Jeffrey Walkenhorst's  Instablog

The Saturday 7/04/09 Barron’s cover story, “Shorts Story” by Gene Epstein, highlighted five short ideas from Short Alert, a North Carolina-based research firm with respectable track record on the short side. Barron’s even took a victory lap on Monday 7/06/09, “Barron's Short Picks All Fall Down”, as the picks were down in “midday trading” while the overall market moved higher. In the cover story, Mr. Epstein wrote “that the firm … produced annual returns averaging 18.3% from 1999 through 2008.” The article also included commentary from a New York University professor about earnings manipulation and how ‘short sellers can make a positive contribution by trading against these subterfuges.’

We agree that uncovering companies using accounting shenanigans makes for great short candidates, as does finding firms with broken business models, unsustainably high leverage, and/or negative secular trends. However, we think at least one of Short Alert’s five short calls is off the mark: j2 Global Communications (JCOM).



As background, j2 Global was founded in 1995 and provides fax, voicemail, email and call handling services to individuals and businesses worldwide. We’re long the stock (full disclosure) and believe the company is the exact opposite of each major short rationale noted above, with the possible exception of negative secular trends (the major knock on the stock). Yet, in this regard, the sky isn’t falling anytime soon.

j2 Global’s core, cash-cow, subscription-based eFax business keeps adding corporate customers while the company’s voice services business continues to scale. In addition, the company’s financial results, metrics, and position are strong:

• In 2008, the company generated revenue of $242 million in 2008 (+9% Y/Y) with gross and operating margins of 81% and 41% (GAAP), respectively, earnings per share of $1.58 (GAAP), and free cash flow of $91 million (38% of revenue).

• As of 3/30/09, the company had no debt and cash/investments of $179 million (17% of market capitalization), and consistently generates astoundingly high return metrics, including a return on net operating assets in excess of 60%. Few companies are capable of this feat, period. Year after year, j2’s management team runs the business to maximize margins, free cash flow, and returns on invested capital.

• Finally, among category killer companies such as Cisco Systems (CSCO), Digital River (DRIV), eBay (EBAY), Qualcomm (QCOM), and Salesforce.com (CRM), j2 Global slightly edges Qualcomm for the highest profit per employee (measured by GAAP EBIT) and has the highest return on equity of the group (please see below table - click to enlarge). As of 7/27/09, JCOM offered the highest FCF yield per share. j2 Global’s high profit per employee illustrates the quality of the company’s business model and extremely cost conscious management.

For those interested, we include a detailed analysis of the short thesis and j2 Global's numerous competitive advantages on our blog - link here.

Shares of j2 Global could certainly decline if the economy weakens further and/or the broader market again tumbles. Yet, aside from these scenarios, the short thesis appears fickle, particularly in the face of a high quality business model with numerous competitive advantages. Further, although the risk of technological change cannot be ignored, j2 Global should continue to generate significant excess cash that management can use to both further grow the business and return to shareholders through additional share buybacks. As the market leader with a large cash balance, j2 is well-placed to take advantage of incremental industry consolidation during the down economy. Finally, potential near-term positive catalysts include: (1) continued improvement in usage trends for credit-sensitive customers, (2) incremental M&A activity, and (3) renewed share buyback program (early 2010 seems likely as cash accumulates on the balance sheet, barring a major acquisition, which seems unlikely). The company reports June quarter results Wednesday 8/05/09.

Disclosure: long JCOM, EBAY.