I believe that Stamps.com (STMP) is highly overvalued and will not deliver the growth implied by the current 22.4x P/E multiple. In fact, there is reason to believe that the >100% share price appreciation since July is the result of unsustainable and at times counter-intuitive trends in financial performance. Immediately following this period of potentially unsustainable momentum, management/insiders liquidated significant holdings, potentially validating skepticism over reported performance and lofty expectations.
Furthermore, STMP's recent strength on news that it has settled its IP litigation with Endica is being misinterpreted by the market as a significant positive development for the company. STMP was the originator of the lawsuit, which unsurprisingly resulted in numerous countersuits between the two companies. After numerous years and substantial legal cost, the two companies have agreed to simply not continue to sue one another. STMP did not "win" the lawsuit as it was not able to have Endica cease competing with it or gain any sort of monetary payment for its claims. As the company did not take out any legal reserves for the lawsuit, it is unclear why the market viewed the news as a positive catalyst.
Brief Business Model Review: STMP operates stamps.com which offers customers subscriptions of $15.99-$39.99 per month for which they can print postage, through a downloadable software application, directly from a personal printer. The product allows for printing on stamps, envelopes or on weighed/metered mail. STMP makes money 4 ways: 1) monthly fee ("Service"), 2) supplies, such as scales and blank stamp sheets, 3) postal insurance, and 4) "Photostamps" where customers can print stamps featuring personal designs. The revenue breakdown between these categories in 2011 was 82%, 15%, 2%, 2%. Usage based fees are <20% of revenue, and there is no direct charge per stamp. The business is driven by the ability to attract new customers, given the Service revenue contribution and that >41% of customers cancel their service annually.
Negative Option Marketing: Historically, STMP has used "enhanced promotion" or "EP" (better known as negative option marketing) whereby STMP combines a "risk-free trial" with some unrelated give-away ($100 gift card, for example) and fine print to start auto-charging a customer until he cancels the service (which is very, very difficult to do). STMP started de-emphasizing this channel in 2007 as it is generally considered predatory and unethical (it is illegal in parts of Canada for these reasons, for example). Revenue and earnings from angry, duped customers deserve a very low multiple indeed. However, while the non-enhanced promotion business still uses lots of tricks to get sign ups (hence over 41% of the customer base churns annually in non-EP, well over 50% in EP), the recent run up in share price is due to growth in the "core" business, which supposedly excludes enhanced promotion.
To get a flavor for how STMP communicates dishonestly with customers as well as investors, see the Consumer Affairs website on stamps.com. I also recommend signing up for the service and trying to cancel, to see if you agree with management's description to investors of cancellation as "easy." It is worth remembering that the nature of the business tends to have many upset customers.
Counter-Intuitive Trends Underlying "Timely" Non-Enhanced Promotion Business Growth beginning in 2Q 2011
Sudden Acceleration in "Core" PC Postage Revenue: The stock has run up on an increase in growth in the "Core" PC Postage business, which - according to the Company - excludes enhanced promotion. Reported growth accelerated significantly in 2Q 2011 to 23% from 14% the quarter before.
Productivity in Enhanced Promotion Inexplicably Dropped: When STMP began to cut back on marketing dollars for Enhanced Promotion ("EP"), one would have expected the lowest ROI dollars to be cut, bringing up the average Y/Y productivity of the remaining spend. This is what happened in each quarter since the change in 2007; however, that trend changed markedly in 2Q 2011.
Non-EP Service Revenue Inexplicably Increased: Core (non-EP) Service revenue can be calculated because essentially all EP revenue is Service (I have confirmed this with management). Core Service Rev/Customer suddenly increased, by coincidence, also in 2Q11, which also bucks a long term trend. We can tell that the inflection point in 2Q was likely not the result of the logical core business drivers. The increase was not caused by lower churn: Paid Customer Cancel Rate actually increased sequentially by 17% in 2Q when sequential Non-EP Service Rev/Cust grew by 6%. It was also not caused by more SMBs signing up, who might pay higher fees: SMBs added shrank Q/Q by 6% in 2Q11 while Service Rev/Cust grew by 6%
The chart below shows the timing and magnitude of the shifts that preceded the "timely" stock price appreciation. Note that EP Marketing Productivity is calculated as EP Marketing Spend / EP Revenue
How Much Growth Could This Have Represented?: If EP productivity had not inexplicably changed, EP would have accounted for significantly more revenue. If one were to run-rate the Q1 level and accounting for seasonality, the "missing" revenue would have represented 25% of the reported growth in the "Core" business in the 4Q11 and 16% and 17% of the growth in 2Q and 3Q 2011. While the Core business is no doubt growing, the business momentum (and likely the share price on the dates at which insiders sold) is related to the degree of inflection in 2Q, 3Q, and 4Q 2011.
Lowered Expectations: On the 4Q 2011 conference call, management guided to significantly lower growth in 2012. Although they do not give explicit guidance, they guided to a 10%-15% increase in customer acquisition spend, which is a deceleration compared to an approximate 17.5% increase in 2010. As the business has ample cash, and if momentum is as strong as previously stated, why would management slow down investment now? It is worth noting that management owns almost no shares now, so near term increases in share price would not benefit management as shareholders (this is one of the reasons management teams are often paid in stock: to create shareholder alignment). Further, higher share prices do - of course - mean that any new option or share grant to management will have higher strike/issue prices.
Massive Insider Liquidation: Reason to be Skeptical of Momentum
STMP has several aspects of its management compensation structure that are unusual and, combined with management behavior, do not suggest long term belief in the Company's performance. The Company's 2010 14A Proxy (2011 14A not yet filed) confirms that management has received $0 in equity-based comp over the last 3 years and that essentially all options ever granted vested during Q2 2011 (page 22). No members of management currently own significant stock outside of options. The CEO and CFO/Co-President owned 485,040 and 147,164 options respectively at 12/31/2010 with strikes from $7.08-$13.40. And you'll note pasted below from the Company's 2010 14A Proxy that the final meaningful chunk of options vested during 2Q 2011.
In November 2011, both the CEO and CFO liquidated their holdings. The CEO exercised and sold 100% of his options though 7 transactions from 11/1-11/9, when the share price ranged from $31.00-$26.90 (below the price at time of writing) and currently holds just 4,800 shares of stock. The CFO exercised and sold >99% of his options over the same period through 3 transactions and currently holds 1,475 shares. This netted the CEO and CFO roughly $10 million and $3 million respectively and left them with effectively no shareholder alignment. Other members of management have been selling as well. A link to the form 4's for disclosure of insider selling.
The table below compares STMP's CEO compensation structure with a set of similarly sized peers and helps illustrate the unusual fact that management currently holds very little equity interest in the company.
The largest STMP shareholder is Lloyd Miller III, a Director, who has an exceptional track record of selling at the top as well. In 2006, the last time the stock was above $15.00 for a sustained period, Miller had a period of concentrated selling which was followed immediately by a drop from $38.81 to <$15.00; a >54% decline in just 6 months. In January 2012, Miller began his only other period of concentrated selling. He sold 525,045 shares for over $16 million (roughly 4% of the Company's market cap) from 2/7/12-2/12/12. On February 24, he further filed to sell 750,000 shares ($19.7 million worth) according to a "pre-arranged schedule." This represents a sale of roughly 75% of the holdings of the largest shareholder and best-trading insider (and roughly 5% of the market cap). The chart below shows Miller's buys and sells over the last 10 years; the takeaway is likely obvious (i.e., the man has an uncanny ability to sell before the stock price moves sharply lower).
With a 10%-15% increase in customer acquisition spend and customer acquisition costs essentially flat over the last 5 years, management is projecting marked deceleration in growth. Because 82% of the revenue is Service, directly linked to customer count, at the mid-point, this equates to guidance of 14.5% revenue growth in 2012 (assuming the non-Services component grows at 23%) down from 20+% the last 3 quarters. As Service is ~100% gross margin, the mix change will also lead to margin compression. The Company is adding to "R&D" so bottom line growth is questionable as well. A business with declining gross margins, decelerating growth, and nearly half of the "core" customer base cancelling annually does not deserve a premium multiple. At an S&P multiple of trailing EPS of 15.5x, the stock has roughly 30% downside from the current levels. Note that the reported 2011 EPS of $1.73 per share includes $0.56 from the reversal of a deferred tax asset allowance, and thus Adj. LTM EPS is 33% lower than reported. However, the combination of: (i) an unusual lack of management alignment with shareholders, (ii) alarming level of recent insider selling and (III) and counter intuitive and questionable financial trends (which historically tends to increase fraud risk, as any business school professor would tell you), I believe the business should be valued at a significant discount. My price target for STMP is $10, 8.5x LTM P/E, reflective of the significant risks and capped upside in the business at this point, and the >$4/share of cash the business has on its balance sheet.
Other Relevant Data Points:
- Audit fees are strikingly/unusually low: Page 11 of the 14A for 2010 (2011 not filed yet) shows that the Company has paid $362,000 and $352,000 to Ernst & Young over 2010 and 2009 respectively. These amounts are far below what comparable companies pay and therefore call into question the degree to which components such as the segment reporting described above have been thoroughly scrubbed by their (reputable and expensive) audit firm. Similarly sized firms Overstock.com (OSTK), GSI Technology (GSIT), and eHealth (EHTH), for example, each averaged $1.3 million, $1.3 million, and $1.8 million annually over the last two years.
- STMP, despite having 384,900 customers, has only ~500 Facebook likes…
- Usage trends (even if true) are less rosy than they might seem. Despite the increases in postage printed in 2011 (50% up Y/Y and 52% Y/Y in the fourth quarter), monthly churn was actually flat Y/Y in the fourth quarter and down only slightly Y/Y. Store revenue (15% of revs in 2011) was up on year and 4Q only 15% and 19%, so conversion of postage printed to Store dollars actually fell markedly.
- Despite its growth the Company barely has any job postings on LNKD or other job boards.
Potential Catalyzing Events to the Downside:
- Sharp deceleration in revenue growth
- Gross margin compression from shift away from Services
- US regulation of negative option marketing for consumer protection reasons (bills have already been proposed)
- Additional insider selling from Lloyd Miller (CEO & CFO do not have much left to sell!)
The fundamental functionality of the STMP product is actually not bad, and - while there may well be some "enhanced promotion" of numbers going on here - the Company is unlikely to go bankrupt in the near term. Key risks to the short thesis are:
- Post Office Closings: If post office closings do come to pass, STMP may benefit, but likely much less than might be suspected because - as noted above - increased usage of STMP does not correlate directly to revenue.
- Reduced Churn: If the business can prevent or slow down customer cancellations, it would meaningfully help earnings.
- Good Quarter: The Company began its "timely" growth spurt three quarters ago, implying one more quarter before STMP has to comp over this growth.
While a dividend seems unlikely (as it's being considered a growth stock), the company has returned cash to shareholders before and with the insider selling taking place, the Company could authorize a buyback which might help the stock.
Additional disclosure: I have no positions in OSTK, EHTH, GSIT or FLWS. I do not plan to initiate any positions within the next 72 hours.