J2 Global Communications (JCOM) operates in Internet Software & Services industry and is a small cap stock. I think this stock highly undervalued by up to 64% or even more.
Discounted Free Cash Flow Valuation
In this article I will run you through my DCF model on JCOM. In particular I will be using free cash flow to the firm FCFF model to valuate the stock.
Let's start with the top line. JCOM recorded $330M revenue in 2011 which represented 29% growth from 2010. I don't see this growth rate sustainable for the near future and I predict 7.12% growth in 2012, 5.47% in 2013, and 3-5% for the next 4 years.
Coming down to the cost side I predict 42% EBIT margin for the 5 year period projected. Interest expense should stay low because of little long term debt. I forecast taxes to be 24% on average for the 5 year period.
Then I subtract increases in working capital and capital expenditures. I model working capital to increase 7.5% of the revenue increase per annum. Capital expenditures should be relatively low at 1% of the total revenue.
This model uses WACC to discount FCFF backwards to find out the present value. Beta of this stock is 0.92. I project the WACC to be 8.86%. However, I feel in reality WACC could be higher on average in the long term so I will do further calculations with 10% WACC.
I get the value of the firm by discounting the projected FCFF by WACC and adding the terminal value at the end of the 5 year period by calculating a perpetuity with growth of 2.5% and 10% WACC.
I get the value of equity by subtracting the market value of debt and adding back current cash and marketable securities.
Equity value per share is $40.92, which means the stock is 64% undervalued.
JCOM is also undervalued in terms of P/E (10.52) compared to industry (19.07). It's biggest direct competitor Open Text Corp. (OTEX) is almost 3.5 times bigger in terms of revenue and has P/E ratio of 20.29.
P/S ratio for JCOM (3.33) is higher than the industry average (2.12), but that does not necessarily mean that JCOM is overvalued in these terms. It has much higher operating margin (43.82%) than the industry (0.64%) and OTEX (14.32%).
EasyLink Services International Corporation (ESIC) is a smaller competitor, which made $186M revenue in 2011, compared to $343M of JCOM. ESIC has smaller P/E ratio of (8.63) compared to JCOM (10.52), but it has much lower operating margin (16.29%) compared to JCOM (43.82%).
JCOM has 600 employees with is exactly in par with the industry average. In comparison, OTEX has 4,600 and ESIC - 541 employees.
Mean analyst target price for JCOM is $32.17, which shows almost 29% upside potential.
More positive facts
- I projected the long term growth of the company quite conservatively. Some brokers are forecasting up to 12.5% long term growth which of course would mean ever more upside for the stock.
- The company also has 3.4% dividend yield.
- JCOM net profit margin is consistently high at approximately 33%.
- Low capital expenditure ratio (9.72% in 2011).
- Consistent and significant cash flow growth during the last 10 years period.
- Competition in the industry is high and continues to intensify. This may cause threat to revenue and EBIT margin forecasts.
- JCOM is dependent on a small number of telecommunication service providers. This also may threaten the long term profitability.
Financial data taken from Yahoo Finance.
Disclosure: I am long JCOM.