I have to give credit to Whitney Tilson (Trades, Portfolio) for bringing this one to my attention. He released a white paper entitled “MagicJack: My Next Netflix” in February outlining his case for the undervaluation of this stock. The write-up was presented at the 2013 Value Investment Congress where he was the keynote speaker. It carried considerable authority as a follow-up to his prior year recommendation of Netflix (NFLX, Financial) at $54 a share which turned into a quick eight-bagger.
Following Tilson’s public recommendation, the stock surged 85.7% in six weeks. Shares have since come back to Earth. Today’s price is within 9% of where Tilson recommended it and once again presents a wonderful opportunity for enterprising investors.
I have a great deal of respect for Whitney Tilson (Trades, Portfolio) as he always maintains a very concentrated portfolio. He believes in putting full weight behind his best ideas and never hides behind a diversified basket. MagicJack is one of 26 holdings in his fund and accounts for 5.4% of total assets as of the end of the first quarter. But given the stock’s downturn over the last three months, I wouldn’t be surprised if he has been increasing his position.
If you’re not familiar with the magicJack product, take a look at their website: www.magicjack.com. Basically it is a home VOiP system that allows user to plug a phone into their router or computer and make unlimited calls for less than $3 a month. The value proposition is obvious and fills a sizable hole in the home phone market left by cellular communications and slow-to-adapt telecommunication companies.
(Image from magicJack.com website)
In the paper, Tilson gave a list of the ten qualities he looks for in great stock ideas. His criteria are as follows:
1) A tainted company with a beaten-down, heavily shorted stock
2) Great management
3) Fixable problems
4) An enormous, global market
5) Big, lumbering competitors that are resistant to change
6) A paradigm-shifting technology or way of doing business
7) A position of market leadership in the new arena
8) Attractive economic characteristics: high margins, low capital intensity, robust cash flows, a strong balance sheet, and customer acquisition cost far lower than the lifetime value of each incremental new customer
9) A moat around the business to ensure that the company’s market leadership and attractive economic characteristics endure
10) An extraordinary value proposition to customers, combined with great service, resulting in intensely loyal customers who are “evangelists” for the company
Tilson believes that MagicJack checks each one of these boxes, and I am inclined to agree with his thesis. Below are his key points on each:
1) A tainted company with a beaten-down, heavily shorted stock. MagicJack’s stock, at $13.75, is barely half its peak reached in September 2012, trades at a mere 5.6x trailing EPS and 3.3x EV to EBITDA, and 29% of the company’s shares (and 43% of the float) are sold short.
2) Great management. I’ve met three times with the new management team (which has only been in place for a few months without interference from the founder and former CEO), and I’m extremely impressed with them and their track records.
3) Fixable problems. MagicJack’s problems – spotty customer service, unsophisticated marketing, unprofessional web site, and the tendency to manipulate the stock – were all attributable to the former CEO, and are rapidly being fixed.
4) An enormous, global market. In the U.S. alone, there are 70 million households with either plain old telephone service or a bundled “triple play” of TV, internet and phone service from their cable company. While the number of people “cutting the cord” and getting rid of their home phone line is growing, magicJack’s 3.3 million subscribers are only a drop in the bucket, so even if the total market shrinks over time, there’s still enormous room for magicJack to grow in the U.S. In addition, there’s another huge market that magicJack hasn’t even begun to address: the individuals and businesses overseas who want the ability to inexpensively make and receive U.S. phone calls. My parents live in Kenya and are thrilled to now have a home phone line that operates as if they lived in the U.S.
5) Big, lumbering competitors that are resistant to change. Verizon, AT&T, the cable companies…you get the idea…
6) A paradigm-shifting technology or way of doing business. MagicJack uses the internet (voice over IP or VOIP) to carry its calls rather than traditional phone lines, which cuts costs dramatically. I’ve been using the product, both as a second phone line in my home as well as during a vacation in Costa Rica, and I think it’s fantastic. It’s easy to set up and use, the sound quality is excellent, and I’m saving a ton of money.
7) A position of market leadership in the new arena. There’s some ambiguity here because it depends on how one defines the “new arena”. MagicJack has 3.3 million active subscribers and 5.6 million registered users of its smartphone app, so it’s bigger than Vonage, which has 2.4 million subscribers. But if one defines the new arena as all internet calling, Skype is exponentially larger – but as I describe below, it’s comparing apples and oranges, as Skype typically doesn’t replace a home phone line.
8) Attractive economic characteristics: high margins, low capital intensity, robust cash flows, a strong balance sheet, and customer acquisition cost far lower than the lifetime value of each incremental new customer. In the first three quarters of 2013, magicJack’s gross and net margins were a mouth-watering 66% and 24%, respectively, cap ex was a mere $84,000, and free cash flow exceeded net income by a healthy margin. In addition, the balance sheet shows no debt and more than $60 million in cash, equal to nearly 25% of the company’s current market cap.
Regarding customer acquisition cost, magicJack has said that its CPGA (cost per gross add) is in the $4-5 range, a phenomenally low number. I believe this includes the de minimis cost of renewing customers, however, so to be conservative I assume that the cost to attract each new customer is $10. This is still very low relative to the lifetime value of a new customer, which I estimate is around $80, based on the following assumptions:
- The purchase of a $35 magicJack unit at a 60% incremental margin (excluding SG&A) = $21
- 3-4% monthly churn (which I think new management will be able to reduce substantially), which means the average customer stays approximately 30 months
- $2.75/month in service fees (a bit more than the base $2.50/month fee because some customers buy international minutes, vanity numbers, etc., partially offset by some customers who pay $100 up front for five years, or $1.67/month)
- 70% incremental margin on service fees
- Total: 30 months x $2.75/month x 70% margin = $58 + $21 in hardware = $79 in incremental lifetime pretax profit for each new customer
In summary, I estimate that magicJack is getting an incredible 8:1 return on its investment in new customer acquisition.
9) A moat around the business to ensure that the company’s market leadership and attractive economic characteristics endure. The question I get most often is: “How does magicJack make such fat margins charging such a low price? It’s either unsustainable or it will attract many, larger competitors.” (Boy, does this remind me of the consensus thinking about Netflix over the years, yet Netflix continues to grab the lion’s share of all new streaming subscribers.) The key thing to understand about magicJack is that it’s a CLEC (competitive local exchange carrier), which means that, while magicJack has to pay “termination fees” when its customers make outbound phone calls, other carriers must pay magicJack when their customers call magicJack users. This incoming call volume allows magicJack to negotiate better rates with other carriers and significantly reduce network costs. You can see this in magicJack’s financial statements: in 2009, network costs were 22% of revenues, a number that has fallen steadily to less than 18% in 2013.
10) An extraordinary value proposition to customers, combined with great service, resulting in intensely loyal customers who are “evangelists” for the company. MagicJack has nailed the value proposition – at $2.50/month, it’s exponentially cheaper than what most people are currently paying for their home phone line – and the phone service itself works great, but there’s no doubt that magicJack has a lot of work to do on its customer service. In spite of this, however, the company continues to attract new subscribers – 273,534 last quarter alone – with minimal advertising, which speaks to magicJack’s strong brand name and word-of-mouth. Once magicJack improves its customer service and ramps up a sophisticated marketing campaign, I think subscriber growth could take off – which is precisely what drove Netflix’s stock to the moon.
Many investors seem to have written this stock off – likely because of the firm’s failure to increase revenues over the prior 15 months. This lack of growth is primarily attributable to a short-sighted CEO who has since been replaced and the company’s decision to focus on improving product quality and customer service before attracting new business. This idea of perfecting the product before rushing to market and ensuring the delivery of a top-quality offering to customers is shared by other long-game innovators like Apple. Over the life of the company, a one to two-year slowdown is more than acceptable in order to facilitate future dominance of the industry.
Surveys have shown clear improvement in magicJack’s customer satisfaction levels, and the new website delivers a clear, modern feel that distances the company from its previous As-Seen-On-TV image. Even as I write this article, my web history from researching the firm is resulting in magicJack advertisements on the variable ad space of visited websites. They are clearly embracing newer, more efficient client acquisition methods.
Management is capable and refreshed, the product is simple yet effective, gross margins are a healthy 64%, and the company is in a position to secure the market-leading position. This stock has the combined upside of gross undervaluation combined with uncapped growth potential. Whitney Tilson (Trades, Portfolio) concludes his writing with this:
“I think the sky is the limit for the company – and the stock. This is the kind of growth story that investors could really fall in love with, so I wouldn’t be surprised if magicJack has a $2.5 billion market cap in a few years – which would make the stock a 10-bagger from here. “
But there’s more…
One technical aspect of this trade not explored by Tilson is the heavy short interest on outstanding shares. As of mid-May, a full 47% of the float was held short. That number has fallen substantially over the preceding month and I believe will continue to do so. Here’s why.
By comparing the three-year history of stock price and short interest, we are able to get a clearer picture of what is happening.
Short interest surged from less than 10% to more than 45% in 2012 when the stock rose by more than 150%. These higher prices were what enticed the shorts and called them to action based on a perceived overvaluation. Many short sellers then covered as the stock was cut in half and walked away with a nice profit. But the Tilson bump following the release of his white paper sent shares back to the low 20’s and brought a combination of new sellers and increased positions to existing short trades. This selling caused the stock to again fall and another round of short sellers to cover.
Overlaying the charts and comparing month-end figures shows that most of the short sellers are short from $15-25 per share.
This is a significant piece of information to have when you understand the mentality of most short sellers – they are some of the most impatient investors in the stock market.
The old adage is that the market takes the stairs up and the elevator down. Because of this phenomenon, short sellers are used to getting paid quickly. When a stock turns south, it tends to happen quickly and profits are realized in a similarly short period. But the short magicJack trade has been underway for more than two years. Anyone still holding is likely eager to cover and move on. Tilson’s public endorsement of the stock only further scared these already weary bears.
Today they are being offered an easy out. After staring at large mark-to-market losses they can buy back today at break-even or even a small profit since most are short from $15 or higher. The latest numbers reflect that this process is already underway. 14.9% of shorts bought to cover in the last thirty days. This buying pressure, along with suspected additional purchases by Tilson, gave an 18% boost to CALL shares earlier this month. As the remaining magicJack bears decide to buy exit their trades, this will likely result in a further push higher for magicJack stock.
MagicJack (CALL, Financial) is offering something we don't get very often in the stock market - a second chance. Anyone who showed up late to the party and didn't get long before Tilson shared his pick with the world now has the opportunity to buy near the guru's entry. If the company achieves even a portion of the potential growth, investors will be glad they hitched their wagon to this one.
