declines in the legacy internet businesses.
• At the current price, the Company has a market capitalization of roughly $727mm so it may be too small for some investors to participate in a way that would be meaningful for them.
• Until recently, few people understood the profitability of the FTD floral network.  With the filing of the FTD Form 10, the economics of the various revenue streams is now clearer.  In theory, investors could have looked at FTD financials from before the acquisition by FTD or guesstimated profitability based on the publicly traded comps, but my guess is that few investors were actually doing this.
• Historically, the Company has had a very promotional management team and I’m sure many investors won’t touch this business because of their feelings regarding the CEO.  The management team has paid themselves a lot, albeit largely in stock, and is one of the more promotional management teams on conference calls that I have ever heard.  With that said, they have done an admirable job milking the declining legacy business for cash, and most importantly, the CEO is leaving the Company entirely after the spin-off.
• Given the relatively smaller market cap, there is very little analyst coverage.  As far as I can see, the stock is covered only by Craig Hallum and Benchmark Capital.  In the Benchmark Capital valuation, for reasons that do not make sense (likely an error), the analyst ignores the entire cash balance of $1.63/share in calculating equity value and still gets to $8.50/share in value for consolidated UNTD.
• This might be a silly point, but the name “United Online” isn’t exactly the best description for where the real value is coming from.  Because this business was historically primarily dial-up internet through the NetZero brand, many investors still associate UNTD with this business.  In reality, 80% of the consolidated business is an internet flower delivery business that is stable and generates strong free cash flow.

In summary, I believe the true value of UNTD’s segments is being masked by non-cash items and the overhang from the Company’s rapidly declining legacy internet businesses.

Legacy UNTD Business Overview

As I have already suggested, I believe investors today are buying the Company’s strong FTD segment at a discount and that FTD represents over 85% of the enterprise value of UNTD.  But, before we get there it is worth noting that we do get the “free option” on the Legacy UNTD business and that business should be worth something.

The Legacy UNTD business will consist of cash on the balance sheet, the Company’s Content and Media segment and its Communications Segment.

• Content and Media – The Content and Media segment consists primarily of the Company’s Classmates.com business, which allows people to find friends and acquaintances primarily from high school.  The Company sells memberships to people looking to connect with old classmates and more recently has been buying up yearbooks and uploading them so it is now the largest repository of high school yearbooks.  The other main business segment is the Company’s MyPoints rewards business, which links advertisers with MyPoints members who are looking to earn rewards points.  Members earn points by shopping through the MyPoints portal, opting to receive e-mail offers, using the MyPoints toolbar for web searching and participating in research surveys.  Advertisers pay UNTD to tap the network and members get to redeem points for goods.
• Communications – This segment sells dial-up internet access under the NetZero and Juno brands.  While this business is declining, the rate of decline continues to moderate and the business is in profitable decline.  More recently, the Company has begun to market 4G broadband hotspots where they buy 4G access from Clearwire and now Verizon and Sprint and sell it under the UNTD brand.  They have been investing more dollars into this business and it is currently a loss-making portion of the communications segment.

It does not take a genius to realize the obvious threats to these businesses.  Facebook continues to make Classmates.com less relevant, aside from access to historical yearbooks, and advertisers continue to shift ad dollars to different outlets.  For dial-up internet, the vast majority of consumers, with the exception of a few rural areas, now have broadband access.  However, despite the obvious pressures that have persisted over several years now, the Legacy business generates a surprising amount of EBITDA and can provide meaningful upside to UNTD stock beyond the value of FTD.  Below is some brief financial history for the Legacy business:

Legacy Valuation

On an LTM basis, the Legacy segments have generated $53.4mm of EBITDA.  However, there is approximately $20mm of unallocated corporate expense and $11.5mm of LTM capex.  Based on discussions with the Company, I believe that they will work quickly to reduce corporate expense, quite frankly, because they have to.  On the latest earnings call on 7/31/13, they suggested planning is underway to materially reduce the $20mm in corporate expenses immediately after the spin-off.  The latest quarterly results also showed a decline in corporate expenses of approximately 10%.  It also seems like the existing CEO was terminated based on the language regarding his resignation and the Board likely did him a favor so that he would get his severance payment.  However, this should immediately add to results as the criticism over the last several years was how much the CEO was getting paid.  Additionally, as depicted above, should the 4G project not succeed, management should taper off spending and continue to manage the business like a melting ice cube going forward.  While the business is in decline, many of the churn and ARPU metrics are actually beginning to stabilize.  Additionally, gross additions for both Content & Media and Communications are now approximately flat year over year.  While it is difficult to precisely value Legacy UNTD, I do believe the businesses have a reasonable amount of run-off value.  Below are a few ways of valuing the business.

I have excluded the investment in 4G in LTM results for purposes of core valuation and have instead deducted 2x EBITDA for this investment because I believe this business will be stopped if it does not reach profitability within 2 years as management currently expects.  I have just assumed it will fail.  It is worth noting that given recent deals signed with Verizon and Sprint, the company believes the 4G business will be profitable by Q2 2014 and will actually be a growth business.  Previously, they would receive incoming calls and not be able to service customers because they didn’t have the coverage area.  Worst case, the deals are structured largely as variable expenses so as subscribers grow (or do not grow), there is no material new investment.  Since we have been following the Company, we have continued to be surprised by the Legacy UNTD business and how operating metrics seem to be stabilizing if not improving.  The latest quarterly release continued to show that the business should generate decent cash flow for at least the next few years, suggesting our valuation metrics above are conservative.  Additionally, we have not factored in the large corporate G&A reductions that we expect and that have already begun.

While I do not believe this makes or breaks the investment case for UNTD, I do believe under relatively conservative valuation cases, the Legacy UNTD business provides a nice source of value to UNTD shareholders.  I don’t think there is too much one needs to believe to get comfortable that there is $2.50/share of value, especially given the $63mm of cash I expect the business to be left with.  I also think investors get the cheap option that the Communications business and the 4G initiative actually pay off.  If that happens and this business can be flat or even grow, I would expect it to get a better valuation.  For what it is worth, the comparables such as Earthlink trade at EV/EBITDA multiples of approximately 4 -5x.  The Company also had NOLs of approximately $150mm at December 31, 2012 which I have valued at zero, despite obvious value as the Legacy business runs off.  Additionally, the Company has engaged Evercore to sell a patent portfolio consisting of a variety of patents around the internet, mobile advertising, etc.  I have given these patents zero value in my low case, but Evercore was engaged to sell the AOL patents and presumably they took this engagement with some hope of selling this IP.  The analysts believe the IP could be worth anywhere from $.25 - $1.00 / UNTD share.  Take this with a huge grain of salt given the promotional nature of the management team, but on the last call they alluded to “the deal they are currently working on” that should provide Legacy UNTD with income going forward.  They are hoping to announce a sale or licensing of IP before the spin date of 10/1/13.  I expect that they might also pay a dividend or initiate a share buyback at the Legacy business which should be supportive for the stock.  They have said that they will announce a dividend policy before the spin-off.  Finally, it would not surprise me if a competitor that was also shrinking such as Earthlink or AOL merged with Legacy UNTD post the spin-off.  The combined companies could quickly rationalize overhead and preserve the cash run-off for longer and more rapidly utilize NOLs.

FTD Business Overview

While the Legacy business provides for incremental value, the FTD business is obviously the main attraction, which is expected to be spun-out of UNTD by the end of Q3.  I believe the FTD business is very high quality, as it generates a relatively stable and growing cash flow stream in an oligopolistic industry where the FTD brand and “Mercury Man” symbol have strong recognition.  The Company is a leading player in the consumer floral business and maintains a floral network business where they have member florists that pay membership fees for the ability to be part of the network and receive order flow from FTD.  Additionally, floral network members buy various supplies and pay fees for credit card processing and other services provided by FTD.  The Company generates cash flow primarily in two ways:

• Product Revenue (~78% of 2012 revenue) – Product revenue is generated when customers go on the FTD website and order flowers for delivery which is satisfied by either a local florist in the area where the flowers are to be delivered or a contracted third-party floral service which does business with UNTD.  For example, if you want to buy $100 of flowers for your mom in California (and you live somewhere else), you’d go to FTD and order the flowers.  The order would then be routed in the FTD flower network.  FTD collects cash from the customer up front and then pays the local florist a negotiated rate at a later date, once the product has been delivered.  This business has a roughly 23% gross margin and is fairly consistent, as cost of goods sold are primarily the fees per order paid to local florists.  Given the timing of payments, FTD also has negative working capital, contributing to strong cash flow as the business grows over time.
• Service Revenue (~22% of 2012 revenue) – This is primarily composed of annual membership fees charged to floral network members to be part of the network and receive order flow from the FTD website.  While the Company does not break it out, triangulating from several comments in the public filings, I estimate approximately 64% of this revenue is related to member fees, and 34% is tied to consumer order flow.  The variable portion of revenue is tied to credit card processing and other services provided to local florists.  The service revenue has gross margins of approximately 85%, and has proven to be a relatively steady cash cow for FTD over time.  Additionally, as local florists have struggled in recent years, being part of a floral network has become increasingly more important.  I believe FTD and other industry players will continue to gain market share and continue to have pricing power over the thousands of local florists over time.

Summary financials for the FTD business from the recent Form 10 are presented below (LTM through Q1 2013):

FTD participates in a very strong industry structure, with a fragmented customer base in florists that need to be part of a floral network.  While florists take lower margins on orders that are derived from floral network sites, from the perspective of the florist, those are orders that would largely not have materialized in the first place.  Few consumers would search and call a local florist to deliver flowers far away if websites such as FTD did not exist.  Now that they are largely developed, FTD and other industry players enjoy a captive audience in florists that are part of the network, leading to a virtuous cycle where the network’s power grows over time.  The primary competitors in the online floral business are Proflowers (owned by Liberty Media), 1-800-Flowers (public:  ticker FLWS), Teleflora (private) and FTD.  The largest players in the space are believed to be FTD and FLWS, and I have presented their numbers below as a benchmark for the industry.

The numbers above show a very stable and growing industry.  Additionally, it appears that the strong FTD brand continues to gain share relative to FLWS on an annual basis.  It is worth noting that when FTD lost share in the network business to FLWS in 2011, it was largely due to a new strategy by FLWS (i.e., discounting).  Subsequent to that initial shock, it looks like the industry has learned its lesson and stayed rational, as FLWS margins on service have increased and share seems to have stabilized.  There is no doubt that this industry can be competitive at times, with various players discounting to grow orders.  However, over a long period of time the industry has been relatively stable.  To FTD’s credit, they have not chased discounted order volume, sacrificing revenue growth to maintain profitability when they saw competitors doing things deemed to be destructive to profits.  Margins improved in the most recent quarter.

Business Quality

I believe FTD is a strong business that is well protected and should continue to grow for the foreseeable future.  In addition to a strong industry position, the Company requires very little capital to grow and is protected due to the network effect inherent in the floral network business.  The business has many traits that I believe warrant at least a market multiple:

• The risk of disintermediation is low as flowers have already gone electronic and FTD is the leader in the category.  It seems unlikely that we will ever start sending around paper flowers or e-flowers, so the product has relatively few true replacements and has already gone online.  Additionally, most purchases are delivered to a recipient in a different location than the buyer.  I think relatively few consumers have the time (or desire) to look up local florists and make direct orders that way.  Because of that, FTD and other online floral businesses have likely increased the total market for flowers and provide a convenient way to purchase.
• The FTD business has a well-recognized brand name and a good portion of repeat business.  The industry is generally rational and there are only four major players in the online floral business, as opposed to approximately 16,200 retail florists in the US as of 2010.  Given the concentration of online floral players relative to retail florists, the online players are able to negotiate favorable terms with florists in their network who accept lower margins given these orders would likely never have been routed to them in the first place.
• The network effect in the industry is very strong and feeds on itself.  As more members join the network, more orders are routed through FTD and more people are aware of the FTD brand.  This forces more and more florists to join a floral network over time.  Once in the network, florists are unlikely to leave because order volumes would fall significantly without the help of a floral network.  Given the value of being in the floral network, this dynamic also gives FTD pricing power over time with respect to its annual membership fee revenue.
• The business has strong barriers to entry.  While it does not require vast amounts of capital expenditures, the business does require a brand and order flow.  You cannot start a floral network without convincing local florists you can bring them volume and you can’t have volume unless you have florists already in your network that can fill orders.  If I tried to start a floral network and consumer floral business tomorrow I’m pretty sure I wouldn’t get much traction.
• From a financial standpoint, the business requires very little capital to grow.  FTD’s capital expenditures as a percentage of sales were just 1% in 2012.  The business also has substantial operating leverage as consumer order volumes increase because much of the operating expenses are fixed excluding cost of goods sold.  For the service business, pricing and continued growth of member revenue should lead to near dollar for dollar increases in profit.  Finally, because they do not retain physical inventory and collect cash from customers before paying florists, the business has negative working capital and enjoys strong cash flow as it grows.  The business has solid returns on equity.

Financials / Projections

With relatively conservative assumptions, I believe FTD can grow EBITDA and free cash flow (“FCF”) in the mid to high single digits for the next several years.  It is worth noting that in 1H 2013, FTD grew EBITDA ~5% year over year and I have modeled a long-term scenario using conservative assumptions.  Additionally, adjusted for currency and a value-priced acquisition, average order value has been increasing 1-2% per year.  Key assumptions for my projections are:

• 1% annual increase in average order value and 3.5% annual increase in order volume
• 1.5% annual increase in service revenue from membership growth
• Product COGS increase at ~65% of consumer order growth
• Sales and marketing expense increases at rate of order volume growth.  2% annual inflation on all expenses.

Valuation

At a bare minimum, I believe that the FTD business is a better quality business than the S&P 500, and with lower levels of financial leverage.  However, what I like about purchasing UNTD stock today is that one doesn’t have to believe that this trades anywhere near the average S&P 500 company to make a very strong return.  More importantly, because 1-800-flowers (FLWS) is a publicly traded business, market participants will be able to directly assess the valuation of FTD quite easily.  Before looking at the FLWS, is it worthwhile to look at the financial comparison between the two companies:

FLWS is generally viewed as a lower quality business because of its bloated corporate infrastructure, entrenched family ownership of greater than 50% through a B share class with voting control, lower profitability due to its more seasonal gift basket business and a heavier capital expenditure burden.  The latter point drives a significant difference between free cash flow generated at FTD and FLWS.  It is worth noting that analysts covering UNTD agree that FTD deserves to trade at a premium relative to FLWS.

What this means is that there is an obvious framework for how FTD could be valued post the spin-off.  As much as I despise EBITDA-based valuation frameworks (because they completely ignore capital requirements and are generally lazy and useless artifacts of investment banking training programs), as a floor I believe we can value UNTD at the same EBITDA multiple as FLWS.  This is despite the view that FTD is actually a better business.

As I’ve highlighted above, I believe an EBITDA-based valuation, while enough to justify a good risk-adjusted return for UNTD when coupled with legacy value, largely misses the point.  At the current FLWS multiple FTD would be trading at a 10.1% FCF, which I believe is far too high for a business of this quality.  FLWS trades for a 5.3% FCF yield.  Said differently, I think that if FTD truly traded at a 10.1% FCF yield post-spin it would be an incredibly attractive investment opportunity.  The LBO math works at this value and remember that FTD was previously purchased by private equity (Leonard Green) in 2004.  Or, a strategic such as John Malone’s Liberty Media, owner of Proflowers, could easily scoop it up.  I do not think it will actually trade at such a high yield.  I believe a more appropriate valuation framework for FTD should incorporate cash flow proxies such as EBITDA-CapEx multiples or multiples of leveraged free cash flow.  Presented below are the implied equity values for FTD based on a variety of comparable company valuation techniques using FLWS.  I have averaged the equity value techniques to derive FTD equity value / UNTD share.

On the low end, this range of values provides 66% upside in UNTD stock based on the value of FTD ALONE.  At a bare minimum, in addition to this, UNTD should be given credit for the ~$63mm in cash at the Legacy UNTD business.  Additionally, I often prefer to look at valuation in the absolute sense, or at least relative to a broad barometer of valuation.  Over a long-period of time, I would expect that it is reasonable to expect that FTD at least trades in line with the S&P 500.  While the S&P 500 currently trades at an approximately 6.0% FCF yield, I have shown a 7% yield below to be conservative.  I believe an absolute 7% free cash flow yield is conservative for a stable, growing business such as FTD.  A DCF using an 8% cost of capital and a 9x terminal EBITDA multiple yields a similar result as the 7% yield math depicted below.

If FTD were trade in-line with the S&P FCF yield, the FTD value per UNTD share would increase to $11.74/share. 

Finally, it is worthwhile to note that when FTD was originally purchased by UNTD in summer of 2008, there were four interested private equity firms bidding.  FTD was eventually sold for an enterprise value of $754mm, but higher bids were received and failed given the credit crisis and lack of financing.  FTD was also a highly leveraged business at the time, which given the environment, would argue for a lower multiple given the risks and tight credit.  FTD was ultimately sold for a TEV / EBITDA multiple of approximately 10x and at a FCF yield of approximately 9.5%, which is actually lower than implied by the FLWS EBITDA-based valuation approach above.  I think it is reasonable to expect FTD to trade at better valuations than this given the growth of the business, economic environment, and lower leverage.

Conclusion

Taken together, I believe the spin-off of FTD can unlock substantial value in UNTD stock in the next three months.  I have presented ranges below which are based on valuation work presented above.  I stress again that under very conservative assumptions, I believe investors will make an attractive return from the value in FTD alone, even assuming a discount to the multiples of the closest publicly traded comparable.

Key Assumptions:

• Downside valuation assumes EBITDA-based valuation for FTD and average of low valuations for Legacy UNTD. I would view this as the really bad outcome.
• Base valuation assumes 7% yield for FTD and the average midpoint case for Legacy UNTD.
• High valuation assumes equity multiples for FTD and high estimates for Legacy UNTD.

I believe the low case provides excellent downside protection as FTD would be trading at a FCF yield of approximately 10.1%, Legacy UNTD trades at a severe discount to the comps, and no value is given to NOLs, IP, or the prospect that anything at Legacy UNTD “works.”  I believe my midpoint scenario is a very realistic case for where UNTD will trade leading up to and into the spin-off, with the chance for more value should the management team and Board return capital through dividends or buybacks (which would highlight the cash flow.)  It seems highly unlikely an investor would experience a permanent capital loss from buying UNTD today and as the analysis suggests, UNTD provides excellent value with an imminent catalyst.  As already discussed, in addition to the resolution of the IP sale/royalty arrangement, both FTD and Legacy UNTD could be dividend payers which provides some support to the valuation.

Risks

• This business should grow and is relatively well-protected.  There may be some weakness in a major crisis, although the peak to trough decline from the 2008 crisis was just a 10% revenue decline.
• Given the low analyst coverage, the stock can be volatile around quarters.  I have seen instances where the Company has “missed” by $1-$2mm in revenue and the stock has sold off 10-20% temporarily.  I generally view these opportunities as gifts.  Volatility is your friend.
• Competitors could get stupid and decide to get into price wars for business.  Gross margins give competitors room to discount.  Some may treat the initial capture of a floral network member as the investment required to generate consistent consumer product revenue over time.  With that said, FLWS tried this at one point and stopped when it became clear they were hurting their own profitability.
• More grocers are entering the floral business.  This increased competition could reduce order growth over time, although as discussed previously, it is very difficult to replicate the current floral networks or to disrupt them in any material way.
• Traditional execution risks associated with a new management team.  It’s worth noting the management team is largely the same as before the spin, but neither team has run a standalone public company.  The management team could also choose to spend more of the cash flow on lower return projects as opposed to returns of capital such as stock buybacks or dividends.  Should that incremental spend not lead to incremental growth, it would be a negative.
• The spin-off could be cancelled.  This seems unlikely given the Company has reaffirmed the timing of the spin several times and understands very well that the sum of the parts is worth far more than where the current conglomerate trades.  Additionally, existing management receives a bonus for completing the spin-off.  On the most recent quarterly call, they provided an effective date of 10/1/13.

• Spin-off expected by the end of Q3. 
• I suspect this will show up on private equity buyer’s radar again if it spins and trades at a high single digit free cash flow yield with ample borrowing capacity.
• Potential stock-buyback or dividend at either business post separation.  Dividend policy expected pre-spin
• Monetization of Legacy UNTD IP portfolio is expected prior to the spin-off.