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Stamps.com: Go Long But Watch Out For USPS Or Regulatory Action THEN Go Short

|Includes: Stamps.com Inc. (STMP)

Here's a description of Stamps.com:

"Stamps.com Inc. is a provider of Internet-based mailing and shipping solutions. The Company operates through the Internet Mailing and Shipping Services segment. Under the Stamps.com and Endicia branded solutions, the Company's customers use its service to mail and ship a range of mail pieces, including postcards, envelopes, flats and packages, using a range of United States Postal Service (OTCPK:USPS) mail classes, including First Class Mail, Priority Mail, Priority Mail Express, Media Mail, and Parcel Select, and among others. Its customers include individuals, small businesses, home offices, medium-size businesses and large enterprises, and within these categories, the Company targets both mailers and shippers. In addition, the Company offers multi-carrier shipping solutions under the brand names ShipStation and ShipWorks. The Company's products and services include Mailing and Shipping Business and Customized Postage."

What jumps out at you first about STMP is that it has some JUICY margins and extraordinary growth rate. It also strikes you immediately that the forward P/E based on analyst consensus is extraordinarily LOW at 12X. Usually, businesses with thatSo kind of growth rate and margin profile trade for 20-30X NTM EPS.

The first clue is that the short interest on this stock is VERY high at 25% of float. So there are folks out there that believe STMP has an unsustainable business model.

A cursory look at financials makes you scratch your head. Very little disclosure for the phenomenal revenue and EPS growth. Opaque financial statements are not a good thing. Also it appears growth really picked up in Q3 2014, after the acquisition of Shipworks for $22MM (the company's name was Interapptive Inc but their main product is called Shipworks).

The reason for STMP's results become obvious when you read this report:

seekingalpha.com/article/3988425-stamps-...

Prescience Point does a great job of doing some dirty work and it makes sense that STMP is extracting fat margins thanks to the reseller program instituted by the USPS in 2009. So that explains the fat margins. And if you read the transcript of the more recent earnings calls, the CEO explicitly addresses these concerns head on. Here is the relevant portion of the transcript:

"As you recall from our last earnings call, we spent time explaining the complicated area of USPS negotiated service agreements or NSAs, in a subset of those NSA agreements called reseller agreements. An approved reseller NSA agreement allows a reseller partner to buy postage at one rate and then resell that postage to another USPS customer at a higher rate. This reseller area had been the subject of misleading and inaccurate material that was released by various sources attacking Stamps.com's business and its partners.

In the three months since our July earnings call, many of the key arguments made by these sources have already proven to be wrong, so I'd like to provide you an update of what has happened since our July earnings call. The initial argument put forth back in July was that the reseller program was being misused by Stamps.com and its business partners and that the USPS was unaware of this alleged misuse and, once they became aware of it, they would shut down the program in 30 days.

On our July earnings call, we provided some specific information demonstrating why the allegations of abuse by the reseller program were without merit. We also explained how the USPS was fully aware of and benefits from the reseller program.

It has been a most four months since the original reports came out and the assertion that the program will be shut down by the USPS in 30 days obviously did not happen. The USPS has not terminated nor curtailed any reseller NSA agreements.

We're in frequent contact with the top management of the USPS and they continue to be in support of the reseller program. In fact, we're aware of one reseller agreement where a long term extension was proposed by the USPS management and was approved by the Postal Regulatory Commission in July after the initial reports came out. The USPS has consistently extended the reseller program and the Postal Regulatory Commission has consistently approved the program for the past seven years. We expect them to continue to do so in the future.

Another argument put forth back in July was that, even if the USPS management didn't shut down the reseller program, the USPS Office of Inspector General or OIG, was going to start an investigation of the program. However, the OIG has not announced any investigation related to resellers since the reports came out four months ago and we have not been contacted by the OIG nor are we aware of any internal discussion happening at the OIG around this area.

Another argument put forth back in July was that the USPS was going to eliminate Commercial Plus pricing in January 2017 which would shut down or cripple the reseller program. You may recall that there are two commercial rates, the Commercial Base and Commercial Plus. Commercial Plus rates provide an additional average discount of approximately 3% versus Commercial Base. Customers can receive Commercial Plus rates by working with a reseller. The additional 3% discount is one of the primary benefits for customers that utilize resellers. The negative reports argued the USPS would eliminate Commercial Plus pricing in January 2017 and by eliminating that rate, they would eliminate the reason for customers to use resellers, thereby shutting the reseller program down.

However, on October 19, the USPS submitted its January 2017 rate proposal for competitive products to the Postal Regulatory Commission and the USPS rate proposal maintained the same rate structure which included both Commercial Base and Commercial Plus rates. The USPS also maintained the same 3% discount between the two rates.

One additional thing of note was that the USPS also decided not to repeat a previous public statement it made in conjunction with its equivalent finally made a year ago regarding moving towards a single commercial rate over time. We believe the change in their public stance was a strong indication that the USPS intends to maintain the current Commercial Plus or an equivalent rate structure in the future.

After some of the misleading reports came out, there was a lot of confusion over the very complex topic of resellers. Several investors sought out independent industry experts to help understand it. Ruth Goldway, who is the former Chair of the Postal Regulatory Commission, came forward and gave a detailed postal industry insider's view of the reseller program. As you may recall, the Postal Regulatory Commission or PRC, is the government agency that directory regulates and approves all USPS ratesetting, including the negotiated service agreements like the ones that enable the resellers to provide discounts to their customers. Miss Goldway was Chair of the PRC from 2009 to 2014, including when the original reseller agreements were first approved in 2009 and also through multiple approved extensions to the reseller agreements.

In a conference call that was hosted by one of our research analysts on August 8, Ms. Goldway made several insightful observations. She provided information that explained how the overall goal for the USPS for resellers and in general is the generation and the retention of package volume. Ms. Goldway explained how the USPS has an enormous network that can handle a great amount of capacity and their focus over the last 40 years has been to grow volume. She said that the USPS worries about maintaining their package volume and getting package volume into the system in one way or another.

USPS has a huge fixed cost because they must go to every address in the U.S. every day and the more volume, the better their overall economics so long as each package is profitable which it is in the reseller industry. This is consistent with what we explained back in July when we noted that an important goal of the reseller program is not only acquiring new customers but also the retention of existing customers. Whether you label a package as new volume or existing volume, each and every package is critical to generating USPS volume growth and every package is financially important to the USPS.

Mrs. Goldway also provided information which supported our assertion that there are not any restrictions on the types of channels or customers that the resellers were allowed to target. She provided some history of the reseller program and said that what the USPS was hoping for at the time that they established the program was the small volume package shippers which had been the business of DHL when they exited the U.S. market in 2009.

In July, we explained how the reseller program wasn't solely meant by the USPS to be for high-volume shippers, as had been alleged in the original misleading reports. Resellers are in fact authorized by the USPS to offer discount rates to smaller shippers as well as larger shippers. In fact, larger shippers are able to get their own discounts by going directly to the USPS and making a volume commitment. So, the smaller shippers are really more directly the target of the reseller industry.

Miss Goldway also added a few additional viewpoints and told her audience that the PC postage companies are considered to be the Postal Service's most valued partners. She also said that, in her opinion, the reseller program has been very successful and it has benefited the USPS in terms of meeting its initial goals.

At this point, the arguments championed by the misleading reports have been proven wrong by the actions of the USPS and its regulators and have also been discredited by an independent industry expert. Meanwhile, we continue to execute on our business model. We continue to generate significant package volume growth for the USPS. In fact, on August 9, the USPS reported its latest numbers for the quarter ended June 30 and their growth in package volume was 14%. Their growth in shipping revenue was 18%. These are among the highest growth rates the USPS has seen over the past several years. We believe the reseller program and our investment in shipping were important factors in helping the USPS grow their package volume and their revenue."

Okay, so this is a very hairy situation. While I see the case that STMP is abusing the system, it isn't that easy to prove given there are too many counterfactuals. And just going short hoping for regulators to close the loophole is a recipe for sleepless nights and frustrations.

But this isn't an amazing business either so hard to get too much conviction going long.

So hard to have huge conviction eitherway - long or short. The short interest makes this into a potential nightmare if there's a short squeeze. But going long could be ugly if USPS decides to close the reseller loophole.

On balance, I think a small long position is warranted. Small. The best case scenario is this game continues for another few years and STMP keeps growing revenues and earnings at a more than healthy clip. But if this gets too big, it may be time to consider a short position if regulators start to take notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.