Disclosure: The author and the author's fund have a long position in this security at the time of posting.
Short sellers are sometimes compared to criminals shouting fire in a crowded theater.
Although the reactions to both are, in some regards, similar (panicked rush for the exit), I believe an important distinction has to be made. Moviegoers should not be expected to know whether proper materials and safeguards are in place to prevent a fire or to evaluate the probability of a personal injury in the case of an actual fire. On the other hand, "Professional Investors" who dominate current markets, are expected to perform a reasonable level of due diligence on securities that they purchase on behalf of their clients.
So, when a short report "hits the wires", it will either contain new and material information that the professional investors did not consider and should lead the investor to re-evaluate his investment thesis, or it will not, potentially offering an informed investor an opportunity to buy a security he likes at attractive prices.
My personal observation has been that professional investors / the market, often show a limited ability to distinguish between what constitutes "new and material" information and what does not. Possibly, this has something to do with the fact that an average mutual fund manager owns close to 100 securities preventing them from doing an appropriate level of research on the companies they own, but even more surprising (and potentially alarming to those who entrust their funds to professional investors), they do not appear to even read the short-sellers' work based on which they are selling the security in question.
To illustrate this point, I will use Andrew Left's (Citron Research) most recent (at the time of writing) published report on j2 Global (NASDAQ:JCOM). I invite you to access the report available on Citron's website.
But first, a disclaimer: I owned an equity interest in j2 Global's business prior to the short report being published and own a substantially larger position today. So, although I have no expectations that my note will "move the markets", I stand to benefit personally should the stock price of j2 Global goes up - consider me an interested party (as any investor who is short or long a stock they are talking about).
I do not intend this to be a long report on j2. Instead, I want to highlight what I view as obvious flaws and unquestionable misstatements in the Citron short-report that should have been obvious to anyone who actually read it. Therefore, I will structure this note to go through the most salient points raised by Citron.
First Allegation: j2 Global's fax business is a "near monopoly" that will soon crumble when "the key" patent expires.
Source: Citron research
Let us first start with Citron's claim that the fax business is a near monopoly because any intellectual property is only valuable if it allows its owners to earn excess returns by preventing competition. What would you pay for a patent on a drug that currently has multiple branded and generic competitors? The answer is probably not much.
To check whether j2 Global is a monopoly requires only access to a Google search engine. The following link shows the first non-advertised results for "internet fax reviews" (try this yourself).
Clicking on the first non-ad link you, will most likely see the following page (I am based in Canada, so that is why the prices are in Canadian dollars):
Out of the 9 companies shown on that list; nextiva, Maxemail, GreenFax and Sfax are not owned by j2 Global. More importantly, it looks like j2's "core brand", eFax, is more expensive than all the other alternatives with nextiva being cheaper than all of j2's competing offerings.
Clicking on the second link unearths more non-j2 alternatives including: faxZero.com, GotFreeFax.com, Hellofax and, importantly, RingCentral, a NYSE listed company with a market capitalization of $1.26B. Here, I just illustrate the results from the two first links, but there are additional competitors in the space.
After five minutes of "research", it seems quite obvious that j2 is no monopoly. Now, although we have established that j2's patent portfolio falls far short of an impenetrable moat portrayed by Citron, let us still humor the notion that j2's U.S. patent 6208638 is fundamental for the success of j2's fax business.
The key piece of evidence that Citron presents is an article from Stanford Journal of Law, Business & Finance that is titled "Intellectual Property Wrongs". Citron specifically chose to include the following excerpt from the article that suggested that j2 has a history of aggressively pursuing litigation as a tool to weaken competition.
I cannot imagine that a lot of people would be surprised by the use of patent litigation as an offensive or defensive strategy. By no means does this suggest that any one patent is critical to j2, given that you can allege infringement with one random patent.
Specifically, the reader should note that the excerpt makes no mention of the 6208638 patent or its importance.
The same article does, however, contain a couple of other interesting passages that I included below and you can read them on page 288 of the original:
This passage suggests that, between 2006-2007, j2 Global faced four antitrust claims pertaining to patents that the Company acquired in 2005 and whose general description appears to be related to the U.S. patent 6208638, but as I will mention later does not appear to include the 620 patent: "Method and apparatus for transmission and retrieval of facsimile and audio messages over a circuit or packet switched network".
This raises a couple of questions:
If patents are crucial to a successful eFax business, how was j2 Global able to build a $100M revenue business (as of December 2004) without ever owning patents at the center of the antitrust case? More importantly, this raises a question regarding the importance of the U.S. patent 6208638. If I was going to pursue an antitrust case against a competitor, I would think that it would probably be a good idea to include those patents that are actually preventing me from competing. The 6208638 patent was published in 2001 and, therefore, based on the article, would not have been at the core of the antitrust case that focused on patents acquired in 2005. So, at least based on this example, it would appear j2's actual competitors disagreed with Citron's claim as to the importance of the 620 patent. The same article also points out that only one case proceeded as far as summary judgment, where it was dismissed. So four different competitors unsuccessfully sued j2 on anti-trust grounds. Clearly the courts disagree with Citron's allegations that j2's patent portfolio has resulted in a monopoly.
Finally, anyone even casually following j2 Global would know that the company separately discloses revenue that it generates from its IP Licencing activities (surprisingly this fact is omitted from the Citron report…). This segment generated a whopping $6M of revenue in 2015 or less than 1% of total. If j2 was, in fact, this aggressive litigator with a very valuable patent portfolio, you would think they would do better than $6M.
We have established that j2 Global does not have a monopoly in its fax business and we should not expect upcoming patent expiration to have any impact on the company's earning power, unless you believe that Google, Microsoft or anyone else is staying out of the internet fax business because of licencing fees that have to be substantially less than the $6M that j2 generates in total from its patent portfolio. It should also be noted that j2 licences its patents on a percentage of revenue basis (usually single digit percentage) so even the smallest competitors should be able to secure licenses if they can generate comparable cash margins.
Second Allegation: To disguise the company's declining fax business, the company has been borrowing and acquiring unprofitable businesses.
Source: Citron Research
Source: Citron Research
Once again, a reader did not have to do much work beyond the reading of Citron's own report to realize that this allegation is, at the very least, inaccurate. As in its own valuation, Citron is only using $171M as the Net Debt amount:
Source: Citron Research
Yes, today, j2 has $600M million of debt outstanding, but the company also has $256M of cash and $158M of investments on its balance sheet, such that counting the full $600M as if it was deployed into growing the business is clearly inaccurate.
More importantly, Citron's allegation that the company's earnings power has not grown over the past five years is obviously misleading.
Through most of its report, Citron points to EBIT (operating profit), not EBITDA (a more common metric among financial analysts, although not necessarily the right one) or Free Cash Flow (a better metric).I believe that the focus on EBIT is not accidental. Because j2 allocates a substantial portion of its capital to acquisitions, its income statement includes substantial amortization expense related to acquired intangible assets.
Specifically, in 2015 intangible assets amortization expense was $74M, representing 37% of reported operating income. I believe that the vast majority (~87%) of these expenses should be added back to company's operating profit as they do not represent true economic costs (refer to the bottom of the page 15 in Warren Buffett's latest letter to shareholders further discussion on accounting treatment vs. economic reality of amortization expenses).
Regardless of your thoughts on how to treat amortization, I believe that most people would agree that free cash flow (cash flow from operations less capital expenditures) is generally an acceptable measure to evaluate a company's earnings power and certainly a better measure than net income in this particular case.
Furthermore, for a company that allocates substantial capital to acquisitions, an even better measure would be Free Cash Flow per share (this would penalize companies that issue a lot of stock to do deals).
Source: Company Financials
By this measure, management has done a great job at growing the earnings power of the business. And again this growth has been achieved with only $260M in incremental Net Debt over the five-year period!
It is also interesting to note that, although Citron throughout most of its report, focuses on EBIT, it does refer to EBITDA in one instance:
Looking at EBITDA over the past 10 or 5 years or whatever other period you chose clearly shows that this statement is factually inaccurate:
Source: Company's filings
I do not know about you, but 20% 5-year compound annual growth rate does not strike me as "running in place".
Traffic doesn't lie,: Having established that the two key allegations in the Citron report are obviously misleading, further rebuttals are probably superfluous; however, please let me indulge in one more:
Source: Citron Research
The above allegation is self-explanatory and is supported by the following three graphs sourced from Citron's own report, with me adding two lines to better illustrate the beginning and ending values for j2's properties: the red line shows beginning level (Feb 2013) and the green line shows the ending level Jun 2015). So, when the green line is above the red line this corresponds to increasing levels of visitors.
Source: Citron Research
So just looking visually at the data presented in Citron's own report, we see that, although the ASKMEN platform appears to be down slightly, the other two properties are up substantially over the period shown!
Organizing this data into a table format makes this point even more obvious:
Citron's own data shows that traffic at the company's websites is up 36% over the period shown!
Although the traffic does not lie, as Citron has illustrated, you can still mischaracterise what the data is saying.
It is still possible that my investment in j2 Global will prove to be unsuccessful. However, at this point, I think it is almost certain that it will not be because of the allegations raised in Citron's report. I also do not suggest that the reader speculate on the rebound in j2's share price to undisturbed levels ($80-85/share). I base my investment thesis on expectations that, over the next two years, j2 should be able to grow its earnings power per share at 15%+ on an annualized basis. And if I am right, it will not matter that Mr. Left (Citron) is more successful at winning votes (getting people to sell), because, in the long run, the market is a weighing machine where earnings power matters and empty rhetoric does not.
Intelligent investing to all…
Disclosure: I am/we are long JCOM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author and the author’s fund have a long position in this security at the time of posting.