Description
UNTD is a large, and still growing, provider of Internet low priced dial-up access (Juno & NetZero) and other subscription services (email, webhosting, etc...) With today’s pricing and Q3’s financials, EV/FCF = 4.8 and EV/EBITDA = 4.3 Net cash was $3.28 per share, with no debt. Q3 Revenues were $111 Million up from $89 million the prior year and flat from the prior quarter. Over 90% of revenues came from subscriber services. Diluted Net Earnings per share for Q3 were $0.19 up from $0.13. FCF has been running much higher than earnings. Over the past 2 weeks, UNTD has announced a significant acquisition and 25% stock buyback, so this writeup has been a moving target, but UNTD still has an attractive risk/reward ratio.
If these levels of FCF and EBITDA could be expected to continue for several years, we’d all agree that UNTD would be a good value play. Obviously, the investment community believes that all segments of dialup will soon disappear as a viable market. It does not understand that the low priced (value) dial-up market is growing, and will continue to grow, for several years. The total dial up market is indeed declining but that primarily hurts premium priced competitors, such as MSN and AOL, that are caught in the middle, losing customers to broadband and the value dial up alternatives, such as UNTD and ELNK (Earthlink). If you believe that there is going to be a dramatic decline in the value dial-up market, then you should avoid UNTD. However, if you believe that the value dial-up market will decline slowly, stay steady, or increase (see below) then UNTD is undervalued. This recommendation is based upon the idea that the marketplace is confusing the declining prospects for the total dial-up market with the positive prospects for the value dial-up niche.
From UNTD’s recent conference call (www.irconnect.com/untd/conf/3q2004_transcript.html): “The recently released 2004 Jupiter research study on U.S. Internet access growth says that the value dial-up market, defined as products below $15 per month will nearly double by 2008, going from 6.2 million households in 2004, to 12 million households in 2008. The 18 percent compound annual growth rate during the 2004 and 2008 exceeds the 14.4 percent compound growth rate expected for broadband during that period according to the Jupiter study. That is a very strong point. The premium dial-up segment, defined as over $20 per month, is expected to decline roughly 10 million people at a compound annual decline rate of 7.7 percent versus a compound annual growth rate of 18 percent per value dial and 14.4 percent for broadband… It is interesting that in that report they showed 2003 to 2004 was flat at 6 million. So they do think it's going to double and they do think it will end up at 12 million, but they did think that 2003 to 2004 was going to be flat.”
I take these sorts of projections with many grains of salt, but it does make sense that there are a lot of people out there who don’t have a much spare cash but need reasonable access to the Internet. There doesn’t have to be a huge increase in the size of UNTD’s market for this recommendation to do very nicely. To get access to these new users and their demographics, UNTD is working with Best Buy, Radio Shack, Sam Goody, Kmart, and Sam’s Club. By the way, by using a value provider, users do not feel that they are getting a second rate experience. Both UNTD and ELNK rank quite high in the JD Powers customer satisfaction surveys. UNTD’s monthly churn declined to 3.4 percent in Q3, down from 4.5% in June. Both companies are working hard to keep subscribers by keeping them happy.
In addition, the investment community is falling into the common misinterpretation of a decline in growth rate being the same as an actual decline. We hear this all the time on CNBC. In Q3, UNTD had a net increase of 9,000 paying access subscribers. Because this increase was less than the increase in previous quarters, some treated it incorrectly as being a decline in subscribers. For example, see the first question in the transcript of UNTD’s Q3 Conference Call. Earthlink also had a net increase in paying subscribers to their value dial-up service (Netscape is the other major value priced competitor).
As the UNTD CEO stated in the CC: “since 75 percent of the dial-up market -- or 68 [percent] is the number, is still a premium priced, anybody that is out there 9.95 to 14.95 [$ per month] is still very attractively priced against that. And majority of the growth, we all believe, is going to come from the premium segment. So as long as United Online, I can't speak for our competitors, as long as we are priced at a 50 percent to 60 percent reduction versus the premium people, and they still have close to 70 percent of the market, we believe that the price point where we are at is compelling and attractive…” Parenthetically, I have a soft spot in my heart for companies that post transcripts of not just the prepared statements, but the Q&A, of the conference calls. It makes life so much easier.
On October 25, UNTD announced the pending acquisition of privately held Classmates Online for net cash of $100 million. Then last Wednesday, UNTD announced the $150 million modified Dutch Auction buyback of approximately 25% of it’s shares, at a per share price between $9 and $10.50.
Classmates has over 38 million registered members and over 10 million monthly active accounts, of which 1.4 million are paid subscribers. Currently, United Online has a monthly active account base of 6.6 million and 3.2 million paid subscribers, so this is a significant increase. Classmates’ President was formerly President of Nordstrom.com and Lands End. Supposedly, Classmates had been pursued in the past by Yahoo, AOL, etc… There’s the usual talk of synergies and cross marketing. That and $4 will get me a nice coffee. Frankly, I could have done without this acquisition, and for the purposes of this discussion, I’m assuming the $100 million has gone to Internet heaven. This is clearly overly conservative, since Classmates has been EBITDA positive since 2001. For the 9 months ending Sept 2004, they had revenues of $54 million, and operating income of $3.7 million. With $4.9 million of depreciation and amortization, I estimate annualized EBITDA of over $10 million. Regardless, until I get more visibility to the Classmates cost structure and capex I prefer to err on the side of being too cautious.
I believe that UNTD is a better value than ELNK. UNTD has lower EV/EBITDA and EV/FCF than ELNK. Frankly, I think it is better managed also; however, that’s a subjective perspective.
UNTD’s future FCF will be hurt by declining NOL carryforwards: 2005 is $19 million; 2006 is $17 million; and for 2007 through 2020, $12.5 million each year (excludes Classmates). Assuming flat revenues, reasonable cost controls (especially sales and marketing), and taking into account the lower NOL carryforwards and increased interest expense as a result of the buyback, I’m projecting a 2005 FCF of approximately $100 million, which is close to the FCF of 2004. Diluted shares outstanding after the buyback will be approximately 50 million shares, down from 65 million at the end of Q3. Assuming an average in 2005 of 55 million shares, we’re talking $1.82/share of FCF. At a stock price of $10.30 and net cash (end of 2005 after the acquisition and buyback, but using the FCF to pay debt) of approximately $75 million, we have an adjusted current EV of $492 million, resulting in EV/FCF = 4.9 at the end of 2005. This does not take into account tax benefits from stock option exercise or any positive impact whatsoever from the Classmates acquisition.
Once again, if you believe that the value segment of dial-up is going to fall off a cliff, this is not for you.
Negatives
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There were lots of insider sales in August, but not since then. The sales happened after, not before, the Q2 earnings release and nothing has blown up since then so at least there’s not an ethical stench surrounding the sales. As of the Spring Proxy Statement, Directors and Senior Management owned 14% (and Fidelity another 15%) of the company, so management has a lot of skin in the game. Also, in a recent SEC filing, the company disclosed that as of August 2004, the CEO entered into a trading plan to sell an aggregate of 500,000 shares during a period commencing in November 2004 and ending in April 2005. The shares, from stock options, will be sold at market prices twice each month. He does not have any control over the timing of the sales under the plan. As of the date of that filing, he held 858,000 shares (250,000 of which are restricted stock that are subject to repurchase by the Company until January 2008) and options to purchase 4 million shares of the Company's common stock at exercises prices ranging from $1.227 to $18.70
Compensation is high, perhaps excessive.
The CEO, Mark Goldston, is a bit promotional, which is to be expected from a Marketing guy. He has been associated with 2 blowups: From April 1996 to December 1997, he served as President, Chief Executive Officer and a director of Einstein/Noah Bagel Corp. He also served as President and Chief Operating Officer of L.A. Gear from September 1991 to June 1994. Prior to that, he was Chief Marketing Officer of Reebok, President of Faberge USA, and Vice President of Marketing Worldwide for fragrance and skincare at Revlon. He claims that there’s been a “been lot of misconceptions and misreporting… they don't look up the dates that I worked at those companies.”. I don’t totally buy this but his tenure at Einstein/Noah Bagel was just short enough to make one think that he got out as soon as he figured out how bad things really were. You can read more of Goldston’s remarks in an interview at http://news.com.com/2008-1082-908775.html. Goldston seems to have done a great job since he joined UNTD, and he does seem to be working to increase shareholder value. I like his recent comments: “We run this business for the bottom line…I do not believe for a moment that we are underspent [on advertising].” I haven’t seen any indication of funny business (at least, not by the standards of the Internet industry) in UNTD’s financials, but you need to draw your own conclusions.
Stock Dilution: At Q3, there were options on 13.3 million shares with an average strike price of $12.40. Of these 5.9 million were anti-dilutive. If they expensed stock options, their earnings would be cut almost in half. Typically I focus on Free Cash Flow.
Risks
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Sales and Marketing costs get out of hand.
Value Dial-up does in fact rapidly decline.
Avg pricing declines more than expected due to a price war with Earthlink or Netscape or because of a significant price drop by broadband, AOL, and MSN.
Catalyst
Both ELNK and UNTD have a history of large mergers with competitors. There would be obvious improvements in sales opportunities and cost reductions were the two of them to merge. Were this to happen, I think UNTD could be a grand-slam. I have not modeled this possibility nor is my recommendation dependent on it.
Ongoing stock buybacks
Premium dial-up services continue to lose subscribers to broadband and value dial-up.