Description

Don’t CALL now!!!!!!!!

Note:  CALL had a two for one split on December 2, 2011.  I have adjusted all share counts and per-share numbers, so everything is expressed in current shares and relative to the current stock price.

magicJack VocalTec Ltd. (NASDAQ ticker CALL) provides dirt cheap, low quality residential telephone service over broadband Internet connections to residential customers.   In the company’s standard offering, customers buy small a device (the magicJack) that lets them plug standard telephones into their computers and place unlimited calls within the US and Canada.  Customers also get a US phone number and can receive unlimited calls.  That device retails for around $37, and is available both directly from the company online and at major retailers, including Radio Shack and Walmart.  Purchase of the device includes one year of service, after which service is automatically renewed (unless the customer cancels) for $20 per year; with the purchase of a five-year renewal, the annual charge falls to $14.  Customers can port their old telephone number for a $20 fee.  magicJack designs and markets the product and operates the related telephone service, but outsources manufacturing.

For someone who has a broadband connection and is willing to keep a computer running, this is, hands down, the least expensive telephone service of which I’m aware.  By comparison, similar service from Vonage costs $26 per month (though the Vonage device is free, and does not require a separate computer); adding voice to a cable/internet package costs around $15 monthly where I live.  The least expensive competing service that I have seen charges $5.38 per month with a two-year service plan.

There are, however, significant downsides for customers who choose magicJack.  First, broadband calls —low call quality (though this can be a problem with all broadband telephone services), non-existent customer service, a limited supply of phone numbers available which has caused delays in the assignment of numbers, and—the biggest downside in my opinion— adware dumped onto the customer’s computer.

This quarter, magicJack began selling a premium product, magicJack PLUS, which lets customers connect to a broadband connection without a stand-alone computer.  This costs an extra $40 for the device, plus another $10 per year after the first year, but does not require running a computer 24/7 to maintain phone service.  They have also started distributing magicTalk, a software-only (i.e., “softphone”) version of their service (i.e., customers download a program and use their computer, with a microphone and headset, rather than plugging a telephone into a magicJack device).  I have not yet found information on pricing for the softphone.  magicJack also upsells international calls by the minute and receives some revenue from the local telephone infrastructure that it owns (other telephone companies pay magicJack to connect calls to the telephone network, just as magicJack must pay for that connection in cities where it does not have its own infrastructure).

The Customer Experience

The company’s competitive edge is price—the least expensive competing service that allows both incoming and outgoing calls that I’ve seen runs $5.38 per month with a two year contract.  Unlimited calling in the US and Canada through Skype with an incoming number costs $96 per year, with a $40 charge if you want a telephone adapter (but Skype does let you keep your current phone number); similar service from Vonage costs $25 per month (with a free adapter).

There are, however, significant downsides for customers who choose magicJack.  First, though this is true for other broadband phone service providers, call quality is simply not as good in most cases for calls placed over the Internet than for calls made on the public switched telephone network.  The negatives that are magicJack specific are non-existent customer service, a limited supply of phone numbers available (which has caused delays in the assignment of numbers), and—the biggest downside in my opinion—adware dumped onto the customer’s computer.  Here’s a quick tour through some of the limitations of their terms of service (http://magicjack.com/tos). 

• They do not guarantee that the magicJack and/or magicJack Plus device or magicJack APP will always function without disruptions, delay or other imperfections. 
• The device may not be compatible with non-voice communications equipment, including but not limited to, home security systems, medical monitoring equipment, fax machines, satellite television systems, or computer modems.
• They do not guarantee that a requested phone number can be allocated to you or that you can make use of the incoming call feature.  They can “refuse, change or terminate any phone number at anytime.”  If they change your phone number, you are not entitled to a refund if you cancel.
• They can terminate “calls of long duration.”
• If they determine that your use is excessive, (including but not limited to, a customer whose usage is twenty (20) times more than the average magicJack and/or magicJack Plus device or magicJack APP customer usage, or a customer who calls more than 50 different telephone numbers per day), they can terminate your service immediately without a refund.   Of course, it’s not unreasonable for the company to prevent abuse, but compare these terms to those of Vonage, which has a review policy and undertakes to provide notice; Vonage also give guidance as to excessive use, exceeding 3,000 minutes per month.
•  “Some restrictions [on free calls] in cost prohibitive areas may apply.”
• They do not guarantee that they will continue to offer 911 emergency service (to be fair, this is an issue with any broadband phone service).
• They can put you on automatic renewal, though you can opt out on their website.
• They can store information about you and give it to their affiliates and business partners (i.e., anyone who wants to buy it from them).

You can compare to Vonage’s TOS to get an idea of the relative level of customer friendliness of the two companies (http://www.vonage.com/tos/#CUSTOMER).

A broader source of customer feedback is the reviews at Amazon.com (http://www.amazon.com/magicJack-PC-to-Phone-Jack/product-reviews/B0011UXSHK, http://www.amazon.com/magicJack-MJACKPLUS-Plus/product-reviews/B0061R1XI4, http://www.amazon.com/Magicjack-Phone-Device-Magic-Jack/product-reviews/B004TSBU7G, http://www.amazon.com/magicJack-Phone-Device-2-pack/product-reviews/B00154QHHU), where the reviews are (to be charitable) mixed.  Although it’s a few years out of date, PC Magazine (in my experience, usually a fair source for reviews back when they were in business) gave magicJack an Editor’s Choice award in 2009 (see the review, and user comments, here http://www.pcmag.com/article2/0,2817,2250244,00.asp).  Consumer reports gave magicJack a pretty favorable, though brief, review, too (http://news.consumerreports.org/electronics/2010/01/magic-jack-magicjack-test-review-deal-phone-usb-voip-skype-vonage-as-seen-on-tv-infomercial.html).  You can find other reviews on the web, mostly negative, but I don’t trust most product review websites.

Perhaps the most telling quality statistic is the company’s limited renewal rate.  Although magicJack does not report churn statistics (which is itself telling), using the latest numbers for which I have the necessary breakdown, the company sold $80.0 million of magicJack devices in 2009.  At full retail price that would translate into 2.7 million units, though, given the predominance of retailers in their distribution, I’d guess they sold something closer to 3.5 million units.  2010 renewal revenue was $21.6 million, which indicates renewals on around 1.1 million units (some of which might have been sold before 2009, but I’ll be generous and count them all as renewals for equipment bought in 2010).  In other words, around 2/3 of customers do not renew their subscriptions, which strikes me as extraordinarily low for a service that automatically renews by credit card unless cancelled.   By comparison, Vonage, with its monthly churn of 2.4%, loses around 25% of its customers each year.

Marketing

magicJack markets itself primarily with high-volume radio and television commercials (“Eliminate your monthly phone bill FOREVER!!!!!”).  If you haven’t experienced these for yourself (which probably makes you the one VIC member who lives in Antarctica), you can get a flavor for the way they advertise from their website, http://magicjack.com.  Schlock marketing, while it’s usually a good indicator that one should stay away from the product, of course doesn’t mean that a stock is bad.  But marketing is one of the main keys to the company’s limited prospects:  Not surprisingly, given their annual 65% churn, the company consistently plugs around 25% of its revenues back into advertising for new customers (which is comparable to Vonage, at 22%).

magicJack’s potential market is limited.  Basically, the people who buy it can afford broadband but either don’t have a cell phone or really don’t want to pay for an unlimited calling plan, and are either willing to accept adware on their computers (or don’t bother to read the terms of service).  I suppose that, with the magicJack PLUS, some people without home broadband service might “borrow” the broadband connection at their office.  Moreover, the broadband telephony market isn’t growing, at least not in the US and Canada where magicJack operates.  Vonage’s subscriber numbers and revenues are flat, and they said in their latest 10-Q that they are focusing more on upselling international calls by the minute than on maintaining their subscriber base. 

In the longer run, it’s hard to see what magicJack’s sustainable advantage is.  Their local carrier facilities help them provide low cost services, but the market for local phone services is being squeezed by cell phone services, broadband offerings by cable companies, and the convergence of instant messaging with traditional phone service (as best evidenced by Skype).  The company’s R&D budget has come down from five percent of sales in 2009 to two percent in the first three quarters of 2011, so it doesn’t look like they have a major follow-on product in the works.

Financials

Here are magicJack’s reported numbers for the first three quarters of 2011 and the full years 2010 and 2009, plus my projections for 2012, all with the associated percentage of sales.

Sales in the first three quarters this year were $82.8 million (running at a pace slightly below 2010 sales, though the company hasn’t published enough quarterly information to judge seasonal effects).  2010 sales, in turn, were up slightly over those of 2009, with $20 million in renewal revenues offsetting a $20 million decrease in 2009 device sales.  The company attributes the device sales decline to lower margins as retail dominates direct sales to customers and to elevated sales in 2009 as retailers built inventory.  One bright spot in their financials is the decline in SG&A from 2009 to 2010, which made them EBITDA profitable, but SG&A has stabilized at 2010 levels.  So far, the basic story is one of a company with little customer loyalty that has turned virtually all of its sales around into costs.

The company guided to $58 million of sales in the fourth quarter alone, reflecting sales of the magicJack PLUS device (this was the good news that disguised the bad news that the company cancelled its planned underwritten secondary offering “determining that the dilution at current market prices was not worth any benefits it might receive from raising capital” in their December 16, 2011 6-K.  In case you didn’t notice that, magicJack announced in its January 19 8-K that “with increasing cash and short-term investment balances plus expected accelerating income in the future,”the Board had increased the company’s repurchase program to $55 million dollars.  The CEO (or maybe the press hack who drafted the release, you never can tell) said that they had a “tremendous finish at the end of 2011, with a very good start so far in 2012, which will help produce impressive Revenue and Income gains this year.

So, does this mean that magicJack PLUS is a magic device that will plot a course toward high growth and tremendous future earnings?   A skeptic might say “no,” pointing to the large jump in revenues in 2009 over 2008 due to retailer stocking of a new product, expecting that sales will not grow exponentially.  I am that skeptic, though I do project nearly 20% revenue growth (and 135% EBITDA growth) for the company in the fourth quarter.

Valuation

magicJack has a market capitalization of $418 million as I write (at the January 24, 2012 closing price of $17.40).  Subtracting $33 million of cash (and no debt) on their balance sheet, that gives them an enterprise value of $385 million.  At my 2012 EBITDA projection of $10.6 million, that’s a 36.2 EV/forward EBITDA multiple.  By comparison, Vonage, with analyst estimated 2012 EBITDA of $161 million, trades at an EV of $624 million, or 3.9 times forward EBITDA, and I’m not a fan of VG stock at these levels, either.  Nothing that I’ve seen justifies the growth premium that the market has put on CALL stock.

Red Flags

Here are some other issues which don’t directly address relative value, but all of which raise the hackles on my back (yes, I actually have hackles):

• magicJack originally went private by a reverse merger into a US-listed Israeli company in the middle of 2010.  To put things mildly, reverse mergers tend not to outperform.
• Buy, buy buy!  Sell, sell, sell!  magicJack announced a $12 million stock buyback program in July 2011, and also said they would seek shareholder approval for their CEO to own more than 25% of the company’s stock.  The CEO (who owns around 20% of the company), then sold 438,000 shares (about 8% of the stock he then owned, or 2% of the outstanding stock) in private transactions in September (see 13D/A filed October 12, 2011, and adjust for the split).  The company planned to offer 1.5 million shares (including 300,000 shares being offered by the CEO) in an offering led by Oppenheimer in December, but, as discussed above, cancelled that offering a week later because they stock price tumbled.  Now the company has increased its buyback program to $55 million.  According to the latest financial statement, the company bought around 1.8 million shares into Treasury at an average price of $9.57 in the first three quarters of 2011.
• The company is based in Israel.  Though their major operations are in the US, magicJack is incorporated in Israel, which means that governance standards may not be as high as they are in the US and it might be more difficult to recover for any securities law violations or corporate malfeasance.  They have not reported quarterly results so far, though they have undertaken to do so starting in 2012.

Oppenheimer Initiation

Oppenheimer just initiated on the company with an outperform rating and a $24 price target (they were the lead bank in the failed offering).  I don’t have an account at Oppenheimer, so I don’t have access to their research.  I’d love to hear from anyone who has coverage there regarding Oppenheimer’s thesis.

Risks

The magicJack story isn’t entirely negative, of course.  CALL is a great ticker, and that’s got to be worth something.  The major short-term risk is that the company is going to report very strong growth this quarter.  I expect their earnings announcement to come within the next several weeks.  While this is part of my central thesis—their preannouncements and the Oppenheimer report have pumped the stock up (reaching nearly $20.00 this morning, though it is down in later trading), and the fundamentals just don’t justify a valuation anywhere near that), we could see another spike on earnings.    We have put on about half of the short position that we’d like, keeping some powder dry in case there is a big uptick on earnings.

In the longer term, if the company doesn’t change its mind again and offer stock, they can support the stock price for a while by using their cash and EBITDA to buy back stock—but how long can they go on buying stock back at nearly 40 times EBITDA?

The risk that doesn’t concern me much is that I’m wrong in my business analysis and that magicJack will grow until it owns the broadband telephony market.

Catalyst

We’ve seen them say it wants to buy stock back and then (try to) do a secondary before.  I think that’s their game now, and I expect either a secondary and/or an announcement that the CEO is selling stock after earnings (if the CEO’s as smart as I think he is, he’s probably selling right now).  Failing that, we’ve seen the company’s sales spike on the introduction of a new product before.  It might take a few quarters, but I think the market will figure out that a subscription business whose subscribers hate the service isn’t sustainable.