Description

Overview

uSell.com (USEL) is an early stage nano-cap trading OTC with very limited sell-side coverage and high volatility, so we highlight that this idea works best for PAs and smaller opportunistic funds. Irrespective of its relative illiquidity, we believe USEL is deeply undervalued at current levels, selling for 4.4x EBITDA on our FY ‘17E estimate despite what we view as a clear path to nearly doubling EBITDA. Our long thesis rests on several points that are worthy of investors’ attention, as the business’s large market opportunity and improving fundamentals are overshadowed by competitive concerns and the stock being so far under the radar of institutional investors. To be clear, we don’t argue that this is a wonderful business; however, we think valuation is too compelling to ignore for those of us who can be flexible and own such a small company.

Key Thesis Points

• USEL plays in the competitive consumer aftermarket for smartphones. However, at roughly $15-20bn in size globally, this is a large, fragmented, market where USEL has miniscule share today but is rapidly accelerating growth. USEL faces competition, but we believe the company can differentiate itself and continue to take share by leveraging proprietary technology to improve efficiency and profitability in the aggregate for the value chain in used electronics.

• The acquisition of We Sell Cellular in Q4 ’15 has provided USEL with a strong but underappreciated catalyst to strategically evolve its business model, improving its economics and widening its moat. This is already showing up in reported numbers, with the business slated to do $100mm+ of run-rate revenue for FY ‘16E, stabilizing gross margins, and scaling back sales and marketing expenses significantly. However, traditional investors are unaware of the opportunity and the investors who are aware misunderstand the quickly improving structural earnings power of the business.

• USEL’s management team is characteristic of those at much larger public companies known for long-term shareholder orientation. CEO Nik Raman’s pedigree and operational experience as a founder of a business acquired by uSell, as well as significant insider ownership showcase executives’ long-term commitment to the business and alignment with shareholders.

• We believe USEL is significantly undervalued primarily because it is underfollowed; an internet business with network effects benefiting from widespread Street coverage is unlikely to ever present this type of mispriced opportunity. Even assuming a slightly more reasonable 5.5x multiple (sensible if the company actually executes) on our FY ’17 EBITDA estimate produces 50% upside from today’s price (~$0.80). Assuming this multiple moderately compresses to 5.0x on our FY ‘18E estimate, we believe USEL could be a $1.60 stock, or a double from here. Our price target is an equally weighted blend of these valuations, producing a stock that is worth $1.41, representing 76% upside with risk/reward of 1.8x.

Business Description

Based in New York, USEL is a technology-enabled business focused on extracting the maximum value from used mobile devices, particularly smartphones, at large scale. At the core of the business is proprietary marketplace technology that connects a large supply of used mobile devices globally with a market of buyers. USEL’s legacy is based in the flagship website uSell.com, which operates an online marketplace for consumers to search for cash offers from professional buyers to purchased used smartphones. This website historically attracted nearly 1mm monthly unique visitors, connecting consumers with more than 60 partners that specialize in buying secondhand electronics. In Q4 2015, USEL acquired We Sell Cellular (WSC) for $14.6mm in a stock and cash transaction. This transaction provided the basis for the company to migrate its business model from being primarily a consumer marketplace to a wholesale-focused reseller of smartphones. Today, USEL continues to acquire devices from individual consumers on uSell.com, but also sources product from major wireless carriers, big box retailers, and handset manufacturers through WSC. USEL distributes devices globally through a traditional sales force and an online marketplace where professional buyers of used smartphones compete in an auction setting to buy inventory on-demand. The benefit of this model is that buyers can procure high volumes of inventory in a cost-effective way, while minimizing the risk of marketing directly to consumers or procuring inventory directly from sources.

Revenue Model

Historically, a large portion of USEL’s revenue originated from an agent commission model, where GMV flowing through uSell.com would earn a take rate for facilitating transactions between buyers and sellers. In October 2014, USEL launched Managed by uSell, where it partnered with third-party logistics companies to inspect and process devices before passing them along to the highest bidder. By centralizing its inspection process, USEL can now turn inventory faster as devices are graded according to certain standards, and orders can be quickly processed and paid for. Through this revenue recognition method, known as the principal device revenue model, USEL started taking possession of inventory briefly before passing it on to the end-buyer. The majority of volume through USEL’s consumer-facing business today comes through this model. Given that devices sourced by WSC are also bought and sold through this model, substantially all of USEL’s sales are now classified as principal device revenue. Technically, USEL has two other revenue streams, but they account for less than 1% of total sales each and represent revenue associated with the legacy agent commission model, as well as website advertising and providing value-added services to buyers.

Why Does the Opportunity Exist?

USEL is down over 30% YTD, as some execution issues over the last year have plagued the company, and most investors have not given management sufficient credit for the transformational WSC acquisition as the stock remains a “show me” story. The last two quarters of financial results following the WSC deal have not been without issues. In Q1 ’16, though USEL was able to keep the legacy business stable while integrating WSC, gross margins took a hit as Apple’s unexpected launch of the iPhone SE resulted in certain legacy iPhone models in inventory experiencing a drop in value. This impacted results for February and March, but the company noted with Q2 results that margins recovered; going forward, management expects to mitigate such risk by focusing on inventory turns through improved warehouse efficiency and servicing demand by increasingly leveraging proprietary technology.

In addition, in Q2, management rebranded and relaunched WeSellCellular.com, running its first auction in May on a subset of products. Throughout Q2, USEL ran more auctions on the new WSC platform and saw $1.7mm in value of devices sold in May and June. The goal is not to move all of WSC’s volume through these auctions, but management is actively seeking other methods through which it can continuously improve inventory turns and therefore drive margins higher. Meanwhile, on the opex and capex fronts, management has been able to keep fixed costs low and has minimized all capex outlays. The balance sheet is stronger today, with USEL having borrowed $2mm under a Note Purchase Agreement with a lender in Q1. While the company is paying a higher effective interest rate at 13.25%, it also benefits from receiving credit of 75% for new purchase orders towards its borrowing base (compared to 50% previously) and is deferring amortization payments by 18 months (effective Q1 ’16). Though USEL has to prove that it can sustainably improve its operating and financial metrics in the coming quarters, we believe that it is well-positioned to do so based on the numbers already showing signs of inflecting positively and a sound capital structure in place.

Vast Market Opportunity

It is estimated that just five years ago, less than 10% of consumers sold their used devices. However, notably in the last two years, wireless carriers realized that trade-in provided a significant avenue to eliminating costly handset subsidies. The prevalent model now features two components: a leasing/financing component through which the consumer can defer the cost of a device, and a trade-in component at the end of the contract term where the carrier can capture the device’s residual value. The strategic importance of such programs was highlighted when Apple rolled out its own solution in early September 2015 with the launch of the iPhone Upgrade Program. Such programs now have 60-70% adoption rates between the involvement of carriers, retailers, and handset manufacturers all offering different solutions.

The market for used mobile devices is estimated to be approximately $12bn in the US alone. This sizing is supported by the fact that 150 million smartphones were sold in the US in 2014, so assuming an adoption rate of 70% for trade-in/resale programs would imply around 100 million phones entering the market. At an average value around $100 for each device, we get to a market sizing in the range of our general estimate. We view the US as the biggest opportunity for USEL today, as international sales are still a small portion of the total business. At a run-rate revenue this year of a little over $100mm, USEL is clearly underpenetrated in the market today but quickly growing. We believe the sheer size of this market opportunity allows for multiple players to take share rather than supporting a winner-take-all outcome.

USEL Is a Much Better Business Pro Forma for the WSC Acquisition

USEL completed its acquisition of WSC in October 2015. We believe that investors are misunderstanding the extent to which USEL benefits from this deal on a long-term basis, both strategically and financially. Prior to the acquisition, USEL faced a troubling situation as quarterly revenue growth was volatile for a company that theoretically should have been exhibiting sequential growth off of a small base. Similarly, gross margins were under pressure as a glut of used smartphones entered the market in 2014 as trade-in became mainstream, and pricing collapsed as the aftermarket turned into competitive race to the bottom. Without USEL having a reliable, constant supply of devices to source, an earnings model which relied heavily on high gross margins soon started falling apart. At the same time, legacy uSell.com emphasized heavy consumer-facing marketing expenses as a percentage of revenue.

After closing WSC, USEL almost immediately began benefiting from the sizeable volume benefits and network effects associated with WSC’s wholesale-oriented model. The most important financial impacts of the acquisition in terms of our thesis are that USEL will be able to improve margins and drive profitability and FCF generation going forward. With a strong ability to source devices through WSC’s capacity coming online for pro forma USEL, revenue growth provides a more consistent flow of product. In terms of gross margins, they have fallen to the mid-single digit level but are stabilizing. Adjusted for the inventory issues we noted earlier, margins ticked up sequentially in Q2 ’16, and from here, we expect them to increase modestly as Managed by uSell’s technology platform automates more of WSC’s warehouse functions. To be clear, USEL will structurally always be a relatively low gross margin business; however, we do not argue for unit pricing power but instead focus on the cost advantages of operating a wholesale-driven model with marketplace technology. On sales and marketing, the company has been able to effectively turn off consumer-facing marketing like direct response, as the sales model has changed considerably post-WSC. The business now relies on a traditional sales force and the presence of its online marketplace focused on professional buyers to drive top-line, allowing for S&M spend to lever drastically and behave more like a fixed cost.

1. Adjusted for slow-moving and obsolete inventory write-down charges.

Source: USEL historical financials

Skilled & Incentivized Management Team

Our assessment of management is that this is a winning team, and based on a recent shareholder list, it is estimated that insiders own over 60% of the equity. CEO Nik Raman, despite his relatively young age, has a pedigree and acumen for business strategy that rivals that of executives at significantly bigger public companies. Since coming on board when USEL acquired his prior company, ecoSquid, in 2012, Raman has focused on improving the technology offering presented by uSell. A key endeavor of his following the WSC acquisition is further integrating the technology platform to move more inventory and drive improved economics. Further, WSC’s founders, Brian and Scott Tepfer, have remained with USEL post acquisition and received equity in the combined company as a result of the deal. Importantly, as highlighted in the company’s Q2 ’16 earnings call, the Tepfers eliminated their placement rights, which would have allowed them to sell 1.5mm shares every quarter at their election at a floor price of $1.20. Given the stock is currently trading well below this level, had the Tepfers elected to still sell stock at a lower price than the floor, USEL would have had to issue them additional shares to compensate for the shortfall in value. Given the Tepfers’ belief, however, that the combined company will deliver on its long-term vision, they have waived their rights to sell shares, eliminating the possibility of a dilutive event for the business and removing the resulting overhang. As a result, $1.5mm of equity has been added to USEL’s balance sheet and charges to the P&L associated with the rights will not be incurred going forward.

Competitive Advantage

The biggest negative to our bull case is around competition and how USEL provides a differentiated offering. USEL competes with a fairly small but influential set of competitors with wholesale and logistics capabilities. Bears on USEL would argue that as a reseller of mobile devices, the business is providing a commodity service with low margins. The illustration below highlights the key elements of what we believe are competitive advantages. We argue that the biggest sources of competitive advantage in this industry lie in being able to “churn and burn” through as many units as possible, matching supply with demand consistently, efficiently, and profitably. Crucial components of this process are standardization of device grading and logistical capabilities enhanced by superior technology. The sorting process of procured devices into lots based on grade according to quality standards, the ability to match buyers with supply through an intuitive interface, and a robust back-end that seamlessly integrates across warehousing, shipping, and billing/payment functions provides USEL with distinct advantages over the competition. Through our assessment of the competitive landscape and discussions with management, we believe USEL operates using better software than competitors, which should translate into faster inventory turns and lower costs over time.

USEL’s competition is diverse and spans wireless carriers offering equipment installment plans (EIPs) and leases, big box retailers like Best Buy, handset OEMs like Apple, direct-to-consumer buyers like Gazelle.com and ecoATM (owned by Outerwall), handset insurance providers, consumer internet sites like eBay and Craiglist, and large wholesalers and distributors like WSC. It is estimated that there are in the range of 5-10 wholesalers of similar size and with the same certifications (R2; industry standard for data destruction and environmental protection) and financial resources as WSC. Based on discussions with USEL management, we believe that Brightstar (majority owned by Softbank) poses the most significant direct competitive threat, as USEL purchased 94% of its inventory from Brightstar in 2015. Brightstar has valuable customer relationships in turn with Sprint, Apple, and Best Buy. As USEL ramps its sourcing capabilities through WSC, its reliance on this relationship has already decreased to 85% of inventory in Q2 ’16 with management guiding to further diversification in the next 6-9 months. However, in the interim, we feel the reliance on Brightstar for supply is a risk in the event that Brightstar feels competitively threatened by USEL’s growing presence.

Overall, despite the competition in this industry appearing significant, we also note that many of the listed competitors actually also are reliable sources of supply for USEL. This is consistent with our analysis on the vast size of the addressable market; given the ongoing secular shift of faster turn times for consumers using a given handset, we expect that the lines will increasingly blur between competitors and suppliers, and that many players will be able to benefit from increased industry volume. Further, we see potential for consolidation over time in the industry given the number of different parties involved in the value chain and the degree of fragmentation.

Financial Model

Based on public information and our conversations with management, we believe USEL will generate earnings and cash flow according to the following growth algorithm over the next two years of our forecast. The resulting financial model based on our assumptions is also provided below.

Source: USEL filings and proprietary estimates

Valuation

Given the lack of perfect public comparables, valuing USEL is more art than science. Our valuation methodology primarily relies on EV/EBITDA, and we consider multiples for various industry segments pertaining to consumer electronics and distribution businesses more broadly. Depending on how wide a comparable universe one relies on, one-year forward EBITDA multiples tend to generally fall in the range of 6-8x. An interesting data point is Ingram Micro (IM), the largest wholesale technology products distributor globally, a slow-growth $5.6bn EV business that trades for over 6x EBITDA.

We believe an appropriate EV/EBITDA multiple to use for USEL is 5.5x FY ‘17E EBITDA, which is a premium to the implied market valuation of 4.4x on our estimates. If management is able to execute in the coming quarters, we believe this re-rating would be justified. Given the risks associated with illiquid micro-caps, we believe a discount is appropriate to comparable businesses but highlight that USEL should exit FY ’16 with over $100mm in run-rate revenue, will grow top-line at least in the low double digits, and is under-earning today. Therefore, we do not believe a severe discount to peers is appropriate. We also think USEL could be acquired by a strategic for significantly more than where it trades today given its superior technology, but we do not underwrite such a scenario for valuation purposes here.

Risk/Reward: 1.8x on the long side.

Downside: We assume a 15% haircut to our FY ’17E EBITDA estimate due to slower than expected top-line growth from competitive pressures and execution issues, yielding $4.3mm. We apply a 3.5x multiple to this estimate and arrive at a downside target of $0.46, or 43% down from current levels.

Upside: Our price target of $1.41, or 74% up from today’s price, is an equally weighted blend of our valuations based on FY ‘17E and FY ‘18E. We assume a 5.5x EV/EBITDA multiple on our FY ‘17E EBITDA estimate of $5.1mm, implying USEL is worth $1.22, or 50% up from the current price. For FY ‘18E, we assume the multiple compresses slightly to 5.0x, appropriate given the 28% y/y growth in EBITDA we model, and arrive at a stock price of $1.60, nearly double where USEL trades today.

Risks

• Competition: As highlighted earlier, competition is the most obvious risk. If retailers, handset manufacturers, etc. decide that it is more economical and efficient to handle higher distribution volumes of used devices in-house, USEL could be disintermediated. This is ultimately a volume business and not one defined by pricing power, so competition eroding gross margins further could cause shortfalls to management’s plan and drive the stock down.

• Customer Concentration: The Brightstar relationship is being actively deemphasized, but for reasons we discuss earlier, we believe it is still a major risk. Brightstar may decide to effectively shut off its supply to USEL if it believes USEL is increasingly posing a competitive threat. If USEL is unable to quickly diversify away from its concentration to Brightstar in the coming quarters, we expect the stock will not work.

• Supply/Demand Dynamics: We highlighted the historical precedent of pricing collapsing in the retail market for used devices in 2014. If this happens on the wholesale side, there could be downside risk to estimates and valuation.

• Handset Product Cycles: Gross margin volatility could surface again if USEL does not sufficiently protect itself from unexpected new product releases, as was seen when the iPhone SE came out in Q1 ’16.

Catalyst

·         Increased investor awareness, particularly as the stock screens better for valuation on improved metrics going forward

·         Management participation in investor conferences and roadshows

·         Listing on a major exchange upon reaching certain financial milestones