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Connor Haley
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For more information on me, view my blog at: http://thevariantview.com/about/ Founder of thevariantview.com
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CollegeStockPicks
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The Variant View
  • Add Some Love to Your Portfolio 0 comments
    Jul 27, 2010 10:13 PM | about stocks: LOV, IACI
    Thesis

    With downside protection from a recent buyout offer, an inflection point in number of subscribers, a strong likelihood for a higher buyout bid, and a ridiculously cheap valuation, Spark Networks (LOV) is my favorite current holding and is an active recommendation in The College Edge on www.CollegeStockPicks.com

    Shares currently trade at $3.47, but I value them closer to $6. Even my most conservative estimate (which I share below) values them $4.21, or 20% undervalued.

    For those unfamiliar with this small-cap (70 MM), they operate several different niche online dating sites, most notably JDate.com.

    Online dating (especially niche dating sites) is a great business:

     Customers supply the inventory (pictures of themselves)
     The company has negative working capital benefit (subscribers pay monthly subscription upfront)
     Online subscription dating industry averages 20% operating margins (Match(part of IACI), Meetic, eHarmony)
     Subscription based dating is an attractive oligopoly: Top 5 control 80% of the market, generate $1.2bn in revenue with industry profits of $240mn+ annually.
     Attractive value proposition--- avg sub pays $27.50 for JDate and $15 for other affinity
     100mm singles in US (short cycle, high churn, very profitable business)

    What makes JDate particularly attractive (taken from investor presentation)

     80% come to the site organically (word of mouth referrals and high winback rates)
     Spends only 33% of the industry avg in marketing (6-7% vs. 20%+)
     13 years in business.... it dominates the Jewish dating market in major metropolitan cities in US.
     1/3 of members make over $100K, 2/3 make over $55K
     45% of graduate degrees
     94% of subscribers have college degrees
     55% women 45% men
     90-93% contribution margins = revenue less marketing

    Two recent events highlight JDate’s value. First, Great Hill Partners (GHP), a private equity firm which owns 44% of the shares outstanding, recently offered to take the company private at $3.10/share, which represented a small premium to the existing price. Several big stakeholders, notably Osmium Partners, came out and urged the special committee to vote against the takeover, as they valued the company at $6-7 per share. The bid was rejected unanimously from the special committee, and they hired Piper Jaffray to “pursue other strategic alternatives.” In essence, I think that there is a good chance that we will see a higher offer--- either from Great Hill Partners or even one of the bigger online dating services such as Match.com, which would then dominate the niche dating area. Online dating is highly scalable, and at its current valuation, Spark Networks would be a steal for one of the bigger online dating players.

    Secondly, their most recent quarter really shows the true turnaround in the company. JDate.com is where the majority of their value comes from and recently they have been “running off” their general dating sites, such as americansingles.com because it’s simply too competitive a space. Their real advantage is in the niche dating sites such as Jdate. The run-off is nearly complete, and despite losing over 10,000 subscribers in the general market segment as part of this run-off, they actually had a net gain in subscribers with strong growth from JDate and their other affinity networks in Q1 2010.

    The numbers compare Q1 2010 with Q1 2009:

    Average Paying Subscribers
           
    Jewish Networks             93,235   84,644
    Other Affinity Networks   68,124   64,393
    General Market Networks      7,813     17,810
    Offline & Other Businesses    661       1,157
            
    Total                            169,833   168,004

    When valuing Spark Networks, the three key variables are obviously subscriber growth, average revenue/user (ARPU), and operating margins. Since I have already indicated why I think they have reached a bottom, let me give you my reasoning behind my growth assumptions.

    I took a CAGR in subscriber numbers for JDate from 2004-2009. I can't post the chart here, but it is 3.54%. While the other affinity segments are also important, JDate provides the most value. In addition, their growth tends to run very close with JDate.

    I believe that we will see higher than 3.5% growth going forward for two reasons. First, the past few years have been particularly tough for the financial sector (NYC), which has hurt their prospective Jewish member base harder than most. Secondly, with the run-off of their general market networks, the company can now solely focus on managing their affinity networks, which should lead to improved results.

    Industry estimates expect online dating to increase about 15%/annum for the next five years. However, my assumptions are much more conservative than that. In my most conservative scenario, I go ahead and model out 3.5% subscriber growth for the ten year model. Again, I think this is a very conservative assumption, but my research has led me to believe that niche dating sites will experience steadier and slower growth than the big players (Match.com and eHarmony).

    A good sanity check for these subscriber assumptions can be seen by looking at what percentage of Jewish singles you expect to be JDate subscribers. There are 1.8 million Jewish singles in the U.S. Currently there are over 86,000 subscribers, which represents 4.7% of the entire U.S. Jewish singles market. If we assume that 55% (their current mix) of subscribers in year 10 will be attributed to Jdate, then they will have captured 7% of the market, which seems very reasonable given their current dominance.

    Number of Jewish Singles in U.S. 

    1,800,000
      
    End of Year 10 Users      231,465
    % attributed to Jdate  55%
      
    Jdate users             127,305.72
    Market Penetration  7.07%

    Then the question of ARPU comes into play. This is the most difficult to model because it is tough to say how management will play this card because they could certainly slash ARPU to try and accelerate growth. However, given my ultra-conservative subscriber growth estimates, I feel comfortable leaving ARPU steady at 2009 figures ($290/year). Note that this averages to $24/month, which is still considerably less than Match.com ($30/month), and eHarmony ($60/month). You could potentially take issue with my ARPU stance because their latest quarter ARPU dropped to around $247/year on average, but I think is more of a temporary mix in subscriber preferences. If you do believe ARPU will go down, I think you have to believe in higher subscriber growth, which in the models I have created tend to cancel each other. Therefore, in my model below, I keep ARPU steady at 2009 numbers of $290/year.

     

    This just leaves one more key assumption: operating margins.
    Spark’s operating margins have fluctuated from 17% to 20% over the past few years. With their run-off of their general market segment, they should experience considerable margin improvement since the general market segment experienced much worse ROI due to increased competition. I model operating margins gradually improving from 17% to 20% by the end of the ten year DCF. This would put them right around the industry average. Again, I feel like this is very conservative because 1) JDate is such a dominant brand and 2) they are still building out some of their other affinity networks, and as they start to let some of the less successful ones run-off, it will help tick margins higher.

    Then, with an 11% Discount Rate, net capex of zero, their negative working capital benefit, a 3% terminal rate, and their net cash, my most conservative DCF model still values them at $4.21, which is 21% above the current market price.

    So there you have it. An excellent business that has downside protection ($3.10/share offer from GHP), a strong likelihood for a higher offer, and is 21% undervalued even using my most conservative estimates. I actually believe shares are worth closer to $6, and that the current price represents little downside risk, but huge upside. Check out The College Edge on www.CollegeStockPicks.com for more of my recommendations. 

     Variant View

    The mispricing exists because:

    -Spark's small market cap and low share price keep many insitutions away
    -Without a detailed look at the company, investors have seen declining subscribers, even though this should make the business more profitable
    -Investors have had a tough time isolating Jdate's value, but with the run-off of their general dating sites nearly complete, this should no longer be a problem.

    Disclosure: Connor Haley was Long LOV at the time of writing

    Stocks: LOV, IACI
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