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This article will show that Angie's (NASDAQ:ANGI) management are not being transparent with shareholders as they veil over a faltering business model which is in essence becoming just another paid-directory website for service providers.

Angie's List is a website which, according to the website front page, allows its paying members to "find detailed reviews on roofers, plumbers, house cleaners, dentists and more!". This is a statement clearly aimed at potential members. The next statement on their website front page reads, "Companies can't pay to be on Angie's List".

When I look to make an investment, trust in management is paramount. Angie's statement is speaking to those same potential members and is reasonably interpreted as "companies do not pay us to advertise to you". This is not true and it tells me that if management is not transparent with customers then they will just as likely not be transparent with shareholders. A little digging in the 10-K reveals this is indeed the case. I reveal below what management probably knows but does not want to reveal. The business model just does not work and the company, which is experiencing widening losses year to year, is just a paid-directory dressed up as a members-only review site.

The latest annual report was strangely not available on the company's investor relations page for annual reports. On request, the company kindly sent it to me via email.

In all of the below, all quotes and figures are taken from the latest annual report (unless stated otherwise).

First, let's be transparent about the source of revenue

Whilst members have been increasing at a strong rate year over year as shown in table 1, each additional member is contributing less and less to revenue as shown in table 2.

Table 1:

(click to enlarge)

Service providers generate revenue for the company by advertising to members.

Table 2:

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Table 2 shows the declining value of added members from a $14 contribution in 2008 to $10 in 2011. If a member is willing to pay to become a member it is an indication the member is willing to spend on services. This fact and the risks emanating from a failure to maintain paying members is noted in the company's annual report which states:

Any failure to convince local service providers of the benefits of advertising with us would harm our business.

This unwillingness to pay to become a member spells trouble ahead for the company in selling advertising to service providers as, unless service providers get value for money, they will not renew their contract with the company.

Tables 3 and 4 show service provider advertising revenue quickly outpacing membership revenue as other similar websites, most of them free and providing reviews, compete for Angie's members.

Table 3:

(click to enlarge)

Table 4:

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Table 4 shows revenue from each source as a percentage of total revenue.

Whilst membership revenue grew 34% to $34m in 2011, service provider revenue increased 66% to $56m and in 2011 represented 62% of total revenue.

Sales and marketing costs

No one can deny that's good revenue growth, but don't get excited because it didn't come cheap. Selling costs (to attract service providers) increased 100% to $34m and marketing costs (to attract members) increased 86% to $56m as shown in table 5.

Table 5:

(click to enlarge)

The float of the company in 2011 helped the company to a $117m net cash inflow from financing activities in 2011. The business plan was to spend big on national advertising and promotion and so generate members and advertisers quick enough to get the company to profit before the money ran out. Table 6 shows a $33m net cash operating outflow in 2011. At Sep-2012 from the 10-Q, we know there is just $65m of cash left.

Table 6:

(click to enlarge)

Clearly, given these numbers, revenues need to accelerate relative to costs before time runs out. Let's consider whether this is likely.

Advertising revenue lags selling costs

We see in table 1 how advertising revenue per service provider is increasing, up to $718 in 2011. However we also see in table 5 that selling costs increased significantly in 2011 in line with the business plan.

The company explains in the 10-K that advertising revenues will be recognised over the period of the contract and therefore costs incurred by the company will be recognised ahead of the future revenue stream from the advertiser who will hopefully renew for many years to come.

The company usefully includes a measure they call 'total service provider contract value'. This is the amount active service providers have contracted for advertising regardless of whether the amount has been recognised in the income statement or not. If the company is getting repeat ad revenue for its selling costs then the ratio of contracted amounts to selling costs should increase over time. Simply, if the company sells one advertising contract each year using the same sales method and each new customer renews each year, then at the end of year 10, the company would have 10 contracts but the same selling costs.

At the end of 2011, the contracted amount was $73.6m and the selling cost for 2011 was $34m. A ratio of 2.2. At Sep-2012, the contracted amount was $119.1m. We know the 2011 selling costs were $34m and 9m to Q3 2011 were $22m (from the 10-Q) and 9m to Sep-2012 were $43m so we know that the 12 month selling cost to Sep-2012 was $54m (allow for rounding) and the ratio of contracted revenue to selling costs is again 2.2.

This tells us that after spending $34m in selling costs to generate ad revenue in 2011 and a further $43m in selling costs in the 9 months of 2012, that contracted revenue as a percentage of spending had not increased. Or to put it bluntly another way, holding costs constant, there is no evidence that the book of advertising business is building .

Let's now consider why this might be so.

The website is not sufficiently unique and has low barriers to entry

I believe the website to be of benefit to both members and service providers. If members are paying to join this suggests they have demand for services and hence are valuable to service providers. Fellow members' ratings provide an independent and valuable resource to members. Further, I believe Angie's List is being honest about only allowing service providers with a minimum rating to advertise discounts and provide email campaigns to members.

However, the website is not providing a sufficiently valuable service to members vis-a-vis free websites to attract paying members and hence, in turn, to attract advertisers. The cost of attracting paying members and service providers is more than they are willing to pay in revenues to the company. Quite simply, there are too many free alternatives for consumers to find service provider reviews and businesses to advertise services locally.

Traditional offline directories are now online. Yellow Pages provides online service provider ratings for free. There are also the online giants such as Facebook, Groupon, Yahoo and Yelp. Any sniff of a successful business model and these companies would be quick to replicate it given their reach. It's telling they have not done so.

Revenues per member are declining and memberships are being given away

Don't just take my word for it, the annual report states that "in recent periods we recorded declining total revenue per paid membership overall". This is an awful admission for an expanding business in which losses are still growing. They're spending more each year on acquiring members but receiving less revenue each time.

From page 31 of the 10-K: "Total paid memberships also includes a de-minimis number of complimentary memberships in our paid markets for all periods presented."

Who knows what 'de-minimus' really means. Why not just be open and tell your shareholders and advertisers how many were free memberships.

So it is not clear whether revenue per member is falling due to free memberships or the fee paid by members or both. What is clear is that the value placed on a membership is falling. If that is the case then the value to service providers of each member added is also falling and this in turn will increase the cost to attract each advertiser.

Published renewal rates appear to include non-paying members

Key to this business is the ability to retain paying members. Whilst we know members are paying less to join, management would have you believe renewal rates are actually growing (quoted in the 10-K as 2011 78%, 2010 75%, 2009 73%).

However this is due to more and more free memberships being given away. Non-paying members are being included in the calculation of renewals. The company can increase the renewal rate simply by giving away more free memberships. Remember, "Total paid memberships also includes a de-minimus number of complimentary memberships".

Let's look at the number of memberships being lost for another viewpoint.

Memberships lost in the year as a % of prior year "paid memberships" are: 2011 41%, 2010 40%, 2009 42%.

So even though members are not paying and/or are paying less they are still leaving at the same rate. Given those not paying are less likely to bother to leave, one can reasonably assume paying members are leaving at an increasing rate. And this helps explain why marketing costs to attract members increased 88% in 2010 and 87% in 2011.

Marketing costs to attract members

One would expect marketing costs to attract new members, as a percentage of membership revenue, to fall if members are renewing at a constant rate as management would have you believe.

Let's consider the cost of marketing as a percentage of the membership revenue in each year. Table 7 shows marketing costs increased as a percentage of membership revenue from 79% in 2009 to 120% in 2010 and to 166% in 2011. The business model of recurring revenues is simply not happening if the cost to acquire each dollar of membership revenue is not decreasing each year but is actually increasing. It is likely the company continues to spend such a large amount on marketing cost as it also attracts advertisers.

Table 7:

(click to enlarge)

Selling costs to attract advertisers

Quoting again from the 10-K:

"Any failure to convince local service providers of the benefits of advertising with us would harm our business."

"Our ability to attract and retain participating service providers and, ultimately, to generate advertising revenue depends on a number of factors, including:

• increasing the number of paid memberships in our existing markets;

• maintaining high levels of member engagement;"

Given we've already seen that members are less engaged (table 1) let's consider if this has started to influence the selling costs of generating ad revenue. Table 7 shows selling costs as a percentage of service provider advertising revenue was 50% in 2009 and 2010, increasing to 60% in 2011. Whilst we know some ad revenue is deferred this is not a positive metric.

Unpaid but 'contracted' advertising revenue

At the end of 2011 according to the 10-K page 36, there was $46m of advertising revenue contracted, yet to be recognised. This is not equal to the $14m of deferred advertising revenue on the balance sheet. Therefore one must assume $32m is unpaid at the end of 2011. This is probably the $34m of deferred revenue quoted on page 31 of the annual report.

How secure this unpaid, future revenue is remains unclear from the disclosures made. There are negative comments to be found on the internet about advertising renewals being made against the wishes of services providers. Further, this article by another contributor lays out the details of a class action lawsuit against the company. This metric (and the lawsuit) is one to watch going forward.

Cash position and update for 9 months to September 2012

Let's see how well the metrics have changed in 2012 and whether the company has enough cash to survive.

Marketing costs as a percentage of membership revenue were 210% in the 9 months to Sep-2012 versus 166% in 2011. Clearly the deterioration in memberships continues.

Selling costs as a percentage of advertising revenue were 57% in the 9 months to Sep-2012 versus 60% in 2011. This is a continued, albeit slight improvement.

Advertising revenue increased 96% in the 9 months to Sep-2012 against the same period in 2011. However, deferred revenue only increased 48% at Sep-2012 versus Dec-2011. This ties in with the company's aim of signing up shorter advertising contracts. It does however increase the risk to the business of advertisers not renewing.

The number of service providers increased 51% over the 12 months to the Sep-2012 period versus 60% in the 12 month period to Dec-2011. This deceleration is a concern set against the need to reach profit before cash runs out.

The company used $33m in cash operating activity in 2011 and a further $23m in the 9 months to Sep-2012 (per the 10-Q). On an annualised basis this is $31m for 2012. With $65m in cash at Sep-2012 and burning at the same rate, the company has just over 2 years left in cash reserves.

Conclusion

The business model is based on generating recurring membership and ad revenues. Pay to win the business once and generate a revenue for years to come. Over time, if the model works, revenues begin to outstrip costs. This makes renewals by members and advertisers, both in terms of numbers renewing and the amount paid, a key metric.

My forecast for the business is detailed below. To a great extent this is an extrapolation of the existing trends in the numbers.

  1. Members will continue to be added but will incrementally add less to revenue;
  2. To continue to attract members (to in turn attract service providers), the website will become free to join;
  3. Therefore even greater reliance will be placed on ad revenue from service providers destroying the ethos of the company that members pay (and are hence valuable to service providers);
  4. As the website is free to join, so the potential demand for services from members falls and the benefit of the website to advertisers falls;
  5. Eventually ad spend will dry up as the website offers nothing over free directories, losses grow (even faster) and the company will run out of money.

The decline in revenue per member and lack of ability to build the advertising book coupled with the rate costs are increasing relative to revenues suggests profits will remain illusive and positive operating cashflow will not be reached before cash runs out.

Source: Angie's List: Just Another Paid-Directory Website