Description

On June 1^st, Zedge (ZDGE) was spun out of IDT (IDT). Shareholders of IDT received one share of Zedge for every 3 shares of IDT they held.  Every value investor (particularly on this board) has heard of the “spin off” effect, when a smaller company is spun out of a larger company and has its shares indiscriminately sold by the larger company’s shareholders. There’s reason to think that Zedge could have been subject to even worse spin off selling than typical. IDT is a member of the Russell 3000 with a $300m+ market cap company with a 5%+ dividend yield. Two of IDT’s five largest shareholders (Vanguard, Blackrock) are index funds, and the other three (Renaissance, Dimensional, Acadian) employ mainly quantitative focused strategies. Normally, when a company like Zedge is spun out of a Russell index component, it is included in the index until the next reconstitution (see p. 38). That would normally allow for a company like Zedge to establish a somewhat normal trading market until the indices are forced to sell. Zedge, however, was spun off during the Russell 3000 reconstitution this month and was immediately deleted from the indices. Between getting dropped from the indices and the lack of a dividend, it’s reasonable to think that almost every top holder of IDT is either explicitly precluded from owning ZDGE or runs a strategy that would never recommend owning ZDGE. The resulting selling pressure has driven Zedge down from a when issued price of ~$7.50 to today’s price of ~$3.64/share. However, there’s reason to think a decent bit of the selling pressure may be over: over 3.4m shares have traded in the ~15 trading days (started trading June 3) since spin off, and the reconstitution is about to end (the reconstitution officially takes effect June 24^th, but most selling is done by the prelims on the 10th and 17th). Zedge has only ~7.3m shares in its free float, so it’s likely that most of the extreme selling pressure is over and the remaining shares are held by investors who are interested in holding Zedge shares or, at a minimum, are not forced sellers in the near future.

The forced selling has presented investors the opportunity to buy an interesting start up like company at a depressed valuation. While there’s an opportunity for a near term snap back that could send shares up by 50-100% as the forced selling abides and Zedge returns to around its when issued price, for investors willing to take a longer term perspective there is an outside chance that Zedge could be a ten-bagger or more over the next few years. Obviously such a result would require a bit of good fortune, but it’s definitely within the realm of reason given the optionality on the company’s huge user base. While past performance is no guarantee of future results, it is also worth noting IDT has a history of spinning off companies that unlock substantial value post spin off.

Zedge’s main business currently is the Zedge app. Zedge allows users to download custom ringtones and wallpapers for their phone. While you may not have heard of it, this is actually one of the most popular apps in the world: the app has now been downloaded more than 200m times, is currently installed on over 90m phones, and has over 32m monthly active users. The app was named one of the best apps of 2015 by Google Play. Importantly, Zedge has grown to be one of the most popular apps in the world without making “any material investment in marketing, user acquisition, or advertising” (see their information statement).

All of these user metrics put Zedge’s user base in the same proximity as some of the largest and most valuable companies in the world (WhatsApp, Instagram, Snapchat, Pinterest, etc.). Each of those companies is worth way more than $1B and, on the low end, is valued in the low to mid double digits per user; on the higher end, they’re valued at almost $200/user. Zedge, on the other hand, is valued at ~$1/user.

It’s also worth mentioning SoundCloud, since I find Zedge’s app is consistently around SoundCloud in the Google Play store. Twitter just invested $70m into SoundCloud in a deal that values them at $700m.

Should Zedge’s users be worth as much as any of those tech giants? The answer there is almost certain no. Zedge has not monetized as well or as quickly as those other companies, and Zedge’s business doesn’t benefit from the same network effects as the tech giants. The lack of network effect reduces Zedge’s moat and its ultimate trading multiple, and Zedge also does not benefit from the type of constant checking of news something like a Facebook has (based on how I’ve seen people use Zedge, people pop onto the app once a month or so to put in a new ringtone and wallpaper versus something like Facebook where people might check every hour). However, it’s reasonable to think that Zedge shouldn’t be valued at 1/30^th- 1/75^th as much on a per user basis as those giants. It’s also worth remembering that it’s probably better to have a app / platform that users actually like / use and then figure out a way to monetize them than it is to have an easily monetizable app that doesn’t have any users; at one time or another, people have doubted the monetization potential of just about every app and online company, including Snapchat, Facebook mobile, Twitter, and Instagram. Snapchat is a particularly interesting one to think about compared to Zedge. Snapchat started by getting a bunch of users hooked, and it seemed they had no obvious ways to monetize them without distracting them and destroying the user experience. The most obvious ways were probably payments or promoted snaps sent directly to people, but promoted snaps would likely interfere with user experience and payments would be an awkward extension into an already very crowded (and regulated) field.  Instead, the company invented some novel monetization strategies (basically becoming a media distribution platform) and is now making a fool of people who mocked them for turning down Facebook’s $3B acquisition offer. Pinterest is another interesting one to consider as its model has some loose similarities to Zedge; the company was able to raise hundreds of millions before ever even considering monetization and has rapidly scaled since they started monetizing. Again, I don’t think Zedge is worth anywhere close to those companies, but it’s worth remembering that having a ton of people using an app presents a lot of optionality for monetization. It’s also worth thinking about the LNKD buyout, which “puts these companies more into play now because what we’re seeing is concrete evidence of how important data, users and owning a component of time spent are.” Zedge provides a ton of users and data on what those users like (in the form of wallpapers / ringtones users download); that info is likely pretty valuable as a marketing tool as people generally have a pretty unique connection to most of the stuff they put on the background of their phones.

Zedge is currently a profitable company (LTM revenue of $11m, LTM net income of $2.5m). Going forward, the company will add ~$900k in SG&A/year to support them being public, so LTM net income could more accurately be looked at as ~$1.6m. At today’s share price of $3.65, Zedge’s fully diluted market cap is <$40m and its EV (adjusted for cash from options) is ~$32m, so Zedge wouldn’t make for a “traditional” value investment at ~3x revenue and ~25x P/E, though those multiples are certainly interesting when considering the company has grown revenue 30% YoY YTD. However, I think when the company is thought of as an option with potentially huge value, the company looks dramatically undervalued.

The Zedge “option” can pay off in two forms, but basically comes down to a simple bet: Zedge has~32m people a month using their app (and over 90m active installs) and history suggests that when that many people use and like your product, there is a way to make a significant amount of money from them. And given Zedge’s significant operating leverage (gross margins of 85-90%, net income went from ~breakeven in FY14 to a $1.6m profit in FY15 on a ~$2.5m increase in revenue), as the company’s monetization of their user base improves their bottom line should improve rapidly. 

The first way the option could pay off is by improving monetization on the Zedge app itself (increasing revenue per monthly active user). This can take a lot of different forms. The company currently makes most of their money from programmatic advertising (i.e. banners at the bottom of the app and interstitial ads that pop up while you’re using the app). However, there are several different venues that Zedge could pursue that could add to their revenue per user. One example is Zedge Stories, where content creators can use Zedge to provide a “story” that incorporates wallpapers, videos, ringtones, icons, and notifications. Zedge already signed one deal for this feature with IDW Media (which is also controlled by Zedge’s Chairman), and there’s reason to think other movie studios and games could be interested in using this feature given the potential to form deeper connections with fans. There are plenty of other ways to imagine monetizing Zedge’s user base; one in particular I find interesting is sending out promoted ringtones to encourage people to sample new music. You could also imagine them using the customization aspects to market live events (you downloaded a Taylor Swift ringtone? She’s playing in your neighborhood next month! Here’s a link to buy tickets! You downloaded a football wallpaper? Here are offers for tickets to see them play, merchandise, etc.), but the bottom line is there are a lot of ways for Zedge to increase user monetization.

The second way the option could pay off is by using Zedge to steer users to other apps they create that are easier to monetize. Indeed, the company is already looking into this as they are beta testing their “Snakk” app and plan on rolling it out later this year. The way management describes the app makes it sound loosely similar Bitmoji, the app snapchat bought for more than $100m earlier this year (it’s worth noting that most discussions of Snapchat buying Bitmoji discuss how persistently popular the app is on the iTunes store, similar to how persistently popular Zedge is on the Google Play store) and the Gboard app. Yes, this might seem silly, but I think the potential here is huge: while it’s not quite the same, the popularity of “Kimoji” type apps shows the appeal of apps that allow for personalization of messaging and that consumers are willing to download plenty of these apps and add-ons. While creating and monetizing any app is a roulette wheel, I think Zedge has a much better than normal chance of introducing new hit apps once you combine the ability to market to their existing user base with the amount of customization and user data they have from tracking the way users interact with Zedge and what they end up downloading on it (note: early user reviews of Snakk (they’ve launched in a few markets) are generally positive). It’s also worth remembering that while they have 32m monthly active users, they have more than 90m active installs and 200m installs in total, so the base that they’d be marketing to is potentially huge, particularly if they use strategic push notifications to increase active install engagement.

While both of those options should increase Zedge’s revenue per user, it’s also worth noting that there’s still plenty of room for Zedge to grow their user base. Monthly active users continue to grow in the double digits year over year, and the company is introducing a new “set my ringtone” feature that could serve as a viral marketing device for bringing in users’ friends (users chose a ring tone that they want people to hear when they call and then send it to all of their friends. If their friends have Zedge and accept, it automatically sets the users ringtone to that song. If they don’t, they’re prompted to download Zedge).

There is one last option that could massively increase Zedge’s value: iOS. Apple currently allows almost no customization on their phones, including not allowing users to easily set their own ringtones. In late January, Zedge had figured out a workaround that would make it easier for users to customize their ringtones through the app. Apple thought this was a breach of their terms and took Zedge off the iTunes store from January to March. Zedge responded by relaunching the app with a wallpaper only version for iOS. If Apple ever allows for more customization on people’s phones, Zedge’s business could more than double overnight (Apple’s announcements of widgets at WWDC seems to be a small step in this direction). Also, while the incident was less than ideal, it also shows how popular the Zedge app is: Zedge was off iTunes for ~2 months, and when it relaunched it launched as an inferior, wallpaper only product. The inferior product didn’t stop people from flocking to download the app and the app quickly shot to the top 50-60 on the iTunes store.  Zedge also plans on making sure all apps in the future are equally accessible between iOS and Android, so in the future the iOS versus Android discrepancy should drop.

It’s also worth discussing another reason why the spin off could unlock growth. Under IDT, Zedge has noted that they were being run somewhat for cash flow. While that’s fine and has allowed Zedge to produce positive net income, it’s probably not the appropriate way to run a rapidly growing start up. Instead, Zedge should be plowing back all of its profits into itself to invest in future growth (hiring more engineers, pushing out new products and apps, and continuing to accelerate user growth). Now that Zedge is public, they can run themselves for growth, use more options to lure employees, etc. There are already signs the company is doing exactly that, as they’ve increased their headcount from 46 to 55 this year. While that might scare some value investors, given the size of the potential payoff from successfully monetizing their users, I think it’s exactly the right strategy going forward.

Catalysts

The most obvious catalyst is the exhaustion of forced selling from the legacy IDT holders. And obviously longer term, the results with Zedge will be driven by continued growth in the user base and user monetization. But there is one more shorter term catalyst that could spur shares closer to fair value.

On June 9^th, Zedge reported Q3’16 results. Revenue was up 17% and monthly active users were up 18%. In a vacuum, those are impressive numbers. However, that’s down from a 38% increase in revenues and 32% increase in monthly active users in the first half of the year, so investors might be worried that Zedge is approaching the limits of its monetization potential. In addition, operating income was actually down YoY in Q3 (from $404k to $243k). And both revenue and operating income were significantly down sequentially from Q2’16. It’s easy to see how all of those numbers could worry investors, particularly ones who were just handed shares from IDT and had never done work on Zedge.

I don’t think the huge post-spin sell off is at all related to fears of the app “topping out” as the sell-off started before the company posted results, but it is worth addressing those concerns. I think there were some significant one time issues that drove lower than normal growth and operating leverage during the quarter. As mentioned above, Zedge was kicked off of iTunes at the end of January and came back during late March. That means for more than half the quarter, Zedge was unavailable on iTunes, and it relaunched as a less useful wallpaper only app. It’s hard to imagine that being off iTunes for that long wouldn’t have an impact on user acquisition, and launching as a less useful app almost certainly drags down their iOS revenue/user. The fact they were able to grow so strongly without iTunes is actually pretty impressive. With the app back up and running normally, we should see strong user and revenue growth in Q4. In addition to revenue / user growth, operating income also decreased YoY during the quarter, but the explanation there is much simpler: Zedge is investing in growth, particularly headcount growth, which is increasing SG&A costs. Given the operating leverage in the business and the huge payoff from continued growth, I think the investment in headcount and infrastructure makes sense and should create significant shareholder value. The company also incurred additional costs prepping for the spinoff. Lastly, the sequential decline was driven by normal seasonality in the business: Q2 tends to be strongest as it includes Christmas, which not only has the strongest advertising rates but also includes a lot of people who get new phones. As soon as people get a new phone, they tend to go on an app downloading spree, which often includes Zedge and thus generates a small boost to MAUs during the quarter.

Risks

There are obviously risks when investing in any app / tech / start up company. Most of the risks can be summed up by simply stating that tech / apps move fast and are very competitive, but there several specifically identifiable risks. The first risk is that I’m simply wrong and Zedge can’t improve user monetization. Moving on from that, 85% of users are on Android, and Google could make unilateral changes to the app market that could eliminate Zedge (i.e. eliminate customization a la Apple). I think that’s unlikely, but it’s the most obvious risk. Google could also chose to make the app themselves and crush Zedge, but I don’t think they’d be interested in doing so for a variety of reasons, including that they haven’t done so over the past five years. Zedge could struggle to launch new apps and burn money trying to do so. Apple is paying particular attention to improving their messaging apps and Google’s Gboard is already excellent, so it’s possible Zedge is launching Snakk dead on arrival, but I don’t think that’s a huge concern at today’s valuation and there’s generally room for more than one of these apps (again, just look at how many emoji apps people are willing to download) and my discussions with management on Snakk make it seem like it has some unique features and functionality. Longer term, there’s risk as we transition from smartphones to whatever’s next (wearables, VR, etc.), though I have trouble imagining that the transition would come quickly enough to devastate Zedge’s business in the next five to ten years (management has also stated several times that they see huge opportunity in the customization market as we shift from handsets to wearables and whatever’s next). Zedge also has some macro exposure, as their revenues currently come almost exclusively from advertising, so economic weakness that drives advertising rates down will obviously impact them as well. In terms of exits, with both Marissa Meyer and Ballmer gone, it’s likely bidding for smaller, startup like companies will be less frothy going forward, and the tumblr acquisition will probably weigh on everyone’s mind when acquiring a company with a ton of users but limited monetization to date, but I think that’s a long way away and the investment thesis rests on Zedge improving user monetization, not a takeout at a silly valuation.

Outside of those normal business risks, I think the biggest risk here is company control. Similar to all IDT spinoffs, the stock has dual control that gives the chairman, Howard Jonas, full control of the company without equivalent economic risk. While he’s historically been very generous with insider compensation and shareholders will have to live with that, he also has a long history of value creation at these spin offs. The company is also going to be investing a significant amount in growth, including issuing stock to new hire employees, so investors should also expect continued dilution going forward.

It’s also worth noting that the company did a $3m equity raise from IDT and other controlling shareholders at a pre-money valuation of $27m right before the spin off happened. Investors at today’s prices are buying in at roughly that valuation, so it’s reasonable to wonder why I think value is so much higher than that valuation. My understanding is that this valuation was done to provide Zedge with enough cash to function comfortably as a standalone. In addition, apparently IDT and the other investors had made a deal with Zedge in connection with their first series of investments that would allow them to do one last investment at a discounted rate before the company went public. Take that for what it’s worth, but I don’t think that the pre-spin valuation is anywhere close to the company’s underlying intrinsic value once all of the upside is accounted for. 

Catalyst

New app monetization

Continued user growth

End of forced selling