The shares of magicJack (NASDAQ:CALL), referred herein as "MJ", have for a long time topped the list of the most shorted stocks on the Nasdaq. For our readers that are less familiar with the details of this company and with its management's history, we highly recommend reading also the detailed analysis of Copperfield Research published in January 2013 which caused a drop of 13% in the company's share price and triggered several class action lawsuits.
What makes MJ's shares attractive for retail investor and causes a headache for short sellers, is the fact that the company is generating a strong cash flow. In this article, we will explain why this is going to end soon and why MJ's share price will collapse as a result. We will highlight MJ's unfair competitive advantage through the use of loopholes in FCC regulation in order to avoid the payments of taxes and fees, allowing it to offer cheaper priced services than its competitors. In addition, we will provide evidence that the FCC is in the process of closing these loopholes, which will result in MJ losing its unfair advantage. Regardless if the SEC will intervene first, as suggested by Copperfield Research (an opinion we share), the new legislation will have a destructive effect on MJ's business and we believe MJ's days of being a profitable company are short lived.
When comparing MJ to its competitors, it is clear that two factors contribute to MJ's profitability: (1) low pricing of its services which attract subscribers and allowed it to gain market share; and (2) the fact that MJ does not pay various taxes and fees its competitors pay. Would MJ be paying these amounts, it would have had either to: (1) substantially increase the subscription fees to offset these extra costs; or (2) bear these extra costs and report a profit significantly lower than it does today. Since it is clear from the thousands of complaints posted on various websites that MJ subscribers join because of the low cost and not of the quality of service provided, the increase in prices to offset these extra costs would cause MJ to lose business to its competitors.
We believe MJ structured its corporate structure in a way that would enable it to exploit loopholes in the FCC regulation and we provide evidence that the FCC has already started the process of closing these loopholes. These relevant taxes, fees and charges include:
- E911 fees (Enhanced 911). 911 fees are collected monthly by telecom providers to fund 911 operation centers around the country. In 2006 the FCC added all VoIP providers to the list of telecommunication providers that are required to collect and remit 911 fees (E911).
- USF fund. All telecommunication providers have to contribute to a fund which was set up to promote the quality of service, provide affordable rates and advance the availability of telecommunication to all customers.
- Local taxes. Telecommunication providers are subject to various local taxes according to the location of the subscriber.
911 fees - MJ has been providing its subscribers with an E911 (Enhanced 911) service which is similar in many ways to the traditional 911 service and relies on local communities to provide the emergency service. The FCC introduced a law requiring all providers of "Interconnect VoIP" service to collect these fees from their subscribers and remit them to the local counties, as do traditional phone service providers. These fees vary by state and county and are in general in the range of $0.2 to $3.0. The FCC's definition of an Interconnect VoIP provider includes providers that "permit users to receive calls from and terminate calls to the public switched telephone network." Vonage (NYSE:VG) for example, a MJ competitor, is an Interconnected VoIP provider as its users are able to place and receive calls to and from other phone users. MJ claims in its SEC filings that it does not need to bill its subscribers for E911 services, as it is not an Interconnected VoIP provider. Would MJ charge these amounts to its subscribers, the bill of an average MJ user would increase by an estimated $12 (based on an estimated average of $1 per month per line)? This corresponds to a 40% price increase after MJ already increased rates by approx. 50% in early 2012. Such an increase will obviously reduce the attractiveness of the MJ service. In its 2012 10-K filings, the company provided the following disclosure:
"The Company cannot predict whether the collection of such additional fees or limitations on where its services are available would impact customers' interest in purchasing its products."
MJ claims that it is not an Interconnected VoIP provider as defined by the FCC. MJ is relying on a loophole in order to work around the definition: One of the MJ group companies, magicJack LP, sells the magicJack device and provides free incoming calls while a second company, YMax communications, provides the free outgoing calls, so that none of the companies, on a standalone basis, provides both services (each is providing only One Way VoIP). Sounds fishy? Well it is.
Subscribers of MJ see only one combined service, which is the ability to receive and place calls. This is also how MJ markets the service and even how MJ presented it to the FCC on various occasions:
"Using the Internet (including a cable modem, DSL, Wi-Fi or other system), customers are able to call other magicJack devices wherever located, any PSTN-connected telephone as well as customers of other VoIP services. The magicJack device also enables customers to receive calls from any other magicJack device, PSTN-connected telephone and other VoIP services."
Obviously, local governments which are losing 911 fees from MJ subscribers did not swallow this frog and have been zeroing-in on MJ to collect these fees. In March 2010 the Emergency Operation Center of Kanawha County filed an official complaint to the Public Service Commission of West Virginia and claimed MJ failed to collect and remit E911 fees.
MJ argued in front of the Commission that due to its corporate structure, none of the companies of the MJ group provides both services and therefore it is not an Interconnected VoIP provider as defined by the FCC and therefore it does not need to collect and remit E911 fees. During the hearing, two experts provided their opinions and testified that according to their understanding, MJ does provide Interconnected VoIP services (link 1, link 2). In addition, the experts provided evidence that MJ does not actually offer or allow subscribers to receive only incoming or outgoing calls.
We believe that MJ did not want a court to rule on whether MJ is an Interconnected VoIP provider and therefore decided to settle in September 2011 and to start collecting and remitting the E911 fees to the Kanawha County.
Even though MJ agreed to start remitting E911 fees, MJ failed to disclose this important precedent to its shareholders in any of its filings, although this precedent has a material effect on the company's financial performance. In addition, it opened the door for additional counties to claim E911 fees from MJ going forward and significantly increases the risk of MJ being liable for the payment of fees related to prior periods. In its 2011 10-K filing (the year in which MJ agreed to start paying E911 fees), MJ still made the following statement and failed to mention it already agreed to start paying E911 fees at least in one county:
"Many state and local governments have sought to impose fees on customers of VoIP providers, or to collect fees from VoIP providers, to support implementation of E911 services in their area. Such fees are often put in terms of a fee placed on monthly bills, or focused on use from a specific location. The application of such fees with respect to magicJack users and the Company is not clear because the Company does not bill its customers monthly, nor does it bill customers at all for telecommunication services. The fees in the great majority of cases could be owed by the end user and not the Company, as the Company does not know the end user's location because the magicJack device is nomadic. Should a regulatory authority require payment of money from the Company for such support, magicJack LP may decide to not offer its 911 service in that area or to develop a mechanism to collect such fees from its customers. The Company cannot predict whether the collection of such additional fees or limitations on where its services are available would impact customers' interest in purchasing its products."
This is not a theoretical isolated future problem for MJ. In January 2011, in response to the FCC's inquiry of whether to extend the E911 to cover also non-Interconnected VoIP providers (such as MJ claims to be), three Colorado counties filed their suggestion to the FCC to close this loophole. These counties go further and even name specifically MJ in their letter (emphasis added):
"It is too easy for a company to organize its VoIP business model to avoid being subject to the 911 mandates established for interconnected VoIP service providers. One company with a growing presence in Colorado and around the country is the YMax Communications Corporation ("YMax CC"), which sells a device called magicJack". Moreover the counties continue and argued: "YMax's corporate strategy in avoiding payment of E-911 fees has the potential to become widespread as more and more households give up the traditional landline telephones and turn to less expensive, broadband based options for voice communication. Thus, customers will rely on the YMax CC phone service as their sole telephone service, without the same protection afforded customers of other VoIP providers that are interconnected. YMax CC could decide at any time to discontinue provision of 911 services, to the detriment of its customers' safety."
MJ still claimed in its latest annual filing that it is not clear whether it is liable for the payment, although it has already agreed to start and collect this fee at least in one county, if not more. In its 2012 10-K, the company provided a bit more details (emphasis added):
"Certain E911 regulatory authorities have asserted or may assert in the future that the Company is liable for damages, including end user assessed E911 taxes, surcharges and/or fees, for not having billed and collected E911 fees from its customers in the past or in the future. Although the Company strongly disagrees with these assertions and believes that any such authority's claims are without merit, if a jurisdiction were to prevail, the decision could have an adverse effect on the Company's financial condition and results of operations. The Company may attempt in the future to act as a billing agent for certain 911agencies."
It is obvious from reading between the lines that MJ received claims for amounts owed to local governments for failing to collect these fees in the past and that MJ's management failed again to disclose it has already set a precedent and agreed to start paying these fees. Vonage's 2012 filings provide some more color on similar claims made against other VoIP providers and that it has also started to collect and remit 911 fees (emphasis added):
"We have received inquiries or demands from a number of state and municipal taxing and 911 agencies seeking payment of Taxes that are applied to or collected from customers of providers of traditional public switched telephone network services. Although we have consistently maintained that these Taxes do not apply to our service for a variety of reasons depending on the statute or rule that establishes such obligations, we are now collecting and remitting sales taxes in certain of those states including a number of states that have changed their statutes to expressly include VoIP."; "In addition, many states address how VoIP providers should contribute to support public safety agencies, and in those states we remit fees to the appropriate state agencies. We could also be contacted by state or municipal taxing and 911 agencies regarding Taxes that do explicitly apply to VoIP and these agencies could seek retroactive payment of Taxes."
As the FCC is considering changing the regulation to broaden the E911 fee net, counties and states have started to close in on MJ and other VoIP providers. MJ has already set a precedent of agreeing to pay at least one county and therefore it is probable that MJ will be required to collect and remit E911 fees going forward also in other locations.
Assuming that an average MJ subscriber subscribes for a period of two years, and that 80% of the 10 million devices sold were sold in the US (MJ does not disclose on a regular basis the number of devices sold or the number of active users), MJ could be liable, without accounting for fines, damages and interest, for an amount in the range of $200 million for its failure to collect and remit E911 fees.
Going forward, MJ can either add the E911 fee to the subscription fee, reducing the attractiveness of MJ's offering, or bear the increased cost, cutting its annual profit by an estimated $36 million (assuming 3 million active subscribers and 1$ per month E911 fee per line), which would amount to about 75% of the company's 2012 Profit Before Tax.
USF Fund - the USF fund was established in order to fund various telecommunication goals of the government, such as providing affordable telecommunication services to schools, libraries, low income consumers, etc. All telecom providers contribute to the USF fund based on their interstate revenue. In 2006 the FCC added the Interconnected VoIP providers to the list of contributors in order to allow for fair competition between traditional and VoIP providers.
MJ provided the following disclosure in its 2012 10-K (emphasis added):
"Universal Service Fund ("USF") and Other Funds - The FCC and many PUCs have established USF programs to ensure that affordable telecommunications services are widely available in high cost areas and for income-eligible telephone subscribers. Other fees are imposed to meet the costs of establishing and maintaining a numbering administration system, to recover the shared costs of long-term number portability, and to contribute to the Telecommunications Relay Services Fund. All telecommunications carriers contribute to these funds, and the requirements have been expanded to interconnected VoIP providers. The FCC and many PUCs have for a number of years been considering substantial changes to the USF system including changes in contribution methodology. Some proposals, if adopted, could have a material adverse effect on the Company. Federal USF fees have to date only applied if a company bills for telecommunication services. magicJack LP does not bill for domestic local and long distance telecommunication calling services.
MJ does not contribute to the USF fund as it claims it is not billing its subscribers for local and long distance calls, but rather bills them for an access right to its servers, while providing phone calls for free. How long will the FCC tolerate this?
Vonage provides the following disclosure in its 2012 10-K (emphasis added):
"On April 30, 2012, the FCC released a Further Notice of Proposed Rulemaking on reforming federal universal service fund ("USF") contributions. Currently USF contributions are assessed on the interstate and international revenue of traditional telephone carriers and interconnected VoIP providers like Vonage. The level of USF assessments on these providers has been going up over time because of decreases in the revenue subject to assessment due to substitution of non-assessable services such as non-interconnected VoIP services. If the FCC does reform USF contributions, it is likely that Vonage's contribution burden will decline"
The FCC published the following request for comments on how to increase the number of contributors to the fund and minimize competitive distortions (emphasis added):
"Furthermore, the USF contribution base, largely comprised of assessable telecommunications service revenues reported by companies, has recently begun to shrink as residential and business customers have begun to migrate to communication services that do not contribute to the Fund. Who should contribute? We seek comment on clarifying or modifying the Commission's rules on what services and service providers must contribute to the USF in order to reduce uncertainty, minimize competitive distortions, and ensure the sustainability of the Fund. In particular, we seek comment on two alternative approaches to defining what services or providers should be subject to contribution obligations: (1) using our permissive authority, and/or other tools to clarify or modify on a service-by service basis whether particular services or providers are required to contribute to the Fund; or (2) adopting a more general definition of contributing interstate telecommunications providers that could be more future proof as the marketplace continues to evolve."
In addition, the FCC is dealing specifically with One-Way VoIP - the service MJ claims to provide (emphasis added):
"In particular, we seek comment on whether competitive neutrality concerns now support the inclusion of one-way VoIP services within the contribution base. Some parties argue that the one-way VoIP exemption is "an enormous loophole" that creates competitive disparities. USTelecom has argued that the current system "unfairly penalizes traditional voice providers (and ultimately their customers) and artificially skews the market." One-way VoIP providers, on one hand, and providers of traditional telephone and interconnected VoIP services, on the other hand, have acknowledged that they compete against each other. XO, for example, argues that the exemption provides "a significant artificial cost advantage" for non-assessable services that provides "a powerful incentive for consumers to replace [assessable services] with less costly non-assessable services." We seek comment on the extent of competition between one-way VoIP and other services that are subject to assessment, and how that should affect our analysis. Commenters are encouraged to provide data to support their analysis. If one-way VoIP providers are brought into the contribution base, what would be the appropriate transition period?"
It is most certain that when the FCC revises its USF fund contribution criteria, it will eliminate the loophole which MJ uses to avoid the contribution. The current rate of contribution to the fund is approx. 15% of the provider's interstate revenues, while a safe harbor rule exists to determine the percentage of a VoIP provider's interstate revenues. This safe harbor rule provides for a 64.9% contribution factor on the provider's revenues to determine the interstate revenues. Assuming MJ would have contributed to the USF fund in 2012, it would have had to write a $15 million check which would account for 34% of MJ's 2012 Operating Income.
Other taxes - In general, the following taxes and assessments apply to Interconnected VoIP services: sales and use taxes, gross receipts taxes, excise taxes, franchise taxes, utility taxes and various state and local assessments and charges. For example, Illinois imposes a 7% telecommunications excise tax applicable to all gross charges assessed by a provider to a service address within the state of Illinois. The tax specifically applies to VoIP services. Pennsylvania applies a 6% sales tax to all telecommunications services, including interconnected VoIP services. Still, MJ claims it is not subject to any of these taxes and fees (emphasis added):
"State and Municipal Taxes - The Company believes that it files all required tax returns and pays all required taxes (such as sales, excise, utility, and ad valorem taxes), fees and surcharges. It believes that it is exempt from certain taxes, fees and surcharges because it does not charge for telephone services or render bills to its customers. The Company remits sales tax in Florida on sales of magicJack units because its magicJack LP subsidiary's personnel, property and activities are in Florida. Certain states and municipalities may disagree with the Company's policies and may believe the Company should be remitting taxes for past or future sales on certain items or services. Although the Company strongly disagrees and believes any possible claims are without merit, if a state or municipality were to prevail, the decision could have an adverse effect on the Company's financial condition and results of operation. magicJack LP does not have activities or have representation in any other state. However, many states are changing their statutes and interpretations thereof as part of new streamlined sales tax initiatives to collect sales taxes from non-resident vendors that sell merchandise over the Internet to in state customers. The Company may at some time be required to collect and remit sales taxes to states other than Florida. It may also become required to pay other taxes, fees and surcharges to a large number of states and municipalities as a result of statutory changes in the basis on which such taxes, fees and surcharges are imposed. In the event that the Company is required to collect sales taxes or other taxes from direct sales for states other than Florida on sales of magicJack device or renewal of its service offerings, it will bill and collect such taxes from its customers. The Company will examine any future fees and surcharges imposed as a result of statutory changes and determine on case by case bases whether to bill its customers or increase its initial or access right renewal sales prices to cover the additional fees and surcharges."
How long can the company hide behind the claim that it does not provide incoming and outgoing calls or does not charge for telephone service, but rather bills for "access" to its servers? It's only a matter of time until the local tax authorities zoom in on MJ which will have to start and pay these taxes, as do other providers. Vonage yet again provides some more color on what is really happening in the VoIP industry and the fact that local governments are going after VoIP providers for non-payment of taxes. Vonage disclosed it started to pay local taxes and that it has created a reserve relating its past exposure (MJ, although subject to the same risks, has not provided such a reserve):
"For a period of time, we did not collect or remit state or municipal taxes (such as sales, excise, utility, use, and ad valorem taxes), fees or surcharges("Taxes") on the charges to our customers for our services, except that we historically complied with the New Jersey sales tax. We have received inquiries or demands from a number of state and municipal taxing and 911 agencies seeking payment of Taxes that are applied to or collected from customers of providers of traditional public switched telephone network services. Although we have consistently maintained that these Taxes do not apply to our service for a variety of reasons depending on the statute or rule that establishes such obligations, we are now collecting and remitting sales taxes in certain of those states including a number of states that have changed their statutes to expressly include VoIP. In addition, many states address how VoIP providers should contribute to support public safety agencies, and in those states we remit fees to the appropriate state agencies. We could also be contacted by state or municipal taxing and 911 agencies regarding Taxes that do explicitly apply to VoIP and these agencies could seek retroactive payment of Taxes."
The table below illustrates the effect on the 2012 Operating Profit of MJ, if it had paid the E911 fess and contributed to the USF fund. Obviously, one could argue MJ could have increased subscription fees to offset the costs, but then its market share and revenues would have dropped significantly.
Cost of revenues
1.Adjustments to reflect the payment of $1 per user per month, according to an estimated 3 million active users (from the 10 million devices sold), and the contribution to the USF of 15% on the applicable safe harbor rule of 64.9%.
To summarize, we believe that these loopholes which are used by MJ for unfair competition with other providers will be closed by the FCC during 2013. MJ will have the option of either bearing the cost of these added fees and taxes in order to maintain its market share, or significantly increase the amount it charges for its services, which would make it far less appealing to subscribers, as MJ is not really known for its quality of service (voice quality and support). On top of that, MJ has probably a huge undisclosed liability relating to past non-payment of taxes and fees, probably higher than its cash balance or even market cap.