This article was posted to SumZero, a digital community for portfolio managers, on December 16, 2013
“Shares of MagicJack (CALL) are deeply undervalued due to an enduring but outdated short thesis. Shares trade at just 3x 2014 EBITDA, management is forecasting double digit revenue growth and the short interest is enormous at 30% of shares outstanding.”
MagicJack is an obscure VoIP telecom company that may finally be emerging from the firm grip of short sellers after a minus-40% stock price performance year-to-date in 2013. After reversing a six-month down trend with a 9% gain on Friday 12/13, the stock trades at $12.29 per share, giving the company a market cap of $220 million and an enterprise value of $173 million, reflecting balance sheet cash of $47 million. Figures include the effects of recent stock repurchase and issuance transactions with MagicJack’s controversial founder and former CEO.
We believe that CALL shares are deeply undervalued and that fair value is $20 per share today, even before giving any effect to new management’s stated initiatives that include a refresh of the tired and tacky MagicJack brand, a web site upgrade, a more polished advertising campaign, expanded retail distribution, possible pricing revisions, international expansion and monetization of the MagicJack app. If management successfully executes and efficiently allocates capital from its cash-rich balance sheet, a $30 share price may be achievable in a 12-18 month horizon. The prospect of a sale of the company in 2015 - following a period of brand rehabilitation and operational execution in 2014 – seems plausible and further supports a $30 price target.
MagicJack is solidly profitable, having generated adjusted EBITDA of $44 million in the first nine months of 2013 on revenue of $105 million. Operating margins are high and capital expenditures are negligible; virtually every dollar of after-tax income converts to free cash flow. On an EV/EBITDA basis, MagicJack trades at a multiple of 3.2x 2013 EBIDTA of $54 million and about 3.0x 2014 projected adjusted EBITDA of $58 million, which may be conservative given management’s 2014 guidance of “double digit” revenue growth. It’s not often investors find a company that trades at 3x EBITDA. It’s even more uncommon to find a company that trades at 3x EBITDA and yet has 30% of its shares outstanding sold short and is forecasting strong growth. This unique profile indicates that the MagicJack short thesis continues to have considerable traction. We’ll review and refute the bear case below.
A $20 near-term price target on CALL shares would merely value the company at 5x 2014E adjusted EBITDA, similar to the multiple at which closest comparable Vonage (VG) trades and slightly below the EV/EBITDA multiples of no-growth/capital-intensive telecom companies like Earthlink (ELNK), Frontier (FTR) and CenturyLink (CTL). Should management deliver on its guidance of double digit revenue growth in 2014 and margins remain intact, a case can certainly be made for an 8x valuation multiple, which equates to a $30 share price for CALL using $58-$60 million of adjusted EBITDA.
Its first product introduced in 2007, MagicJack now has 3.3 million paying customers to its low-cost VoIP service, which it provisions via a peripheral device that can be purchased at retail (Wal-Mart, Radio Shack, etc) and plugs into the user’s computer or broadband router. Users can make unlimited, high-quality calls within the USA and Canada via a conventional telephone or headset for about $3 per month. Standard features such as call waiting, voicemail and voicemail-to-email are included and existing phone numbers can be ported over to new MagicJack customers. Outbound international calling minutes can be purchased from the company and customers can use the device when traveling abroad to call back to the USA or Canada at no additional cost. The MagicJack app for iOs and Android, introduced in 2012 and with 5.61 million registered users at September 30, currently allows for free calling to the USA and Canada from anywhere in the world using Wi-Fi or 4G mobile networks. The company generates revenue from sales of the MagicJack device, customer renewals, fees from other carriers who terminate calls on the MagicJack network, prepaid international calling minutes and wholesale fees.
THE SHORT THESIS
The bear case on MagicJack is described here (http://seekingalpha.com/instablog/890075-copperfield-research/1436471-magicjack-vocaltec-call-accounting-illusions-vanishing-financials-and-a-dark-history) in a scathing January 2013 report by a short seller calling itself Copperfield Research. Among other allegations, the report cites MagicJack’s unconventional reverse merger heritage, accounting irregularities, securities fraud, stock price manipulation, material misrepresentations, offshore domicile and unsustainable business model. Above all, the shorts focus intently on an alleged pattern of unethical behavior by MagicJack founder and former CEO Dan Borislow, whose “reckless and deceitful” activities, they say, threaten the company’s very existence. In valuing CALL shares at $5 to $7, Copperfield even called on Nasdaq and the SEC to halt trading in CALL shares. After dissemination of the report last January, CALL shares declined from $17 to $14 and have been mostly trending lower throughout 2013.
Borislow may be a terrific entrepreneur but his ethical shortcomings are undoubtedly troubling and allegations of accounting improprieties under his watch must be taken seriously. But nearly one year after Copperfield’s report, no “financial shenanigans” (Copperfield's term) have been revealed and, as of early November 2013, Borislow has no further involvement with MagicJack. Indeed, the MagicJack short thesis is built almost entirely on past actions (some of them, like selling puts on company shares, highly questionable) and involvement of an individual who no longer has an operational or managerial role at the company. As for Copperfield’s charge that MagicJack operates an unsustainable business model due to “massive, undisclosed” liabilities related to a failure to collect fees for 911 services and impossibly low capital expenditures, we don’t believe either issue is cause for alarm. MagicJack, in fact, collects 911 fees from customers (and presumably remits them to the proper authorities), carries no such balance sheet liability and the company expenses (rather than capitalizes) R&D, a line item that actually doubled in size during the first nine months of 2013 versus the same period in 2012.
In summary, we believe that the Borislow-driven short thesis is outdated and no longer valid.
As for claims that MagicJack's business is obsolete, subject to robust competitive threats and likely to continue declining, we disagree. As the low-cost provider (due to its CLEC status and broad network that minimizes access/termination fees) with a unique portability feature (the ability to travel internationally with the jack and call back to the USA at no cost), an undermanaged retail network, plenty of international growth potential and an untapped asset in its iOS and Android app, we believe that growth is achievable. Further, we note that MagicJack's valuation is so undemanding that market expectations are extremely low.
CATALYSTS FOR SHARE PRICE APPRECIATION
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