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Crexendo [(EXE) – $2.81]

Rating: Buy

18-Months Price Target: $8

Crexendo, headquartered in Phoenix, is basically a high-potential, re-startup believed to be at or very near the inflection point of making significant progress with its new recurring revenue B2B business model providing cloud-based infrastructure services to small and mid-sized businesses.

The company is run by CEO Steve Mihaylo, who buys any blocks of stock available when he can of the 10.5 million shares now outstanding. He owns 4,205,000 shares with a cost basis believed to be about $59 million (~$14 per share), including 405,000 shares in recent open market purchases. In addition, the company itself has bought 900,000 shares between 12/1/10 and 9/30/11, including 724,000 shares in a tender offer at $4.75 (although no further company purchases are expected at this time).

Mihaylo founded a public company named Inter-Tel in 1969 and took it to nearly $500M in revenue before it was sold for approximately $720 million in 2007. Inter-Tel was in the telecom equipment, services and software business. Steve’s educational background is accounting/finance, but his skill is marketing. However, he is relentless on cost control and careful on the granting of stock options. He has access to former strong performers at Inter-Tel – one just did join him at Crexendo. Inter-Tel II appears to be on the way.

Crexendo's previous name was iMergent, which provided website development, eCommerce and hosting services to entrepreneurs and small office/home office (SOHO) customers through a seminar marketing format under the StoresOnLine name. The stock was a huge success some years ago (exceeding $30) and had real revenue and earnings – over $100M and over $1 per share, respectively. Partly because of the reputation of seminar marketing, the company was a target of shortsellers – which should not be an issue with its new B2B business model. It is believed that Mihaylo got involved thinking that website development, eCommerce and hosting was a synergistic extension of telecom services and that there was potential for a relationship between Inter-Tel and iMergent. However, Inter-Tel was sold and the bad economy eventually caught up with iMergent, with an insufficient percentage of consumer customers able to pay up front for its product offering.

Mihaylo took over management of iMergent in November 2008, changed the company’s name to Crexendo in 2011, and ran the seminar marketing business while he was building a Web Services and Network (Telecom) Services business for larger companies. Telecom services is now more of a Voice over Internet Protocol (VoIP), software-based business, than the more equipment-oriented Inter-Tel business he started decades ago. Crexendo evidently can save customers 25% or more on their telecom bills and believes that a weak economy is actually good for their telecom business. During the last two to three years that the company was building its telecom services offering, it got regulatory approvals in 46 states (and DC) as a CLEC (Competitive Local Exchange Carrier), and for the September 2011 quarter had about $700,000 of revenue from 400 business customers in its Web/Network Services B2B segment, mostly for web services.

On 7/1/11, the company determined that seminar marketing had no long-term future – that it was a “fair weather” business – and it was closed down. However, hosting and service to existing customers was continued – and other non-seminar avenues of marketing to that general customer segment are being pursued. Collection of discounted receivables relating to (typically) 2-year finance contracts with customers in that business is successfully ongoing, will continue for the next 18 to 24 months and provide cash flow support to the new B2B initiative. The concern has been whether the company could successfully make the transition from its discontinued seminar marketing business model to its new recurring revenue B2B business model.

In a 12/15/11 announcement, showing that the company is about ready to go with providing telecom services to larger companies and with a nationwide rollout, Mihaylo stated:

We are completing a beta test of providing hundreds of devices and phone lines to a business with locations in multiple venues, the results have exceeded our expectations. I am fully convinced we have the right services and solutions for everyone from the large enterprise customer to the SOHO……We are moving forward with our nationwide rollout in January and we are aggressively expanding our sales force to handle our expected growth.

The CEO has publicly said that success is primarily a matter of good execution and not something that he hasn't basically done before – and that the key is hiring a direct sales force, his initial marketing strategy. He also used Value Added Resellers (VARs) with Inter-Tel, but that is a marketing model that is more suited to higher cost equipment that needs servicing than lower cost software that does not.

The stated gross margin for Crexendo’s new recurring revenue business model will be 60%-65%, increasing to 65%-70% when it achieves a good volume of sales. The company is now positioning itself as providing cloud services – eCommerce, website hosting, and telecom, on a B2B basis. It has indicated plans to add at a later date such services as broadband, operator services and cloud storage. Capital expenditures of only $1-2 million would be needed to build out existing infrastructure to two fully redundant data centers capable of handling 100,000 customers. Crexendo sees its marketing advantage as cost savings to the business customer combined with (eventually) one-stop shopping for a wide range of services, some with innovative features. Telecom services are also being offered – but not as the main thrust – to groups of consumers, when marketing costs can be contained. This would include marketing to affinity groups, as well as to the hundreds of thousands in the StoresOnLine customer base.

8x8 Inc. (NASDAQ:EGHT) is Crexendo’s much more mature, nearest comparable competitor, with $83 million of projected annual revenue and about a 66% gross margin. The Motley Fool published a 12/24/11 article on that company which contained the following comment:

… businesses of every size are getting more comfortable with cloud-based infrastructure services every day. The year to come could very well be the one where VoIP telephony hits the tipping point and starts a period of exponential growth. I'd put that likelihood at about 30%. Extend your time frame to five years, and I'm certain that this will happen before 2016.

This suggests that Crexendo is moving ahead with these new initiatives at a very good time. A company catching a favorable secular trend has a nice tail wind to help ensure favorable performance over a significant period of time.

The public Crexendo forecast on the last conference call was for a $24 million revenue run rate at 12/31/12, at which level it is believed that the company would be roughly cash-flow breakeven. The balance sheet at September 30, 2011, had $10.6 million of cash (including a certificate of deposit) and $19.3 million of discounted finance contract receivables to support the business transition (versus $3.1 million of accounts payable and accrued expenses, and no debt). The accountant is top-drawer – Deloitte Touche. Within three to five years, if successful, the company could achieve perhaps $1.50 in fully-taxed earnings per share per year and conservatively sell in the mid-20s. For comparison purposes, 8x8 Inc. (EGHT – $3.17) stock now sells at 32 times the average earnings per share estimates ($.10) of analysts for its fiscal year ending March 2012 (and has a much higher operating cost structure than Crexendo will have).

The company pays a 2 cent quarterly dividend, giving a 2.8% annual yield at the current stock price. Mihaylo said on the last conference call that he might reduce or eliminate the dividend if cash were to become an issue. Therefore, now was obviously the best time to cut or eliminate it, if he thought he would ever have to, because it was somewhat expected. Given that the company just announced on 12/21/11 that it will be paying the January dividend, there is a logical inference that Mihaylo believes that he may not have to cut it in the future. However, he would never have raised the issue at all if he did not want it understood that proper management of resources could include cutting or eliminating the dividend at some point in time.

One of the risks is that cash on hand plus payments on 2-year finance contract receivables might not be enough to get over the transition to the B2B business model. Payments on the entire receivables block are somewhat front-end loaded. Therefore, the dividend announcement suggests that, for the (important) first six months since stopping seminar marketing on July 1, receivables collection and cash usage for the new initiatives continue at least on target; and is an indication that financial results for the quarter ending December 31, 2011, will meet stated expectations of being cash flow positive (including cash from receivables collected).

As to future cost factors, building a productive internal sales force is the major “gate issue” and incremental cost for Crexendo. On 11/7/11, the company stated that it had 28 salespeople (many of them recent hires), with a fully productive salesperson believed to be capable of producing $400,000 of annual revenue. The first quarter 2012 target sales force is 35-40 people, with 15-20 fully producing. The goal of hiring 3-4 per month is within its control. If cash gets tight because of too much sales expense – for example, too large a percentage of the sales force is recent hires and not yet fully productive, because of a stated 60 to 120 day training and productivity ramp-up – the company could ease up on hiring of more salespeople until revenue productivity of recent new hires better supports the related expense. Finally, it is believed that the CEO could and would personally finance the company if that were to be needed.

Mihaylo is a “public company” executive. He knows what institutional interest can mean to a stock’s performance and is expected to “go on the road” to tell the story when he has one to tell, perhaps by next summer. If the company makes progress and institutions do not buy, he might reasonably be expected to be the "institution" who buys the stock up to higher levels.

As to the stock itself, it appears to be “sold out” under $3, but this has been a bad market for this kind of stock, which has been aggravated by the transitioning from its previous core seminar marketing business to its new recurring revenue B2B business model. Mihaylo says on conference calls and to anyone who will listen that he is a block buyer of the stock. However, he was not able to buy that much stock during the recent five week period that the company was not in a quarterly earnings report related quiet period – 80,000 shares at an average price of $2.81. (The company has recently entered a new quiet period and will be in it until year-end results are reported in early March.)

There are two basic characteristics that great speculative investments have, (i) reward potential that is vastly larger than downside risk and (ii) the probability of a favorable outcome is reasonably high and, hopefully, well-defined. With Crexendo, the upside potential to downside risk may be as much as 10 to 1 and it appears that the probability of success is gradually resolving itself in a favorable direction and becoming better defined. If Crexendo progresses as expected, it could perhaps be the second half of 2012 before the stock achieves meaningful recognition. However, within an 18 months timeframe, the stock could achieve very significant gains – an $8 target price (a valuation of about 3.5 times the revenue run rate). That specific timeframe was chosen to conservatively allow the company some leeway on achieving the $24 million revenue run rate at 12/31/12 target. If it does hit the revenue target for the end of 2012, the price objective should be reached sooner.

The 5-year historical price and volume chart appears to support the preceding comments from a technical analysis perspective. One can see the prior high volume peak price in the mid-20s (the 3- to 5-year upside potential); that the stock has been bouncing along at much reduced prices and very low volume for over 3 years, with the current price at the bottom of the range; and that the 18 months target of $8 is the high of recent years.

Disclosure: I am long EXE.