Mystery Stock

What multiple would you pay for a business with the following EBITDA profile?

To help you out a bit, allow me to include a couple more details:

• The company is in an internet-related field (some advertising, some subscription revenue)
• Their EBITDA growth has been generated with just a bit of net debt ($800m) and ~0 equity issuance
• Capex requirements are fairly low - about $40-50m per year (ie, EBITDA converts to FCF pretty well)

Does 10x EBITDA sound like the right number?

To me, it sounds pretty, pretty, pretty low. This is not some pharmaceutical business where customers are getting scammed. This is not a hardware business that has generated a hit that will be tough to replicate. This is an advertising and subscription business.

One caveat: the growth has mostly been generated by acquisition. This is not an organic grower. They have completed >150 acquisitions over the years, mostly of obscure companies. But while investors have gotten occasionally burned by acquisition-driven growth (Valeant, Tyco, and others), in certain cases they have come to view this strategy as sustainable. Here I'm thinking of a TDG or a Constellation Software, both of which trade at higher multiples (15x and 20x EBITDA respectively) than our mystery stock.

Before I reveal the ticker, I must disclose that I was short (and wrong) on this name at a previous firm. The thesis went something like this:
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1. The company's main product is a declining, legacy business that subscribers don't really want.
2. The constant acquisitions are required to keep the business flat and should be viewed as essentially maintenance capex.
3. They use aggressive accounting.
4. They have run out of good acquisition targets.

I was short the company around 2013. As you can see from the EBITDA chart, their core business was NOT in material decline. Acquisitions were additive and weren't merely for treading water. In fact, deals totally $1.5b since Dec '13 have generated substantial returns: EBITDA has grown from $230m to $500m, implying a roughly 18% incremental ROIC (and more if you believe their core business declined). These would be good ROIC numbers for a company pursuing an obvious organic growth path. For an acquisition strategy this is tremendous.

The reveal: JCOM

The name of the company in question is J2 Global, ticker JCOM. Their biggest product -- perceived by many to be in permanent decline -- is called eFax[1]. eFax is a software product that allows subscribers to convert their incoming and outgoing faxes into emails. Faxes still work exactly the same for the other side, but the eFax subscriber doesn't need a fax machine. They simply click on a link in their email to see an incoming fax. 

Shouldn't this business be going away? Do people still use faxes? This was always a key argument of the shorts. In actuality, this business has been stickier than many expected; certainly, its been much more resilient than short-sellers such as myself predicted 5-10 years ago. The company still does about $300m in fax revenue, which is likely to be pretty high margin.

What is interesting about J2 Global is that management appears to be clear-headed about the flattish prospects of the fax business, and executed a strategy that reflects this. For nearly a decade, their capital allocation has been focused away from the fax business: they purchase small, SMB-targeted software companies focused on other verticals (although typically with similar customer acquisition channels). Often, these are not great businesses. JCOM runs them for cash and margins, recycling the extra FCF into more acquisitions, dividends, and stock buybacks. See below for two slides on how they think about M&A:

This is not the typical tech acquisition strategy. In my opinion, most tech CEOs (especially legacy and enterprise tech companies) pursue acquisitions for all the wrong reasons: to plug technical holes in legacy products, to tell a good story to investors, and to build empires.

Due to their focus on optics and not IRR, those CEOs often pay huge multiples for businesses that don't really have much strategic fit. The canonical examples of this are HP's failed deal for Autonomy and IBM's deals for... most of the companies they have bought. Smaller tech companies make these mistakes too: Progress Software (PRGS) even suffered a proxy fight over their failed venture capital-like acquisition strategy. 

JCOM, instead, has focused on tuck-ins of cash flowing businesses[2] at cheap prices. In this way, they are a more like a PE firm, which also extends to the ruthless way they operate their acquirees (this is hinted at in the slide referencing "shrink to grow"). There are many news stories about them laying off employees at newly acquired firms (see here and here) in order to increase profits. While some people might be turned off by these stories, I appreciate management teams that make the tough decisions needed to build a sustainable business.

And JCOM has, in fact, built sustainable businesses outside of eFax. The largest of these is Ziff Davis, which they originally purchased in 2012 for $167m. At that time, Ziff Davis was a holding company for various tech and media-focused websites, with PC Mag being the best known. It was run by CEO Vivek Shah, who worked closely with private equity firm Great Hill Partners to buy the business out of bankruptcy in 2010.

Vivek and Great Hill initiated the strategy of buying up underperforming tech-focused websites that Ziff Davis/J2 continues to this day. As a result of this strategy, Ziff Davis now owns the following sites in addition to PC Mag: IGN, Speedtest.net, Mashable, Everyday Health, Medpage Today, askmen.com, offers.com, and others.

​JCOM's "digital media" segment financials reveals the success of this strategy:

From a start of about $30m in EBITDA in 2013, JCOM's digital media segment (synonymous with Ziff Davis) now does over $165m in EBITDA ($203m as adjusted), or about 40% of the company's total. Perhaps it is no surprise then that Mr. Shah was announced as the company's CEO in September 2017.

I'm still early on in my research of JCOM, but I'm pretty interested. At 10x EBITDA and around 12x 2019 EPS[3], the stock could well be undervalued. I also think it could tick some of my boxes[4] for being subject to investor bias: perhaps investors are overly focused on the (admittedly mediocre) fax business, despite it being <50% of EBITDA. This would be an example of availability bias, and I can tell you that I definitely fell prey to this when I was short the stock in 2013. I absolutely did not understand the savvyness and repeatability of the company's acquisition strategy. 

In my research, I plan to dig in to the following:
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• current-day short theses: 11.3% of the float is currently short. Has the short thesis changed at all from seven years ago? What am I missing here? Are there still accounting-related claims out there that have not been debunked?
• insider transactions: do I need to be worried about the fact that management is pretty consistent sellers of the stock?
• non-fax cloud businesses: what are these businesses, really? And do I believe that they can be driving ~$300m of revenue and $100m of EBITDA? Are these businesses potentially melting ice cubes as well? What do customers of these businesses have to say?

Feel free to leave any comments below.

-Evan

[1] Here and elsewhere, I'm using "eFax" as a catch-all for their fax-to-email business, which includes many other brands such as MyFax and MetroFax.
[2] They don't always generate cash at first. Sometimes these are struggling websites that need to shut down segments of the business and lay off employees before they become profitable.
[3] These are street estimates from Bloomberg - almost certainly adjusted for things like intangibles amortization.
[4] For more about how we think cognitive biases create mispriced stocks, see here.

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