MagicJack Has Been Left for Dead
“When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.” –Howard Marks – Oaktree Capital Management
“Investing is the only business I know that when things go on sale, people run out of the store.” – Mark Yusko
“Investment markets follow a pendulum-like swing: between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced.” -Howard Marks – Oaktree Capital Management
I believe the pendulum of magicJack stock has swung entirely too far to the downside and now presents an opportune time to go long the stock. MagicJack (CALL) has become a textbook deep value play with an Enterprise value to EBITDA of 1.9x, a cash cow of a consumer (core) business spewing out plenty of cash, and the shares have practically been left for dead.
Business Overview: MagicJack VocalTec Ltd. (Nasdaq:CALL), the inventor of magicJack and a pioneer in Voice over IP (VoIP) technology and services, is a leading cloud communications company. With its easy-to-use, low cost solution for telecommunications, the Company has sold more than 11 million award-winning magicJack devices, now in its fifth generation, has millions of downloads of its free calling app, and holds more than 30 technology patents, magicJack is the largest-reaching CLEC (Competitive Local Exchange Carrier) in the United States in terms of area codes available and number of states in which it is certified. MagicJack VocalTec Ltd. and its subsidiaries is a cloud communications company. The Company provides magicJack devices and other magicJack products and services. The Company also provides voice applications on smart phones, as well as the magicJack PLUS, magicJack GO and magicJack EXPRESS, which are updated versions of the magicJack device that have their own central processing unit (CPU) and can connect a regular phone directly to the user’s broadband modem/router and function as a standalone phone without using a computer. The magicJack device uses Voice Over Internet Protocol (“VoIP”) to allow you to make local and long-distance calls to the U.S. and Canada using an existing internet connection. Over the past two decades, VoIP has revolutionized the way people communicate and has become a mainframe technology that is here to stay. Considerable cost savings that VoIP offers to both residential as well as enterprise users as compared to traditional PSTN telephony is the key market driver. VoIP adoption is rapidly growing in the enterprise space with companies realizing that efficiencies could be gained through the simplified management of a single voice & data network. At its most basic, VoIP is an internet phone service. Instead of having your phone calls delivered through your local phone company they are instead delivered through your Internet connection.
The Company’s large existing user base, pricing advantage, efficient customer acquisition model, low cost service delivery and customer care capabilities, position it well to compete effectively in the future.
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CALL is an uncovered and unloved $110 million market cap company trading at 5x cash flows – and that’s before you back out the 51 mm ($3.43/share) in balance sheet cash and no debt – EV/EBITDA is under 2x. While earnings are steadily declining from the legacy business – it is still a cash cow with a fairly sticky user base of 2.21 million active subscribers. The stock trades just above six year lows. CALL has recently moved up a point on decent volume as is usual around the earnings period, the stock is sitting around a multiyear support/resistance level of ~$7. The run-up is likely due to a better than feared Q3 earnings (stock popped 8% on the day of) and the recent break-neck rally in small cap stocks.
Let us dig into the Bear Case(s) for MagicJack: (With my base cases following each bear case)
“The technology of the Magicjack device is irrelevant and will continue to be disrupted, the core (consumer) business is a melting ice cube.”
This may prove to be the case, while Magicjack’s core user base is fading it is still relatively sticky. With a monthly churn rate of 2.4% (28.8% annually) on a current user base of 2.21 million, I am modeling the continued churn as well as trending activations in line with the previous two years – with a conservative 17.5% decrease in activations each year for the next four. This leads me to believe that subscribers (subs) will decline as follows. Also, CALL’s low cost-structure allows it to be the cheapest in the space at $35 a year. Anyone looking to save several thousand a year on cell phone bills from major carriers can do so for peanuts with a Magicjack device – this is the niche CALL can likely continue to stay relevant in.mj-3
In a conservative model below we can feed through MagicJack’s estimated revenues and gross profits from the expected trend in subs.
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At the current valuation, primarily looking at a sum of the parts basis the stock is a classic cigar butt (very cheap, with opportunities for future puffs – aka cash flow generation) even if the ice cube melts and there is no stability.
“Short interest is 21%, these guys know it’s going to zero, management misses on every objective, management has to reach for growth through acquisitions at 30x EBITDA (Broadsmart – late 2015/ early 2016), they are not returning cash to shareholders but diluting them through desperate acquisitions.”
The capital structure is free of debt and the company has $51 million in cash, the cash buffer combined with the cash flow characteristics of the business should support the stock. The recent activist involvement could bring some stability and a greater focus on creating value and returning cash to shareholders.
CALL has excellent cash-flow characteristics. When a new majicJack is sold, it is paid for the equipment and a year’s worth of call subscription. The call subscription portion of the payment is booked as deferred revenue and converted into revenues on the operating statement over the course of the year. The same thing happens when someone renews their subscription; most renewals pay for a full year up front.
Management is milking the consumer business for the cash flows – Management on the Q3 call – “We continue to identify potential areas for cost reductions to maximize cash flow from the consumer business.” The analysis below shows how management has been able to handle a decreasing top line – cost of revenues and operating expenses where each down 19.7% and 31.1% respectively – this lead to an increase in margins.
YEAR ENDED DECEMBER 31, 2015 COMPARED TO YEAR ENDED DECEMBER 31, 2014
Net Revenues
Total net revenue was $101.0 million and $116.3 million for the years ended December 31, 2015 and 2014, respectively, representing a decrease of $15.4 million, or 13.2%. The decreases in the components of net revenues were primarily attributable to the following:
· a $8.7 million decrease in revenues recognized for the sale of magicJack devices, primarily as a result of lower unit volume on the sale of magicJack devices.
· a $1.3 million decrease in shipping and handling revenues primarily as a result of the reduction in unit sales mentioned above.
· a $2.7 million decrease in other magicJack related products reflecting lower unit sales on the device.
· a $1.8 million decrease in revenues from prepaid minutes primarily as a result of lower usage of prepaid minutes and;
· a $1.1 million decrease in access and wholesale charges primarily reflecting lower network traffic.
These decreases in components of net revenue were partially offset by an $0.2 million increase in access right renewals. This is why you own the stock – the access right renewals are quality, largely steady cash flows.
Cost of Revenues
Total cost of revenues was $34.1 million and $42.5 million for the years ended December 31, 2015 and 2014, respectively, representing a decrease of $8.4 million, or 19.7%. This decrease in cost of revenues was primarily attributable to:
· a $3.8 million combined decrease in costs related to the magicJack devices, shipping and handling and credit card processing fees primarily reflecting lower unit sales of the magicJack device;
· a $4.3 million reduction in network and carrier charges reflecting lower network volume and continuing efforts to negotiate more favorable rates with other carriers.
While revs declined 13.2% yoy management was able to target 19.7% decrease in cost of revenues, thus aiding margins.
Total operating expenses were $41.5 million and $60.2 million for the years ended December 31, 2015 and 2014, respectively, representing a decrease of $18.7 million, or 31.1%. This decrease in operating expenses was primarily due to:Operating Expenses
· a $11.0 million decrease in marketing-related expense driven by (i) a $7.2 million decrease in advertising media buys reflecting management’s decision not to spend significantly on media buys, (ii) a $1.2 million decrease in marketing related personnel costs driven by a decrease in head-count, and (iii) a $2.6 million decrease in sponsorships and other advertising spend reflecting a more conservative approach to our marleting spend in 2015;
· a $6.4 million decrease in general & administrative expenses primarily due to (i) approximately $5.0 million in lower legal and other professional expenses reflecting less litigation, and the settlement of certain regulatory and tax-related matters.
· a $1.4 million decrease in research and development costs primarily reflecting lower personnel related expenses and a decrease in research and development related consulting costs.
With 21% of the float short, any of the catalysts (listed later) coming into play can get the stock out of the doldrums and on its way to trading on the same planet as its intrinsic value.
“MagicJack’s entire business is in decline all across the board”
While it may look this way, The company’s growth initiatives (Broadsmart and SMB (Small/Medium Business) operations) are on their way to leveraging MagicJack’s assets already in place to drive the top and bottom lines. While I’m not taking managements word for it they say the following – “Both of these are targeting business voice customers and industry segment that is growing and what we believe our low cost infrastructure and other core assets bring significant value.” And Broadsmart “The business is highly profitable, having generated approximately 13 million in revenues and 4.6 million of EBITDA in 2015, an EBITDA margin of over 35 on an unaudited basis. For 2016, the Broadsmart business is forecasting over 20 year-over-year growth in sales.
There is a large “governance discount” built into the shares at the moment – where investors have such little faith in company management & board that they assume they will continue to destroy value. This is explained by CALL being a $12 stock last November before management embarked on a 40mm cash acquisition of Broadsmart – paying 30x EBITDA for a business not expected to meaningfully impact EPS for the next couple years. This cut the stock in half over a couple months as they have suspended the buyback as well. But do these two moves really destroy 100mm in value for MagicJack? The market has written off any moderate stability out of CALL – this gives an embedded call option on the growth of the company’s initiatives targeting the enterprise segment.
Catalysts
Activist Investor Kanen Wealth Management: Kanen Wealth Management is a 5% owner of MagicJack (9% of their portfolio) and wrote a letter in late August calling for board representation and change at CALL. Kanen getting board representation would solidify the case for the underlying value in shares of CALL, an activist like Kanen is going to appoint responsible “outside” professionals who are going to get in there and say “we need to get the business on track number 1 – create value and be good stewards of the cash flows we generate, and secondly we need to return capital to shareholders via buybacks & dividends” this reduces the risk of the board attempted to buy growth which is what they may be thinking sitting on half the market cap in cash and no recapitalization strategy.
Highlights from the activist letter: We believe, with “effective execution” on the right growth initiatives, as well as an equally important focus on capital allocation, significant upside exists for CALL shareholders. However, the “status quo” must cease, and “correct change” be implemented. We are immediately calling for two simple yet extremely important changes.
A $50 million stock buyback to be executed over the next three years (a conservative estimate of our projected free cash flow, exception being if our stock no longer trades at a significant discount to our peers)
Addition of two new board members with proven track records of delivering high returns for shareholders. The additional criteria for the new board members will be that they have telco/VoIP experience and will be engaged with and exercise active oversight of management, holding them accountable to our goals of growing and reinventing the company. The clear objectives will be to:
Ensure growth of app revenue
Bring in international revenue
Grow “Magicjack for Business” (small enterprise)
Grow B.S. (enterprise)
Reduce churn to below 1.8% and in-line with our peer average, through more effective renewals, (focus on auto renewal) and improved customer service
Foster a culture of innovation and creativity that is married to execution and results
We believe significant upside exists when our articulated game plan is executed upon along with a large share repurchase. For example, if CALL were to generate organic growth next year, with revenue growing 5-9% and EBITDA at a faster rate, we believe the market will “reprice CALL shares” at or near parity with Vonage Holdings Corporation. Our math is as follows:
Total revenue of $112.5 million in 2017:
$86 million consumer core
$2.5 million app revenue
$16 million B.S. revenue
$6 million Magicjack for Business (SMB)
$2 million Other
We would anticipate EBITDA $30 million full year with EBITDA margins increasing in 2H 2017 as revenue grows. If our share count is reduced to 13 million by 2017 year-end (through stock buyback) and we trade at a 12x EBITDA (Vonage Holdings Corporation currently trades at 14.93x EBITDA) our stock would trade at $27.20 per share before adding back cash.
While the EBITDA multiple expansion is likely farfetched, Kanen’s goal of better governance could significantly turn the tide. I don’t think there is any reason for these parties to enter a proxy fight – CALL will likely settle with Kanen soon.
Growth Initiatives drive top and bottom lines: As previously discussed, SMB and Broadsmart both are just now coming online this year and seeking to grow in the enterprise VoIP segment. Business adoption will help drive the global VoIP market to expand at a 9.7 percent compound annual growth rate between 2014 and 2020, from $70.90 billion to $136.76 billion, projects Transparency Market Research. Given the size and growth in this market if SMB/BS were to gain any traction this could drive earnings and significantly change investor perception.
Recent Consolidation of VoIP: Broadsoft acquiring VoIP Logic, 8×8 purchasing Contactual, Transcend United merging with LiquidSmoke, and West Corp. acquiring Smoothstone, shine a light on the growth of small business VoIP. Highlighting that the cornerstone in the VoIP marketing message is the ability to launch and manage a business phone system at a significantly reduced cost. With the growth in SMB VoIP, it simply makes sense for VoIP providers to add managed contact center capability to their portfolio. Diane Myers, senior research director for VoIP, UC and IMS for IHS Markit, said in a September 2016 research note – “But as the market continues to scale, consolidation amongst industry continues to rise, particularly in North America. Market participants are looking for greater scalability, infrastructure maximization and cost savings. During the first half of this year, over eight deals were completed, a trend that IHS market said they expected to continue.” CEO Vento previously headed TeleCorp PCS Inc., which was sold to AT&T Inc. in 2002 for $5.7 billion. Insider ownership at CALL is high with the chairman owning 2.5% of outstanding shares or roughly $2.7 million, and three other directors each having over a million tied up in MagicJack shares. At the current valuation, the company could get acquired by a strategic player (attractive due to Intellectual Property, market share/seasoned brand, cash on balance sheet + cash flow generation from renewals, and synergies).
WhatsApp was acquired by Facebook in 2014 for $20.8 Billion, primarily for its vast user base. MagicJack differentiates itself from WhatsApp and Viber because its service allows users to call any fixed or mobile phone line, not just people who are using the same application.
MagicJack is redomesticating its headquarters from Israel (possibly to avoid political risk) to the US which may not move the needle much but CEO Vento said the following about the move, “We are pleased to be redomesticating our parent company to the U.S. and believe this step will make us an attractive security for large institutional investors who cannot hold a position in non-U.S. companies. We plan to fully maintain our Israeli operations as they are critical to our business.”
Moreover, due to increasing smart phone penetration and demand for mobility among the corporate and individual consumers, the market for computer-to-computer VoIP services is expected to show minimum growth, wherein computers (desktops) are gradually being replaced by smart phones and other portable devices. These trends are working against MagicJack’s consumer business, as MagicJack’s “edge” is in its cheap pricing (no monthly bills) and unlimited calling to any United States & Canadian number. As more of the large carriers have switched to unlimited calling plans this has taken an edge away from Magicjack’s unlimited calling “edge” but the price differential is still an attractive proposition for consumers. The rising demand for mobility encourages the corporate and individual consumers to adopt smart portable devices such as tablet and smart phones. As a result, the demand for affordable VoIP services also increases, wherein these devices can also be used to communicate over the internet. Thus, with the increasing penetration of these smart portable devices the number of subscribers of phone-to-phone (mobile VoIP) and computer-to-phone VoIP configuration are expected to witness high growth rates over the forecast period. MagicJack’s mobile app launched on May 10th 2016 and grew to 100,000 subscribers in the first month – this service is attractive to international travelers.
With half the market cap in cash, a core business well apt to generate a cumulative total of 65+ million in after tax earnings ($4.20+ in EPS) over the next 5 years (modeled below), market discounting zero growth and high cash burn on growth initiatives that could prove to grow the business’s reach, and an activist knocking on the door – the margin of safety is high and investors are risking a dollar of downside to obtain four to five on the upside.
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The above accounts for zero growth in revenues and earnings from SMB & Broadsmart from 2016 – 2020.
My estimated base case is cash eventually will be returned to shareholders (currently $3.43/share, consumer business top line decreases 15-17% annually, margins largely the same – consumer business generates an average 16mm in pre-tax income annually till 2020, 3% of float decreased annually, growth initiatives aren’t a home run but don’t flop either. All this gives you 50% upside. The bull case lies in new board becoming shareholder friendly and exceptional stewards of cash, they milk the consumer business for cash even while its top line dropping 15-17% annually, profit margins can stay the same over next 4-5 years. Growth initiatives moderately live up to management’s expectations and are profitable. The bear case would look like cash being burned, growth initiatives are basically a flop, consumer business will die of new technology in just a couple years.
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As Ben Graham said, “the stock market is a voting machine in the short-term, but a weighing machine in the long run.” The cash flow generation of the core business, combined with growth in the enterprise segment, and a return of capital to shareholders will tip the weighing scale and the pendulum back into favor for MagicJack shareholders.
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