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Following the publication of this article, we intend to continue transacting in JCOM and we may be long, short, or neutral any time after the date of publication. We undertake no obligation to update or supplement this article or disclose changes in our position in JCOM securities. Nothing in the article should be construed as investment advice or an offer to buy or sell any security.
J2 Global, Inc.'s (JCOM) primary business is providing electronic fax services. which as you would expect is a dying business. The company has grown mainly through acquisitions. Indeed, over the last decade they have spent $347M of $715M in FCF on acquisitions. After reviewing the company's investor presentations and reading through their 10-Ks something strange caught my eye.
The company reports monthly churn rates of a little over 3% in FY2009, dropping to about 2.4% in FY2011. This monthly churn equates to a customer staying with company for approximately three years. However, the company discloses in its 10-Ks that it amortizes acquired customer relationships over much longer periods of time.
In the chart below we show the differences in the average customer relationship and the length of time JCOM amortizes acquired customer relationships. We were unable to find monthly churn data prior to FY2009.
It's also worth noting that JCOM discloses two different amortization periods for 2010. In its FY2010 10-K the company says its weighted average amortization period for customer relationships is 6.3 years. A screenshot of the relative portion of the 2010 10-K is below.
In the FY2011 10-K the company now says in amortized customer relationships over 6.7 years. A screenshot of the relevant section of the 10-K is shown below.
Just how significant are changes to the amortization period for customer relationships? Well, lengthening the time over which you amortize something reduces the expenses you recognize each year. As an exercise in comparison we show what JCOM's earnings would look like over the past three years based on an estimate of customer relationship amortization costs if those costs had been amortized over the same period as the company's average customer relationship as implied by its monthly churn numbers.
A chart showing the pro forma additional amortization expenses and pro forma net income and EPS is shown below followed by an in depth explanation of our methodology for estimating additional amortization costs.
We estimated the additional amortization expense associated with the decrease in the weighted average amortization period for customer relationships by estimating the original amortization amount ascribed to customer relationships by dividing the historical cost of acquired customer relationships by the weighted average amortization period disclosed by the company. We then took the difference of that value and the value of the historical cost of customer relationships divided by the average length of customer relationships as implied by the companies average monthly churn rates. We also cross referenced the amortization estimates of our model with the estimates the company disclosed for that year. We found our model likely under estimated the additional amortization costs by about several million dollars each year.
We wonder why the company chooses amortization periods for customer relationships that are almost double the length of its average customer relationship?