Great Cash Flow, Good Balance Sheet and Low P/E Make Incredimail a Prime LBO Target

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I co-wrote this post with Elan Zivotofsky, Former Head of Goldman Sachs Israel Research (NYSE:GS) and Former Head of Israel Technology Investment Banking, Lehman Brothers (OTC:LEHMQ). Like me, Elan is also long MAIL and deserves most of the credit for this blog post.

As someone who has been involved in analyzing, structuring, financing, and investing in Leveraged Buyouts (LBOs), I see IncrediMail (MAIL) as a prime candidate for an LBO. Given the high level of free-cash flow, combined with the incredibly low valuation currently attributed to the company, (and the current low interest rate environment), an LBO of Incredimail could be a highly attractive transaction.

Background on LBOs

Leveraged buyouts enable private equity investors and entrepreneurial management teams to re-capitalize and purchase companies whose market valuations are not properly reflecting the potential cash flows and business value of the enterprise.

The idea behind an LBO is for the purchasers of the company (oftentimes including top-management) is to use excess cash on the balance sheet and ongoing free-cash-flow generation to help fund the purchase of the company, often using debt as a means finance the transaction.

Companies with the following characteristics make for more attractive leverage buyout targets:

  • 1. Generate high levels of free cash flow relative to their valuations
  • 2. Have high net-cash/low existing debt balance sheets
  • 3. EV/EBITDA valuations are relatively low
  • 4. High level of insider (top-management) ownership
  • 5. Market conditions or investor perception that depresses stock price valuation

Incredimail matches all of these criteria with flying colors: MAIL currently generates approximately $10-12mm of annual free cash flow, has over $30mm of cash on the balance sheet and no debt, and trades at an enterprise-value multiple of less than 5X.

The strategy of buying an asset using leverage (real estate is a classic example) is to use the cash-flow generated by the asset to comfortably pay interest and principal payments and still have cash left over. If financed correctly, the buyers of a highly cash-generative business can use a relatively small amount of up-front equity, but can end up owning all of the equity over time, greatly enhancing the actual returns on their equity investment. Incredimail is currently generating so much excess cash, that it could easily be acquired without a large upfront payment, and the purchasers could end up owning the whole business (by paying down the debt) over a relatively short timeframe.

Let’s take a look at the numbers.

1. Let’s assume that an acquirer paid a generous 25% premium to buy o MAIL (typical take-over premiums are 20-30% for public companies). Based on today’s close the price tag would be $10, or a market cap of $98mm.

2. MAIL currently has roughly $30mm of cash on the balance sheet. Let’s assume that $27mm of that cash could be used towards the purchase price, so the enterprise value, or actual price to buy the business, would be $71mm.

3. Ofer Adler, CEO, owns approx. 1.8mm shares, and in order for an LBO to work, he would remain CEO, and would take an active role in the transaction. His shares would be “rolled over”, and would not need to be acquired. So the purchase price is now $53mm.

4. A buyer could likely use $15-20mm in equity (cash) and $33-38mm in debt financing, equivalent to a very modest level of debt of 3-3.5X EBITDA.

5. Generally, banks or other sources of financing are willing to provide generous debt-financing for highly cash generative businesses. Even if banks demanded 7-8% interest rates on the debt financing (which seems quite high in today’s ultra-low rate environment), total interest expense on $35mm would be approx. $2.8mm.

6. So, after financing the transaction, there would still be about $8+mm of free-cash-flow per year to either pay down debt (and increase the owners’ equity stake) and/or to pay out dividends to the new owners (and management) of the company. In addition, as a private company, MAIL would likely save over $1mm of public-company expenses.

7. The new owners could eventually either re-IPO or sell the company when the time is right, or keep it private and continue to enjoy a very high level of cash flow.

In summary, a buyer could likely purchase Incredimail –a company generating $10-12mm in cash flow per year - - for roughly $15-20mm in equity, and likely pay down the debt used to finance the transaction in approximately 4 years.

There are three key elements to make such a transaction both feasible and highly profitable:

1. The sustainability of the cash flows - Incredimail does not even need to grow from current levels (though it certainly seems to have a solid growth trajectory), but does need to be able to sustain a level of cash flow generation similar to the current level. While it would seem that the current business model should continue to work, any potential acquirer would need to assess the longer term sustainability. This is true both in terms of the Google (NASDAQ:GOOG) search revenue which has been the company's growth engine. And, sustainability is also tied to the company's ongoing ability to execute on simple and creative products.

2. Management’s willingness to undertake such a transaction - With the CEO holding close to 20% of the stock, his agreement and active participation as ongoing CEO would be crucial.

3. Financing - while it seems to me that banks should be eager to provide financing to a company with the cash flow characteristics of Incredimail (and I have personally been involved in debt financings of companies with far less attractive cash flow metrics), banks have become more cautious over the past 6-12 months.

All in all, this is another indicator that MAIL is undervalued stock and a potential target for an LBO.

Author's Disclosure: Long MAIL

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