magicJack VocalTec (NASDAQ:CALL) is a quintessential cash cow. Trading at 1.1x 2015 EBITDA with 72% of its market cap in cash, no debt and significant free cash flow generation, the company's common stock is severely undervalued. This undervaluation is due to the ongoing decline in the company's legacy magicJack device business since 2012. Investors do not seem to recognize the company as the cash cow it has become. It has transformed from a high-growth consumer electronics business to a stable, high-margin subscription business swimming in cash. I estimate the value of the stock to be worth at least $13.50 per share.
Fixed income-like, subscription-based business
magicJack was the major telecom market disruptor in 2007 with its voice over Internet protocol solution, the magicJack device. For those with minimal tech literacy such as myself, one end of the device plugs into your wireless router or your computer and the other end plugs into your home phone, thus enabling it to make unlimited calls to the U.S. and Canada with a dedicated U.S. phone number. Users pay for the device itself as well as for a contract for the service, typically for one year's worth of unlimited calling, though the company does offer much shorter-term options now. Those are CALL's two primary revenue streams: device sales and subscriptions, or "access right renewals."
Logically, the access right renewals are much higher margin revenues than are the device sales, because there is almost no variable cost associated renewing a subscription. In terms of marginal cost, one can think of the access right renewals as a SaaS business, analogous to a digital sale of Microsoft (NASDAQ:MSFT) Office.
Over the past few years, access right renewals have made up an increasing portion of magicJack's total revenues, and it's not just due to device sales falling. While device sales have dropped by 60% since 2011, access right renewals have increased 75% over the same period. Not surprisingly, gross margins have increased from 53% to 63% over that same period. While device sales represent the customer acquisition that eventually leads to access right renewal revenues, magicJack's financials have shown, year after year, that their existing user base is a loyal one that continually renews the service. In fact, magicJack is the low-cost provider of dedicated U.S. phone lines with unlimited calling. On the most recent earnings call, management announced the lowest customer churn rate in the company's history at just 2.8%. Long story short - while the company may not be adding a ton of new subscribers, the ones it does add are not leaving the service due to cost advantage that the company enjoys.
This brings us to the central point of the thesis. The stock took a 65% dive in the latter part of 2014 as device sales began their decline in the face of competition from more convenient and sexier mobile apps such as WhatsApp, Viber and Skype, and growth investors left the stock in droves. However, magicJack's existing user base has largely not switched over to the competitors, as evidenced by the still healthily growing access right renewals. I believe investors have overreacted and failed to value the high-margin, fixed income-like subscription revenues that now make up the majority of the company's business.
Turning to the company's financials, margin expansion in recent years and quarters has helped it cope with its reduced device sales and has preserved and grown the bottom line as the company has transitioned to being simply a subscription-based cash cow. Device revenues have a gross margin of around 60% and falling, while renewals have a gross margin of around 76% and rising. Operating margins have also expanded as the company has successfully cut costs throughout the past year. All of these changes lead to EBITDA margins of ~32%, EBIT margins of 30% and free cash flow margins of ~15%. The company converts a large percentage of EBITDA to free cash flow because it has almost no capital expenditures (~1% of revenues), minimal history of M&A and consistently negative net working capital.
70% of market cap in cash, no debt
A quick look at the company's balance sheet reveals its significant and growing cash position, currently at $82 million or $5.21 per share, a whopping 70% of the current price. Furthermore, the company has no corporate debt, meaning that the market is quoting the enterprise value at $40 million. That price yields a multiple of 1.5x 2015 EBITDA and 3x 2015 free cash flow. More than half of the company's liabilities are deferred revenues and will therefore move from the balance sheet to the income statement over time as these revenues are recognized, and all at a fairly low cost given the company's increasingly wide gross margins. The superb balance sheet and capital structure provide the stockholders with a $5.21 floor on the common shares.
You might well wonder what good all this cash does just sitting there on the balance sheet. Given that the company has minimal capex and R&D, is not active in the M&A markets and consistently operates with negative working capital, it is unlikely that management will squander the cash on unsuccessful acquisitions or the like, and I would expect most of it to eventually be returned to shareholders. In fact, the company announced a $20 million share repurchase program at the end of 2014 that will be 100% completed by the next earnings release. While the stock initially soared on the announcement and execution of the buyback, the share price has recently languished along with the broader market. Furthermore, acclaimed Buffett/Munger disciple Whitney Tilson of Kase Capital owns shares and calls in to every quarterly earnings call to advocate for returning more cash to shareholders. Management has historically been receptive to and cooperative with Tilson and other shareholders.
Management also owns 4% of the common with significant option holdings at a strike price of $14 - so using the corporate cash to dramatically reduce the share count would make them rich as well.
Sensible, low-risk growth initiatives
Another catalyst for value realization would be success in any of the company's three initiatives to restore the business to top line growth. Management is pursuing these opportunities very sensibly; they are directly adjacent to the existing business and require almost no risk of capital up front.
The first such initiative is geographic expansion to Mexico. The company will soon launch its long-awaited partnership with Telefonica's subsidiary in Mexico and offer their service directly to Telefonica's 20 million Mexican subscribers. This is a logical market for the company's unlimited U.S. phone number service, as many Mexicans have family, friends and business partners across the border in the U.S.
The second initiative is "enterprise," or selling the phone service to small businesses in the U.S. To this end, management announced on the most recent earnings call an exclusive agreement with the Patel family to begin installing the device in hotels that the Patel's represent, a market of over 15,000 potential hotels. Anyone familiar with the Patel family and their history of tremendous business success in the U.S. knows that they represent the highest quality of products, services and business practices.
The last initiative is mobile. The company now has a free and a paid premium app and is working diligently on converting its many free subscribers to paid subscribers, and has hinted at the possibility of supporting the free version with ads in the future.
If any of these initiatives were to add substantially to the top line in 2016 or 2017, this would be pure upside not baked into my model. And management is determined to risk minimal cash up front in developing these initiatives until it sees the opportunity for substantial return on invested capital.
Dirt cheap valuation at 1.5x EBITDA, 3x free cash flow
I valued the company using discounted cash flow analysis at $12.50 - $15 per share or 65% - 100% upside from today's $7.60 price. I used a 3-year hold period and an exit multiple of 2x EV/EBITDA and a 10% discount rate, and ascribed $0 value to any of the company's three potential upside levers. For the key operating assumptions, I assumed a 5-year revenue CAGR of -7.5% which, due to margin expansion, corresponds to an EBITDA CAGR of 2% and a FCF CAGR of 5.5%. Even with very bleak top line assumptions, the present value of future cash flows is far above the current market price.
Obviously, there are flaws to every valuation methodology and the DCF analysis is no exception. But just think about it: the actual business ex-cash is trading for $35 million, while the company is set to produce ~$15 million in free cash flow in 2015. That's a 43% yield, and doesn't include any potential upside from growth initiatives or any return of cash to shareholders. While you can't know exactly what any business will look like 5 years down the road, you have the ability here to invest in a stable, cash-generating company at a cheap price with the odds tilted in your favor.
Key risks and mitigants
Risk: The company could squander its cash, failing to return it to shareholders or invest it at attractive returns.
- Mitigant: Two of the company's three primary growth initiatives utilize partnerships with reputable third parties so as to reduce the initial cash outlay. Management vows not to spend significant cash on any of these initiatives unless/until there is significant evidence of attractive returns.
- Mitigant: Acclaimed Buffett/Munger disciple Whitney Tilson of Kase Capital owns shares and calls in to every quarterly earnings call to advocate for returning more cash to shareholders. Management has historically been receptive to and cooperative with Tilson and other shareholders.
Risk: The company's declining product activations will undermine its growth in high-margin renewal revenues and ultimately lead to the demise of the business.
- Mitigant: While this is obviously true over the long-term, the company has spent the last year making much needed improvements to its customer service, with renewal/expiration notifications to existing users being the primary focus. The result is that the company has recently been posting its lowest user churn numbers ever. Expect this effort to continue to mitigate the decline in device activations.
- Mitigant: magicJack is still the lowest-cost voice over internet protocol option and costs far less than traditional phone plans. While the service may lack in sexiness or add-on features, it provides a much needed service to customers at the lowest price on the market, which keeps its customers renewing in the face of far more expensive alternatives.
Disclosure: I am/we are long CALL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.