Spark Networks, Inc. (NYSEMKT:LOV) is in an inflection point - it is shifting from growing its subscriber base and revenues, on account of profitability, to focusing on its bottom line. While its public image is all about love and faith, behind the scenes, one finds a different story: a nasty proxy fight and skeletons in the coffin in the form of poor corporate governance practices. The story gets even more intriguing, as a high-profile value investor is pitching the shares, while the largest shareholder recently liquidated their entire position.
Spark Networks is the operator of the internet match-making services JDate and ChristianMingle, as well as several other international niche dating websites. Users of those services pay a monthly subscription fee to search for a date and a chance for a relationship, based on common beliefs, interests and preferences. JDate, The Jewish network is the mature segment of the two, encompassing about 90% of the Jewish dating business. It is highly profitable, but not growing. ChristianMingle, the Christian networks segment, is Spark's main growth engine. It is growing rapidly, but bleeding money. The following table, taken from 2013 10-K, tells the story:
As one can see, the Jewish networks are in stagnation, even a small decline. In contrast, the Christian networks' paying subscribers count outpaced JDate subscribers in 2012, and more than doubled since 2011. The segment operating results provides additional insight:
JDate is able to (nearly) maintain its revenue, while expensing only a 10%-13% of it as direct marketing expenses. In contrast, ChristianMingle's marketing expenses exceeded its revenue in each of the last three years (and before that, as well). Clearly, Spark's management was focused on growing the Christian networks' revenues at an impressive CAGR of 60% during the last two years, and was willing to spend the cash to sponsor this growth. Considering the significant unallocated operating expenses, the company is operating at a deep loss. Can ChristianMingle's revenues grow, or even just persist, should this unsustainable level of direct marketing expenses be moderated? Patient investors will find that out during the next few years, but some clues can be found in the filings today.
I have discovered Spark Networks through Whitney Tilson's presentation in the May 2013 Value Investing Congress, which he has made public on his website. The dynamics of the business are indeed compelling. Mr. Tilson has described his search for Netflix-like businesses, which have the following characteristics:
- Low price and high perceived value by customers
- Dominate a niche
- Asset-light, scalable business model
- Nimble, innovative, customer-focused management
- Strategy of taking all profits from current cash-cow business and reinvesting in a much larger, related growth opportunity, making traditional earnings and cash flow-based valuation metrics useless
Spark fits the bill, but comes with a load of problems, which I will describe shortly. Whitney Tilson is not the largest holder of the company's shares, though. He currently own less than 1.5% of the company, which equals to 3.89% of his Kase Capital portfolio, per his 12/31/2013 13F. The largest stockholder is Osmium Partners, LLC, a collection of hedge funds, which is run by the activist investor, John Lewis. Osmium owns collectively 14.1% of the company, having started to acquire shares as early as 2008. Osmium recently turned activist on Spark Networks, engaging with the company in a ugly public proxy fight to win the majority of board seats (4 out of 6) in the upcoming annual stockholders meeting.
Osmium believes that the inherent value of the company's business model is locked due to mismanagement. In its own words (taken from DFAN14A, filed March 10th, 2014):
Osmium has spent considerable time understanding Spark Networks and its competition. The Company operates in the paid online dating industry, which is characterized by at-scale competitors generating significant EBITDA margins with strong organic growth rates. The business model is attractive because subscribers pre-pay for the right to provide content and labor. This leads to a business dynamic where, over time, positive customer experiences drive referrals, win-backs and renewals while strengthening the network effects and reducing the customer acquisition costs. Consequently, industry leaders generate 30% EBITDA margins while smaller competitors generate 20% EBITDA margins."
Whitney Tilson also praises the business model, referring to it as a "winner-takes-most" business, given the very strong network effects.
I agree with both Osmium and Tilson, and will add that the pre-condition for a network effect to be material is that the addressable market of the network has to be segmented and well-defined. If I were a single person looking for a serious relationship, I would want to subscribe to the largest network encompassing my addressable market. The largest and dominant network is bound to get larger and larger, while the smaller ones will either merge with it or disappear. It is my prediction that the competitive landscape of ChristianMingle, consisting of a multitude of dating websites, most of which not having a clearly defined addressable market, will eventually consolidate around a few segmented services. Those segments can be either regional (e.g. a website having the largest network in NYC), based on a sexual preference (e.g. Gays and Lesbians), or formed around a religious belief, as Spark Networks wisely chose early on. So as far as the competition goes, I believe that ChristianMingle has little. OKCupid, Match.com and the other dating websites target the general non-Jewish public, religious Christians included. Only ChristianMingle is focused on targeting those that the religious faith is an important factor to. I take the company's statement of ChristianMingle's addressable market being 30x JDate's with a grain of salt, but it does not really matter much if it is 5x, 10x or 30x.
The strength of pursuing religious beliefs should not be under-estimated. For Jews, it is granted that the vast majority of singles, even the non-religious ones, will prefer or even restrict themselves to a Jewish spouse. The author, who is Jewish himself, can attest that the will to carry on the Jewish legacy is deeply rooted in Jewish tradition. The case is even stronger for males seeking a female spouse. According to Judaism, the religion is inherited from the mother's side, hence the children will be Jewish only if their mother is Jewish (or converted to Judaism). As for Christians, while the general non-religious public may not care, I believe that religious Christians do want to find a spouse who shares their faith. Therefore, for religious Christians, faith is one of the most important parameters in a potential spouse.
JDate is an amazing franchise. The JDate brand name is known to practically every teenage and grown-up Jew in the western hemisphere. I urge readers to do their own brand awareness research. Ask a Jew, young or old, what is JDate, and you will be amazed to find how strong of a brand name it is. For those searching for a serious relationship, there is nothing beyond JDate worth subscribing to. It is a monopoly. If ChristianMingle can be half the success among religious Christians that JDate is among the general Jewish public, stockholders would be the happiest folk. It is worth mentioning here Howard Marks' saying that the best time to buy a franchise is during its formation, not when it has reached its maximum potential. ChristianMingle is at this stage, building its brand and strengthening its moat.
Spark Networks has an abundance of growth opportunities. The real question an investor faces is whether this growth can be profitable. The first and obvious growth opportunity is expanding ChristianMingle's subscriber base. But, as we have seen, this comes with a price (in the form of direct marketing expenses). The company can grow internationally, but that would require significant capital expenditures as well. In addition, the company can grow advertising revenue using its existing platforms. While the potential advertising revenue is probably significantly lower than subscription revenue, it may be achieved with less capital expenditures. As the company states in its 2013 10-K:
We believe there is an opportunity for additional revenue from the sale of advertising on our Web sites. We expect advertisers will continue to seek highly targeted environments such as ours to complement their brands and reach niche consumers. We intend to remain selective about our choices for advertising partners so as not to adversely affect the quality of our user experience. In addition, we are uniquely able to offer advertisers not only online advertising but also an offline presence at our various parties and events around the country."
Additional sources of growth worth mentioning are:
- Using JDate's near-monopoly status and its resulting pricing power to introduce subscription price increases.
- Resource Conversion activities, such as acquiring small competitors or spinning off JDate.
Spark Networks' management is long-tenured, but its success is being debated publicly. CEO Gregory Liberman served as President from 2006 and as CEO since 2011. He was appointed to be chairman of the board in November 2013. CFO Brett Zane was appointed CFO in December 2007.
John Lewis of Osmium Partners rightly complains about some corporate governance practices. One of which is the excessive pay of executive officers. Executive pay has moderated a bit in 2013, possibly not unrelated to Osmium's activism. As described in the company's Proxy statement, filed on April 11th, 2014:
CEO Greg Liberman made $1,471,737 in 2012 and $900,015 in 2011. The pay of $825,000 in 2012 in stock options is especially disturbing, given that he is overseeing a non-profitable small capitalization company. In total, the company has nearly 3 million options outstanding, with an average exercise price of $4.18. Lucky is the CEO, 1/36 of whose granted options are vesting each and every month.
The disclosures continue to reveal some fishy pay practices. One is the option re-pricing which was conducted in 2009 (taken from 2013 10-K):
Due to the re-pricing of most options in 2009 and limited option exercise history, the Company is using the "simplified method" calculation, to determine the term of the options. The "simplified method" calculation derives the term by averaging the vesting term with the contractual terms."
I'm no expert in option pricing, so maybe my concerns are moot. Nevertheless, the term "simplified method" to describe option pricing is a red flag to me.
Another fishy disclosure is this one (taken from the same 10-K):
Options to purchase 3.0 million, 3.8 million and 3.5 million shares for fiscal years 2013, 2012 and 2011, respectively, were not included in the computation of diluted net loss per share because the options were anti-dilutive."
Albeit the hefty compensation, executive management holds too few shares to my liking, 0.2% of outstanding shares in total. CEO Liberman holds only 14,406 shares to date.
Osmium Partners has good reasons to be concerned, not only on pay practices, but also on the board's accountability and fiduciary practices:
Further, it appears Company management itself does not understand its own capital allocation decisions. After spending what we believe to be approximately 100% of the Company's current market capitalization on direct marketing for Christian Networks, CEO Greg Liberman admitted the following: "Over the past quarter and a half, we have been working very closely with the marketing attribution partner to identify the true value of each of our marketing investments, both online and off.". This is unacceptable. We find it shocking that a Board with significant tenure would have allowed management to speculate with approximately $114 million of stockholders' capital without proper oversight and without publicly disclosing metrics to judge results."
On management as operators:
... industry leaders generate 30% EBITDA margins while smaller competitors generate 20% EBITDA margins. Given these dynamics, and current management's inability to deliver an acceptable return on capital, we think the best course of action, in the near term, is to shrink the business to a point where the Company can reach tolerable EBITDA margins and focus less on management's desire to consume additional empty calorie revenue."
I personally do not think that Spark's existing board and management are inherently immoral or totally incompetent. John Lewis of Osmium may be exaggerating. Yet, I do think there were mistakes, and too little thought was given to shareholders' interests or to improving corporate governance practices.
The main dispute between Spark's executive management and Osmium Partners is over appointing directors to the board. This opportunity came along Osmium's way when the largest holder, Great Hill Partners, liquidated its position and dismissed its two directors in late 2013. Initially, Osmium demanded those two board seats, but after an unclear turn of events, one with conflicting versions from each side, Osmium is now pursuing the majority of the board, four seats in total. Osmium has laid out a clear plan to increase value to shareholders, which include the following steps:
- Scrutinize direct marketing investments.
- Increase management stock ownership, and tie compensation to the company's performance.
- Examine the company's user experience and service offering.
- Increase visibility to operational metrics, and promote accountability of the board to the company's performance.
- Improve corporate governance, and remove the existing "poison pill", which complicated future changed in control.
- Evaluate strategic alternatives - which means search for M&A and other resource conversion opportunities.
The proxy fight will reach its peak in the Annual Meeting of Stockholders scheduled on June 18, 2014. I see this fight in a positive light. Whether Osmium wins or loses the board seats, the process serves to wake up the executive management and the board, mandating them to take actions for the benefit of shareholders. Executives' excessive pay has already been moderated. In addition, existing management already practically adopted part of Osmium philosophy and vowed to forgo growth and focus on profitability. As CEO Liberman noted in the Q4 2013 conference call:
On the ChristianMingle front, now that we have achieved critical mass as promised, we will turn our focus to demonstrating the inherent operating leverage within our business. As I touched upon earlier, with the solid ecosystem of subscribers and brand awareness at an all time high, we expect to reduce our direct marketing spend in several areas where we are seeing a lower return on marginal volume basket or channels with partners who operate in an inappropriate manner."
Isn't this change in operations practices amazing?
In this section, I shall review Whitney Tilson's valuation, Osmium Partners' Valuation, and mine.
In his VIC pitch, Tilson values Spark as a sum of the parts of its main assets: JDate and ChristianMingle. He values JDate at $144 million, giving it a rough 6x multiple to its mid-2013 TTM operating profit contribution of $24 million. ChristianMingle is assumed to evolve to a range of potential operating profit contributions ranging from $30 million to $225 million, depending on contribution margin (50%-90%) and revenue ($60-$250 million). Multiplying ChristianMingle's future contribution by 4x-8x gives a minimum of $120 million and an upside of 12 times this amount. In summary, JDate and ChristianMingle are worth at least $264 million, and potentially much more. Compared to an enterprise value of just over $140 million at the time of Tilson's analysis ($106M at the time of mine), it is clear why Tilson sees value. However, at the risk of being completely off, I humbly suggest that Tilson's presentation may not discuss explicitly one aspect of the valuation. Unallocated operating expenses amounted to $29 million in 2013. Those included SG&A, services, depreciation and other expenses that each company must incur as part of the regular conduct of its business. Let's assume that cost-cutting would have reduced this number by 20% to $23 million. Under the same methodology, applying a 6x multiple would result in a -$140 million of negative value to the company that should be added to the company's value. Making this adjustment would still result in an attractive risk/reward ratio for the company, with value (in EV terms) of as low as $124 million, and upside of over a $1 billion.
Osmium Partners value the company a bit differently (taken from PREC14A Proxy Statement, filed in April 17th, 2014):
We believe Spark Networks today trades at a fraction of what it is truly worth. Although it may be a challenge to value Spark Networks, sell-side analysts value Match.com's subscribers at $930 to $1,014 each.22 In contrast, Spark Networks subscribers are currently being valued at only $363 per subscriber.
Spark Networks' industry leading Jewish Networks brand has 87% contribution margins, which comes to $267 in contribution per subscriber per year. In the hands of a strategic buyer, we believe the vast majority of the contribution dollars would fall to EBITDA. Based on recent M&A activity and comparable transactions, we believe Christian Networks subscribers could be valued at $650-750 per subscriber. Therefore, it is our belief that it is not unreasonable to value Spark Networks at six times Jewish Networks contribution dollars, or $1,560 per subscriber, plus Christian Networks at $650-750 per subscriber, which would imply a sum-of-the-parts value in the $10-12 per share range."
Again, a 100% upside from today's prices.
I tend to think on Spark's valuation in the following way: reaching revenues of $100M in the next 1-3 years is not unreasonable, even considering cutting some direct marketing expenses. 25% EBITDA margin should be a conservative estimate, given Osmium's commentary. Compare it with Netflix's 56% EBITDA margin (well, the company is not Netflix, after all). $25M multiplied by a 8x EV/EBITDA will result in EV of $200M, almost twice the current EV of $106M. 8X EV/EBITDA is justified given the company's growth prospects, zero debt and strong brand name (JDate). Worth noting here is the loss carryforward tax assets, ensuring that the company will not pay taxes in the years to come.
I'm encouraged to have discovered the company when it was trading around 5$, compared to $7, when Whitney Tilson pitched it.
While the upside is hard to value, it is clearly high. As for downside protection, there are no hard assets, but I believe that there is very little chance that JDate alone is worth less than $100M, so at current prices, an investor gets ChristianMingle for free.
The stock has been declining since mid-2013, and seems to have not found a bottom. The decline may been related to the planned liquidation of the Great Hill Partners' funds, which was the largest stockholder, owning more than 43% of shares at its peak. This may have created a selling pressure and an opportunity to buy shares cheaply. Investors may be avoiding the uncertainty of the proxy fight. It is an unloved stock, and the price is dominated by pessimism.
Spark Networks is a buy. Its core business model is sound and lucrative. Years of mismanagement have created an opportunity to buy shares cheaply, as both management and its largest shareholder, Osmium Partners, are determined to address the core issues and turn it around. The price is compelling, with a low downside and a high upside. Resource conversion opportunities are likely, as the industry will eventually consolidate due to network effects. I do hope that Osmium wins the proxy fight in June's stockholders meeting, but even if not, I believe that the chances of a successful turnaround and value enhancement are larger than of a terminal decline. I take confidence in Howard Marks' teaching, that "the pendulum [of pessimism and optimism] will eventually shift". It always does. As a deep value hunter, I am pursuing this falling knife, and if the price should fall much further (and my thesis do not change), I will reach out and pick up more shares. I'm in.
Disclosure: I am long LOV. 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.