Current Price [10/1/13]: $33.17
Target Price: $16.75
Web.com (WWWW) (or 4W) has enjoyed one of the biggest years of any stock in the market, returning 124% YTD. With 3 consecutive quarters of mid-single digit average-revenue-per-user (ARPU) growth, investors jumped in the bandwagon of this ARPU growth story. As a result, valuation ran up close to 5x TTM revenues. Management's low-teens revenue growth target gave the street ammo to support this valuation. My analysis will demonstrate this is a web of illusions.
YTD Stock Price Performance vs. TEV/Revenue (Source: Capital IQ)
4W's biggest success has been selling the upsell/cross-sell story to the street, while misguiding investors with aggressive non-GAAP reporting. This is the biggest issue I have against this company. 4W has been running a promotion campaign rooted in this non-GAAP prowess, and has been cheered by the street for doing so. 4W utilizes a "throwing-the-kitchen-sink" approach to pamper non-GAAP numbers:
GAAP net loss to non-GAAP net income reconciliation (Source: 2Q13 10-Q)
The real story shows 4W has serious problems. 4W lost money in 6 consecutive quarters and 13 out of the last 16. Over the last 10 years, 4W was profitable in 5 years with cumulative net income of $14.3M, compared to a cumulative loss of $238.7M in the 5 money-losing years. Acquisitions created a balance sheet full of goodwill (49% of total assets) and negative tangible book value equal to -$19.50 per share.
How did 4W get here? The main culprit is David Brown, Chairman and CEO. He assumed the CEO role since 1999 and has taken 4W to a path of M&A driven top-line growth. In the process, he and his team have shown serial aversion to profitability and an uncanny ability to promote a story that is "too good to be true."
In this piece, I will debunk the 3 myths pushing this stock to historical highs:
- Non-GAAP reporting (and an accounting irregularity)
- Balance Sheet de-levering
- Growth opportunity
My analysis indicates the stock is at least 50% overvalued due to the debunking of the above arguments. The short thesis is further supported by the following catalysts:
- Widening of operating loss
- Further increased insider selling
- General Atlantic divesting remaining stake
- Failure to acquire .web rights
I discussed this idea with regular Seeking Alpha contributor Igor Novgorodtsev and he also expressed interest in publishing about 4W independently. This report represents my own analysis and opinion on the business.
4W offers domain name, website design, hosting, and online marketing services to SMBs in North America, South America, and the UK. 4W has 3M subscribers, 2.7M of which were acquired with the acquisitions of Register.com and Network Solutions (NS). 4W derives 97% of total revenue from subscription services, most of which are month-to-month and cancellable without penalty at any time.
The model has domain name registration as the initial service. Once a customer buys a domain name, 4W tries to sell additional services. The flagship product is eWorks! XL, a Do-It-For-You subscription package sold for $115 a month that includes website design/hosting, marketing, and tracking services.
With $458M TTM revenue, 4W has roughly a 12% $ market share. However, brand awareness is limited at best. 4W still operates acquired brands as stand-alone brands with similar offerings and different pricing. References to Web.com are buried in minuscule footnotes in the NS and Register.com websites.
Furthermore, marketing campaigns to build awareness are limited to meaningless sponsorship of the PGA's minor league tour and one professional player. Contrast this with GoDaddy.com's (GD) nationally televised campaigns, including slots on Super Bowl airtime. Also, a simple comparison of search trends over the last 12 months shows 4W's search activity for all brands is insignificant to that of GD.
Lack of awareness is a clear problem for a so called internet business offering commodity products. Competition counts companies such as Amazon (NASDAQ:AMZN), Yahoo (YHOO), Google (NASDAQ:GOOG), and Intuit (NASDAQ:INTU). These big players have been offering comparable solutions for years. Bulls argue 4W is the only company exclusively targeting SMBs. That is a fallacy. A simple search of "website services for small businesses" returns links to YHOO and INTU, and examination of these sites provides evidence they cater primarily to SMBs as well.
Moreover, GD generated 50% of revenue (~$650M in 2012) from SMBs and is targeting 70% of $5B target revenue by 20181 (revenue CAGR of 31%). GD uses the value of its strong brand to increase its customer base. Another competitor is Germany's 1&1 Internet, who claims 12.5M paying customers and has a large international presence. These are a huge contrast to 4W's ~3M subscribers and $408M 2012 GAAP revenue, mostly derived from SMBs.
Myth 1: Non-GAAP reporting (and an accounting irregularity)
The strong stock performance has been rooted by non-GAAP results. However, 4W has been using aggressive reporting gimmicks to misguide investors. I will point out 2. The first stems from how 4W uses purchase accounting related to the Fair Value Adjustment to Deferred Revenue (FVADR). 4W started recording the adjustment after acquiring Register.com and NS, gaining 2.7M registry customers.
4W adds FVADR at 100% margin to GAAP revenue (first noted here) when reconciling GAAP vs. non-GAAP results. This practice is aggressive considering there is a cost to fulfill the obligations to customers. Furthermore, the practice created a discrepancy between balance sheet and cash flow from operations. I will use FY12 for illustration. According to the balance sheet, the increase in current deferred revenue was $49M.
However, the cash flow statement shows a $92M increase in deferred revenue in its cash flow from operations.
FVADR inflates the cash flow statement to the tune of $49M (see 10-K excerpt below) and contributes to 53% of the $92M total deferred revenue boost to CFO in FY12.
I asked the company to explain me the discrepancy. Turns out to get to the full $92M change, I need to add the change in non-current deferred revenue, equal to $43M. My bad for thinking CFO should only include current items! In all seriousness, the response from the accounting team mentions CFO is not just current items. Non-current items are included if they fall within the definition of CFO under GAAP.
This is an accounting irregularity. According to US GAAP, non-current deferred revenue is a liability related to revenue producing activities for which revenue has not yet been recognized, and is not expected to be recognized in the next 12 months. Over 12 months is not working capital. Only the cash flow from investing and financing activities show changes in non-current accounts. I reviewed US GAAP rules and my accounting books at hand but couldn't find any instance of a non-current item included in CFO.
Therefore, the $43M boost from non-current deferred revenue is not really part of working capital and should not be in CFO. To my surprise, Ernst & Young (the auditor) allowed this. Unfortunately, my call to their offices was received with "You cannot talk to us directly. You need to go through the company."
Even removing this irregularity from the equation, adding this adjustment is unwarranted for 3 reasons:
- Cash was collected prior to the acquisitions. I confirmed with 4W most acquired customers were domain customers with contract durations from 2 to 10 years. Any person acquiring a domain pays the cash up front. This is cash collected by NS or Register.com prior to the acquisitions and should not influence cash flow now.
- Attrition warrants no adjustment because revenue may not be recurring. With >12% annual churn (discussed later), there is no reasonable basis to assume the obligation will continue. According to 4W, churn assumptions are included to estimate fair value of deferred revenue. There is a reason the acquired deferred revenue is recorded at a 51% discount to book value!
- The adjustment will eventually fade out as registry contracts associated with the acquisitions reach expiration. During 1H13, the FVADR was $23.5M versus $50.6M during 1H12. According to 4W, the adjustment will be minimal starting next year. Since it was never meant to last (unless acquisitions continued perpetually), the working capital tailwind will go away. True cash flow is not only lower and misrepresented but will grow at a much lower pace.
The second gimmick is the addition of stock-based compensation (SBC) to non-GAAP as many other money losing companies do, such as Salesforce (NYSE:CRM). A company that grants restricted stock and options should consider these as cost of doing business. Adding SBC back as a cash item for analysts to incorporate in their valuation models understates the impact of dilution from future SBC awards.
Myth 2: Balance Sheet de-levering
Convertible debt was issued in August to repay $208M of the first lien term loan and $43M of revolving credit drawn. After this issuance, total balance sheet debt declined to $609M. Management wants investors to believe the balance sheet improved. The convertible was issued at 1% coupon, decreasing the average interest cost to 3.2%. First lien leverage ratio declined from 4.29x to 2.64x using 4W's non-GAAP EBITDA metric. The new ratio puts them significantly below the 5.25x limit in debt covenants.
The first thing to note is non-GAAP EBITDA. FVADR, discussed in the prior section, overstates real cash earnings, thus GAAP metrics should be used. TTM GAAP FCF is $81M, a fraction of $152M non-GAAP EBITDA reported by 4W in the debt issuance presentation. The second thing is the real impact on leverage. Overall leverage decreased $59M on paper. Since the convertible was issued at a discount, the $67M unamortized discount will flow as part of the interest expense, reducing net income.
The bull point on this topic relates to the conversion opportunity because conversion would decrease leverage significantly. The conversion price was set at $35. However, conversion is not really at $35 per share. For any time prior to 5/15/18, conversion will occur only if the stock price on 20 of 30 consecutive trading days within a quarter exceeds 130% of the $35 conversion price. That is, conversion in the next 4.5 years could only occur if the stock exceeds $45.50, 37.2% above the current price.
In summary, with no conversion expected and no accounting tricks, leverage will not really decline as the short thesis unfolds. Current leverage stands at 7.3x TTM GAAP EBITDA.
Myth 3: Growth opportunity
The 2 levers that move revenue for 4W are net subscriber additions and ARPU growth. With both, 4W expects revenue growth rates in the low teens. I will now explain how 4W will miss its target.
4W has demonstrated inability to grow subscribers organically. Prior to the Register.com acquisition in 2010, 4W had 275,000 subscribers. This represents a depressing 2,000 subscriber gain from 2007 when Web.com was acquired to reach 273,000 subscribers. Current subscribers of 3.06M are only up 2.1% since 2011, when 4W acquired NS. Only 47,109 net subscribers were added YTD. At that run rate, subscribers will grow ~3% this year.
Subscribers Growth: 1Q12-4Q13E (Source: Company Filings)
Churn will prevent organic subscriber growth. ICANN data through May'13 shows ~178k transferred out of .com and .net registries in 2013, equivalent to 5.9% of the subscriber base at the end of 2012. This traditional way of measuring turnover results in 14.7% annualized churn without counting transfers out or cancellations of any other domains 4W operates.
4W measures churn by adding gross subscribers to beginning of period subscribers in the denominator. This method yields 1% monthly churn. Interestingly, 4W justifies this method because of cancellations from these same subs within a quarter, signaling some customers have a very short tenure. In my view, this method understates the real churn of the business.
To achieve a higher growth rate, 4W would need to acquire additional subscribers. The table below lists 4W's most significant transactions. With 2.96M subscribers acquired in these deals, all growth was achieved via acquisitions. In addition, the revenue multiple paid increased with every transaction and the estimated 3.4x paid for NS signals acquisitions won't get cheaper.
ARPU grew Y/Y at 7.1%, 5.6%, and 5.6% in 4Q12, 1Q13, and 2Q13, respectively. Current ARPU of $14.1 is still below pre-acquisition of $16.7, implying an 18% growth opportunity to go back to the starting point. The 2013 run-rate implies growth in the 5-6% neighborhood. At this pace, it will take about 3 years to realize the full opportunity.
ARPU and ARPU Growth: Last 8 Quarters (Source: Company Filings)
There are 2 reasons that will limit ARPU growth to the mid-single digits at best. The first is pricing. 4W is already incurring in aggressive discounting to stay competitive. Pricing between own brands is different and with different discounts across Web.com, NS, and Register.com to entice customers. Despite discounting, prices are still above those of competitors such as GD and 1on1 Internet on website design, online marketing, and e-commerce services.
The second reason is the churn rate in value added services. 4W does not disclose this rate. Deutsche Bank estimated the churn in these services in excess of 5% monthly. To put things in perspective, DB was an underwriter on the recent convertible offering and even purchased from the additional allotment available to underwriters. A 5% monthly churn is equivalent to a 79% compounded annual rate (60% simple rate if one wants to be generous). This estimate is reasonable considering subs are cancellable for no cost at any time, there are many cheaper alternatives, or the need may fade in a couple of months.
In summary, aggressive discounting to stay competitive and the lack of switching costs in value-add services evidenced by high churn will limit ARPU growth.
Subscribers + ARPU
Given 4W's current leverage and limited internal resources, growth by acquisition is unfeasible without massively diluting shareholders. Growth is limited to ~3% annual subscriber growth and 5-6% ARPU growth for the next 1-2 years. The combination of both comes up short to the low-teens target. A realistic outcome is a revenue growth rate in the mid-to-high single digits for the next 1-2 years, later normalizing to the industry average of 6.2%, estimated through 2018 by IBIS World.
Catalyst 1: Widening of losses
A quick evaluation of the customer acquisition economics suggests making a profit would be a steep mountain to climb. Year to date, 4W brought in 47,101 net customers and spent $68.5M in sales and marketing, suggesting each new customer cost $1,454. Notwithstanding this is big improvement from the $2,281 cost per net addition during 2012, 4W has limited improvements to make from consolidating the customer base post-acquisition of NS.
Comparing this cost to the annual ARPU run rate of $169 implied by $14.1 2Q'13 ARPU, one can obtain a per new customer break-even of 8.6 years. And this is only on marketing! While this estimate is not exact science since part of this marketing can be allocated to renewals and upgrades, it suggests high ROI is not the name of the game.
The other misconception about the business is that of operating leverage. To support the customer base, a registry operator needs to continually invest in storage, bandwidth, and support capabilities. Most of the cost savings from the NS acquisition (4W estimated $30M of annual savings) have been realized during 2013. Going forward, there is not much room for improvement in this regard.
Infrastructure, marketing, and general expenses will largely offset any near-term gross profit expansion. In particular, 4W underestimates the marketing cost of expanding their feet on the street program to cities where they currently don't have infrastructure. A similar sales model contributes to perpetual losses at companies such as Angie's List (NASDAQ:ANGI).
Losses are expected to keep piling because gross profit will barely breakeven with operating expenses. With limited or no operating profitability, 4W will not cover the above $20M in annual interest expenses on the debt outstanding. If accumulated pre-tax losses continue, 4W would not benefit from its NOLs.
Catalyst 2: Further increased insider selling
Insiders picked up stock sales as 4W's price reached historical highs. YTD the stock has returned 124%, significantly outperforming the market. Insider sales have increased each quarter reaching a peak in 3Q with heavy selling from the CEO, a signal that insiders believe the stock is overvalued.
Insiders have sold over 600,000 shares year-to-date, roughly 1.3% of the total share count. With vesting on restricted stock and execution of options, insider selling could continue throughout 2013.
Catalyst 3: General Atlantic divesting remaining stake
General Atlantic (GA)2 invested in NS in 2007 and became a 4W investor upon selling NS in October 2011 for $405M cash and 18M shares ($283M monetized from share sales to date). GA invested $800M to acquire NS but has so far monetized $688M. GA's remaining stake at the current price is worth $85M taking the total value to $772M. This suggests a negative IRR on this deal. Anthony Levy, GA's head of Internet and Technology, sits on 4W's board of directors.
GA has been gradually selling its stake since 2011 (13F filings) as its investment cycle is in year 6. In May, GA sold 2M shares, reducing its ownership stake to 3.8M shares. In September, GA reduced its stake by 1.25M shares in a 144 deal at $30 per share (below market that day). The remaining stake is 5%. The current valuation should incentive GA to divest the entire stake this year to minimize the loss on this deal. Levy would step down from the board, leaving a void in expertise and alignment of interests.
Catalyst 4: Failure to acquire .web rights
4W filed an application with ICANN to become the exclusive registry of the .web domain. The firm and analysts believe 4W has a strong case through the Legal Rights Objection because it owns the Web.com trademark. Obtaining the rights would be a significant opportunity to expand the customer base. This has partly contributed to the valuation run-up because it supports the growth story. ICANN is expected to award uncontested domains by year end but contested domains are still up in the air.
There are currently 8 applicants for .web including GOOG, German internet giant 1&1, and incumbent registry operator Afilias. Due to the number of applicants, the domain will be awarded via auction. ICANN uses an ascending floor auction, meaning that the last one standing wins the rights. In this type of battle, the biggest wallet tends to win. 4W's coins are overmatched by GOOG's cash vaults. GOOG has potential synergies (Business Solutions, Chrome) from gaining the rights. The 2 most likely outcomes are: a larger firm wins or 4W significantly overpays.
Overvaluation = Icing on the cake
Based on trailing TEV/S, valuation is in the mid-4x range, evidence of clear overvaluation given the expected sub-10% growth rates going forward. Forward multiples are evidence of no fundamental support, as the multiple has increased at the same pace as share price. I utilized 2 methodologies to value 4W: discounted cash flows and transaction multiples. I also included an upside case estimate.
It doesn't matter how generous the assumptions are, 4W is worth dramatically less when using a DCF model because of the egregious debt load and poor cash flow composition. My estimates of FCF show 4W will generate $548M of "real" cumulative FCF through 2019. This means, debt will be finally paid off some time in 2020, 7 years from now.
The following assumptions were used in my Base scenario:
- Revenue growth:
- Net subscriber growth of 3% until 2016
- Revenue/subscriber CAGR of 4% until 2016
- 6% total revenue growth during 2017-23
- Gross margin of 63%, above 3-year average
- SG&A equal to 41% of revenue, similar to 3-year average
- R&D equal to 7% of revenue, below 3-year average
- Intangible amortization schedule shown on the 2Q13 10-Q (p. 9)
- No taxes in the next 10 years due to accumulated NOLs
- No acquisitions
- Discount rate of 10% and terminal growth rate of 3%
These assumptions yield intrinsic value per share of $7.94. The low quality of cash flow and the poor acquisition judgment is shown by the significant share of FCF accounted by intangible amortization.
Let's fantasize a deal for 4W could be possible. To any acquirer, the real value of the transaction would be in acquiring the subscriber base. Furthermore, let's assume a potential buyer would pay $285 per subscriber as 4W did when purchasing NS. Applying the multiple to the customer base of 3.1M would yield enterprise value of $871M. Subtracting net debt of $592M would yield equity value of $279M, equivalent to $6 per share, providing 83% upside to a short position at the current price.
Using a revenue multiple as alternative, the 3.4x paid for NS is at the highest end of the transaction range and is still 1 turn short of the current valuation. On TTM revenue of $453M, enterprise value and equity value would be $1.5B and $949M, respectively. In this case, the value per share would be $19.50, providing 41% upside to a short position at the current price.
Upside Case (Worst for the short)
Even at the extreme of 4.5x revenue applied to my estimate FY14 $498M GAAP revenue, value per share would be equal to $33.89, 2.2% above the current price. This valuation is unlikely because no rational buyer will pay 4x revenue or more for an over-levered company with sub-10% growth.
Using the average high valuation under the 2 transaction methods, the DCF estimate, and the upside case estimate, would yield intrinsic value per share of $16.75. Upside potential is 50%.
The primary risks to the short thesis are outlined below:
- Takeover candidate: With 3M subscribers, 4W could be attractive for players such as INTU looking to implement a similar growth strategy.
- Mitigant: Antitakeover clauses (staggered board, discretionary ability to issue blank check preferred stock, and prohibited stockholder action by written consent, among other) would make an acquisition difficult. The +3x revenue multiple to acquire customers and 4W's high leverage would rule out large strategic suitors with enough resources to gain share organically. A private equity exit is not likely after GA's unprofitable experience and the higher multiple to take private.
- Revenue growth: 4W achieves its target of low-teens revenue growth during the next 5 years.
- Mitigant: See Myth 3 rebuttal. The industry consists of 731 direct industry participants (IBIS World estimate) and thousands of freelancers vying for the same pie. Pricing power is limited and switching costs are non-existent, resulting in low attach rates for value added services. Gaining subscribers comes at a high customer acquisition cost.
- Profitability improvement: 4W posted a $1.9M operating profit after 6 consecutive quarters of operating losses3. 4W can spread fixed costs over a larger customer base to improve margin.
- Mitigant: See Catalyst 1 explanation. See also 2012 10-K excerpt below (p. 31) regarding variable expenses. Heavy marketing spend is needed to maintain/gain customers. OPEX will continue to offset gross profit.
- Capital allocation: Management took advantage of lax debt restrictions to issue convertible debt at a 1% interest rate, reducing interest cost by 120 bps. Refinancing opportunities and positive GAAP FCF will facilitate debt repayment.
- Mitigant: While the street praises the debt issuance, leverage has not really decreased. Convertibility in the next 4.5 years is subject to share price exceeding $45.50, an unlikely occurrence due to the above analysis. Debt to FCF is still at 10x after the issue, implying the company will be paying off debt over the next several years.
There is nothing more to add regarding this business. 4W is an overlevered operator running a poor business model better suited to accumulate net losses. Accounting gimmicks and the street's myopic view have extended the valuation run-up longer than is warranted. The shares are worth $16.75 or less, providing at least 50% upside. A short position can be initiated at the current price.
2 GA is a growth equity investment partnership with $18B in AUM.
3 4W incurred operating losses in 13 of the last 15 quarters.
Disclosure: I am short WWWW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.