Berk Sure Has A Way

50x cash flow… that’s Google-esque! Few companies are valued greater than 50x cash flow. Those lucky enough generally grow revenue and earnings in the 50%+ range per year for multiple years and boast businesses with very wide moats. MCHX is not one of those businesses.

The math. MCHX has 38.3 million fully diluted common shares outstanding trading at about $22 a share as of today’s close. It has about $55 mil in cash on hand and a liability in the form of convertible preferred shares of about $50 mil. Therefore, MCHX’s enterprise value is about $840 million. MCHX generated $8.6 million in free cash flow so far this year, $2.9 of it in Q3. Trailing 12 month’s cash flow is $9.6 million, implying a ratio of 87. If you annualize the Q3 cash flow to $11.5 million it gives MCHX an EV/FCF ratio of 73. Even if you annualize their peak cash flow quarter of Q2 2005, you still get an EV/FCF ratio of 50. 50! 73? 87!?! Wow.

Growth? As I outlined in my previous post, MCHX’s revenue growth is largely illusory as it has been coming mainly from acquisitions – primarily domain names. Similarly, organic cash flow growth seems to be stuck in neutral or reverse given that MCHX is acquiring new domains with cash flow every quarter this year. Cash flow should be growing at a much greater rate than what they’ve reported:

MCHX fans will say that the direct navigation business is nearly all profit – domains are truly cash flow machines. However, at $7.7 million in direct nav revenue in Q3, if you assume anything above a 40% cash flow margin, the direct nav business provided greater than 100% of MCHX’s cash flow in Q3 2005. This means that cash flow from MCHX’s other businesses must be deteriorating. MCHX only boosted cash flow by $700k over 2004’s Q3 results. Given what they paid for the domains, you would have expected MCHX’s cash flow to be at least $3 – $5 million higher than last year. If you assume the Direct Navigation business gets a 58.5% cash flow margins (90% margin with a 35% tax rate), an interesting tidbit arises. If you compare the first three quarters of 2004 to 2005 for MCHX’s other businesses (excluding direct navigation), reported revenue rose from $28.7 to $48.6 million, while cash flow dropped from positive $1.7 million to negative $1.1 mil. You know you have deteriorating fundamentals when you grow revenue by $20 million but cash flow drops by close to $3 million.

What about next year? Next year’s analyst projections are actually pretty rosy – “earnings” up 47%. But…digging beneath the surface, this makes some sense since their domains businesses were acquired this year making year over year comparisons favorable and “earnings” as tracked by MCHX’s analysts exclude amortization. That means MCHX’s gets to spend shareholder money without it impacting “earnings”. No wonder MCHX keeps buying companies – what a deal!

Wide Moat? MCHX is not the leader in any of its businesses. I will admit the direct navigation business makes good money (for now), but it relies heavily on user error to generate traffic. It strains credibility to think that MCHX will be able to maintain the same level of monetization while making these domains true destinations. As for the rest of MCHX businesses, they are each strategically weak and lack scale (more on that later).

What’s the story? I said that businesses trading at more than 50x cash flow are growing rapidly and have a wide moat. I forgot one case… when a stock is wildly overvalued. That is the story with MCHX’s valuation. Given its risks, MCHX should probably be trading at a EV/FCF of less than 20, implying it should decline 60-75% from $22 before it is back in line with reality.

I own puts on MCHX stock at various prices.

If you dig through Marchex’s financial statements and press releases, you can piece together a picture of how all of Marchex’s businesses would have performed on a pro forma basis. With some conservative estimates for Q4 of last year, it appears that Marchex is not growing organically. Q4, Q1, and Q2 were $24.2, $24.7 and $24.2 million respectively. 

Since Q4 of last year, MCHX managed to grow to $26.3 million in Q3 of 2005 – less than 9% overall and less than 7% over since Q1 2005! 

The numbers look a bit better if you compare year over year with a 25% growth rate. However, since most of that growth likely happened from Q3 to Q4 of 2004, it is clear that the annual growth rate is decelerating rapidly. 

Based on current estimates, they will grow at ~15% Y/Y in Q4. This is not a growth rate of a stock trading at 50 times cash flow. 

See the table below for historical actuals and my estimates of each of their businesses:

Even if you assume they can grow the direct navigation business (more on that later), MCHX’s overall pro-forma revenue will likely be flat in 2006 from 2005. My guess is that they will continue to buy businesses to mask the underperformance of their core business.

Most troubling about these numbers is the fact that all of MCHX cash flow seems to come from the direct navigation (domains) business. That means that investors are valuing MCHX at $800 million on the back of a business MCHX purchased for around $200 million this year.

I own puts on MCHX at various prices.

MCHX is overvalued. I will admit that they’ve made some smart financial moves and they own some profitable internet domain names. However, MCHX shares are probably worth maybe $7, not $20. I don’t know the folks at Marchex and I have nothing against them. But, I am definitely self-interested – I think MCHX will decline so I own MCHX puts at various prices.

I used to work at LookSmart and saw the challenges that tier two search syndication players (MCHX, MIVA, LOOKD, INCX, INSP) face first hand. MCHX has been able to delay a decline through smart acquisitions (paying 10-20x cash flow for domain names funded by selling stock at 50x), but most tier two search syndication business models are unprofitable, strategically challenged, and deteriorating. The key point is that while the other tier two players seem to be more appropriately valued, MCHX is way out of whack. It is important to note that owning end-user traffic combined with a winning tier one syndication business is beautiful, profitable, and often defensible. Google and Yahoo have built great businesses, but MCHX is not in the same league.

Over the course of a few weeks, I will outline my reasons why I think MCHX will decline. In my opinion, it is a combination of the 10 points below. I will try to blog about each of these in turn.

1. Low Organic Revenue Growth – 7% pro-forma revenue growth from Q1 to Q3 that has been masked by acquisitions

2. 50+ P/FCF ratio (on a run-rate basis) is absurdly high 

3. Enhance and GoClick (search syndication) are deteriorating low-margin businesses likely struggling with traffic quality problems and a lack of scale

4. Most tier two search stocks have stumbled (LOOKD, MIVA, INCX, INSP) and the majority of MCHX’s business is very similar to these players

5. MCHX is stretched too thin across too many products with no real synergy

6. TrafficLeader is a former SEM/SEO leader likely struggling with conflicts of interest

7. Direct Navigation is a slow growth business vulnerable to changes in behavior and technology

8. Wacky corporate structure has two tiers of stock and preferred shares. For a company with less than $100 million in revenue?

9. Marchex is pursuing low quality traffic through irrelevant traffic arbitrage.  More details here.
10. Bubble-era accounting does not take into acquisitions into account

I own puts on MCHX stock.

NOTE: I edited this post on 12/6/05 to link to my recent posts. I aslo swapped out reason 9 (MCHX paying too much for acquisitions) with the current 9 (MCHX pursuing sketchy traffic).

J2 Global Communications is my single largest holding and I am still very bullish on their prospects.   

Background

JCOM is an online communications company best known for their flagship product Efax. Efax is the largest provider of web-based faxing (fax-to-email, computer-to-fax). As of the end of Q1 2005, JCOM had 600k subscribed phone lines paying $17 a month. In addition, JCOM has 8.5 million free fax users. Since turning profitable in Q1 2002 JCOM has rapidly grown its earnings. JCOM produced $0.40 a share in Q1 2005.

Valuation 

At $36 a share, JCOM trades forward P/E ratios of 20.6 for 2005 and 16.2 for 2006 earnings estimates. Given that the company has consistently outperformed guidance nearly every quarter for 3 years, the true ratios are likely even lower. The company is estimated to grow at earnings 40%+ this year and next. If you look at the enterprise value (back out cash) divided by run-rate earnings (current quarter earnings * 4), they are trading at one of the lowest valuations since turning profitable (less than 21 run rate earnings). If they hit their guidance when they report on 7/25/05 (which they indicated they would 3 times in June) then that ratio drops to about 18.5. Outside of the huge run up in late 2003, JCOM has mainly traded between 20 and 26 x run rate earnings and their expected growth rate has remained extremely high (40%+). JCOM an enterprise value of about $750 million and a free cash flow run rate of $40 million. Simple math: if you assume that JCOM can get to 3 to 6 million paying subscribers globally, they could be earning 5 to 10 times what they are now.

Positive Business Characteristics

• Telecom is a large market and efax’s millions of free subs indicate people want online faxing
• Consistent and predictable growth
• High margins
• Low customer acquisition costs
• Sticky product (fax number on business card) means low churn – currently close to mobile phone churn rates of sub 3% per month
• International growth prospects (Europe, Japan, China, India, etc.)
• Patent portfolio seems to be preventing large players from challenging JCOM’s position
• Low stock option dilution 

Potential Catalysts – Short Term (1-2 months)

• Could announce stock buyback now that they have over $100 mil in cash
• Raise 2005 guidance on Q2 call
  • Company has raised guidance mid-year in both the past two years
  • International should begin to pick up
• Outperform Q2 guidance
  • Regularly outperforms guidance
  • Just recently started bounty marketing online – which has been hugely successful for other subscription businesses
  • Q2 is generally strongest quarter 

Potential Catalysts – Medium Term (3-6 months)

• Investors acknowledge how undervalued JCOM is
  • EPS growth – still going at 40-50% a year!
  • Run-rate PE is close to lowest points since profitability
    
• Potential for short squeeze
• Major investment banking coverage / magazine coverage 

Potential Catalysts – Long Term (6-18 months)

• January 2006: Set 2006 guidance well above the $2.25 expected (my guess is $2.50 or above)
• Announce a patent licensing deal with a telco or VoIP player
• Larger telco / internet company buys them
• Create a new pricing model to convert free customers (e.g. $20 a year)
• International growth: Launch of a bunch new languages / markets (e.g. Japanese, Chinese)

Risks – I don’t expect these will happen quickly or abruptly

• Competition
  • Large telcos could bundle product
  • Price war by another player
• Advent of online digital signatures
• Gradual decline of fax machines in favor of emails

I was (very) long JCOM at the time of writing.

More precisely, sell all your long term bond funds (10-30 years).  They can and will lose value.  Since bond prices move in the opposite direction to interest rates, when interest rates rise, you will lose money.  And unlike an actual bond, you can’t get your original investment out because funds don’t have an end date.  Luckily, if you sell now (with the 10 year rate at 4%) you did quite well.

Long term interest rates are going higher.  Too many forces working to push them up:

• Fed will raise rates at a measured pace for rest of year – this will shift demand from long to shorter duration bonds
• Budget deficits at record levels with no end in sight
• The likely return of the 30 year long bond
• The eventual halting of Asian central bank purchases (god forbid they sell!)
• The dollar will weaken against Asian currencies sparking a sell off of bonds   
• Inflation looks like it will be coming back (maybe…)

OK, so interest rates rising.  What to do?

• Sell your long term bond funds or ETFs (and junk bond funds too!)
• Buy shorter duration bonds, CDs or a bond fund

• Have a truly long term perspective?  Buy a long bond and hold it until it matures – you get your $1,000 back

• Got sizable assets, want protection and still want decent yield? Build a bond ladder
• Feeling adventurous and have a stomach for risk?  Short TLT (currently $93.57) the iShares 20+ year Bond ETF

I was short TLT at the time of this post.