United Online: Strong Free Cash Flow Makes for an Attractive Valuation

| About: United Online, (UNTD)

United Online (NASDAQ:UNTD), a curious mix of Internet-related properties, is understandably viewed as not being in the best of competitive positions from a growth standpoint: 18% of its revenues for 2010 came from running a dial-up ISP and 22% from a social networking website that has the disadvantage of not being Facebook. The market was certainly not pleased with its fourth quarter 2010 earnings announcement, sending the share price from $6.71 before the announcement to $5.89 as of this writing. However, United Online offers an impressive free cash flow yield that deserves a second look.

Furthermore, the company is rebranding its classmates.com website into an overall nostalgia services site, memorylane.com, mixing the old service of looking up former classmates with material from the social and cultural atmosphere of the users’ high school and college years. The dial-up segment, although its revenues are diminishing, is consuming capital resources at a rate far below depreciation charges, as with many land-line telephone companies. This allows the segment to contribute, and continue to contribute in future, to free cash flow in excess of earnings. Finally, United Online’s largest division, FTD, which provides flowers and gifts, continues to produce solid results. These three segments taken together give United Online a free cash flow yield of 13.8% based on current prices, which allows it to maintain its dividend yield of 6.7% and also to pay down the debts incurred to acquire the FTD properties.

Turning now to the figures, sales at United Online have been on the decline, partly as the result of the loss of a post-transaction marketing program that was terminated in early 2010. However, although overall revenues have declined 9.3% for 2010 as compared to 2009, the company’s largest segment, FTD, did in fact have higher sales in 2010 than 2009. The decline in sales, then, comes from the dial-up ISP service and the classmates.com website. As I stated above, the dial-up division will probably continue to show declining revenues, although probably not to zero, and continue to spin off free cash flow along the way. As for the memorylane.com/classmates.com property, I can only advise a wait-and-see approach to see whether this will slow or halt the sales decline in that division.

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The free cash flow analysis at United Online is more encouraging, as it has already shown signs of stabilizing. I should point out that capital expenditures increased in 2010 as the result of acquiring additional rights to nostalgia-related intellectual properties for memorylane.com. According to its annual report for 2010, United Online anticipates making up to $6 million in further acquisitions of these rights in 2011.

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Estimated free cash flows for United Online, 2010

1Q2010

2Q2010

3Q2010

4Q2010

Reported operating income (millions)

25832

29836

25607

31415

Depreciation & amortization*

14830

15015

14658

14142

Capital expenditures

5162

10154

5953

10722

Operating cash flow

35500

35697

34312

34835

Net interest expense

6684

5902

5089

5552

Pretax free cash flow

28816

29795

29229

29283

Est. after-tax free cash flow at 40% tax rates

17290

17877

17534

17570

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Estimated free cash flows for United Online, 2009

1Q2009

2Q2009

3Q2009

4Q2009

Reported operating income (millions)

37404

43114

32674

32801

Depreciation & amortization*

14713

15188

15190

14612

Capital expenditures

6347

6085

4758

9006

Operating cash flow

45770

52217

43106

37404

Net interest expense

7853

8466

7044

8616

Pretax free cash flow

37817

43751

36062

28788

Est. after-tax free cash flow at 40% tax rates

22690

26251

21638

17273

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*Depreciation and amortization in excess of capital expenditures is usually tax-free, but focusing on a company’s future earnings power calls for it to be taxed, as the gap between depreciation and capital expenditures may resolve itself in the future. Treating excess depreciation and amortization as untaxable would improve free cash flows in 2010 and 2009 by an estimated $10.662 million and $13.402 million, respectively.

Total estimated after-tax free cash flows were $87.851 million in 2009 and $70.270 in 2010, and appear to have stabilized, for the moment, at roughly $17 or $17.5 million per quarter, despite the increased level of capital expenditures in 2010 relative to 2009. According to United Online’s earnings release, management anticipates that sales for the first quarter 2011 will be between $234 and $239 million, and as the release occurred nearly two months into the first quarter, I find this estimate to be credible. United Online also points out that Mother’s Day in the United Kingdom will fall in April of 2011, which moves an estimated $14 million in sales into the second quarter whereas for 2010 it had been in the first quarter. This estimate is consistent with 2010’s level of sales, and so for the moment, we may expect that 2011’s free cash flow results are likely to resemble 2010’s as well.

I should also point out that United Online’s interest requirements are covered six or seven times by operating cash flow, so there is little risk of debt distress posing a threat to the firm’s operations. As a result, United Online’s present high free cash flow yield appears to be sustainable, particularly if the memorylane.com property shows good performance in the future.

Therefore, I conclude that United Online’s (stable, at least temporarily) free cash flow yield offers sufficient compensation for its declining revenue situation, and I would definitely recommend it as a candidate for portfolio inclusion.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.