j2 Global (JCOM): Half Cloud, Half Digital Media and All About Acquisitions

Geoff Gannon February 25, 2018

j2 Global (JCOM): Half Cloud, Half Digital Media and All About Acquisitions

Guest write-up by Jayden Preston

Introduction

j2 Global brands itself as an Internet service company. At its core, the company’s goal is to participate in the monetization of the shift from analog to digital. They do so in two business segments: 1) Business Cloud Services and 2) Digital Media.

Business Cloud Services (BCS)

The main business here is providing businesses of all sizes with cloud services that meet their communication, messaging, security, data backup, hosting, customer relationship management and other needs. At the moment, the biggest value drivers are their fax and voice products, including eFax, an online fax services that enable users to receive and send faxes over the Internet; and eVoice, which provides their customers a virtue phone system. These are the original businesses of the Company and are called number-based businesses.

In more recent years, j2 has also built up their non-number-based businesses within their BCS portfolio. This group includes KeepItSale, a cloud backup solution; FuseMail, which provides email encryption solutions; and CampaignerCRM, a customer relationship management tool.

The above group of service offerings all have a subscription business model, where the lion’s share of revenue is derived from “fixed” subscription fee from basic customer subscription, with the rest from “variable” usage fees generated from actual usage of services by customers.

j2 Global also generates revenue from licensing their intellectual properties to third parties. However, historically this revenue source has been minimal, around 1% to 2% of segment revenue from BCS. We will thus neglect this in our following discussion.

Digital Media (DM)

Their DM segment consists of the web properties and business operations of Ziff Davis, the physical-magazine-turned-digital publisher that j2 Global purchased in 2012 for $167 million. j2 Global bought the company from private equity firm, Great Hill Partners, with the intention of providing more capital so that Ziff Davis can continue to execute its business plan of building a multi-vertical online publisher that earns revenue from video ads affiliate links, demand generation and data licensing. This is exactly what happened in the subsequent 5 years.

Since the acquisition, Ziff Davis has gone on an acquisition spree, spending nearly $1 billion to expand their web property portfolio. Major properties now include PCMag.com, IGN.com, Speedtest.net, AskMen.com, Everyday Health and Mashable. Revenue of Ziff Davis increased from around $50 million in 2012 to $539 million in 2017, with revenue sources from advertising and sponsorships, subscription and usage fees, performance marketing and licensing fees.

During 2016, their DM web properties attracted 5 billion of visits and 18.1 billion page views, up from 345 million visits and 1.1 billion page views in 2012.

Durability

Business Cloud Services

Durability of the BCS segment mainly rests on whether eFax will still be needed in the future. In 2016, fax-to-email revenue constituted 35% of the Company’s consolidated revenue, or 54% of the Business Cloud segment.

The modern fax machine was introduced in the US in 1964. Since we are now well into the third decade of the Internet era, it is logical for most people to believe usage of fax is on the decline or even wonder why fax is still being used. Surprisingly though, fax volume has actually been increasing. This phenomenon is most prevalent in industries, including financial services, healthcare, government and manufacturing, where security and compliance is paramount.

Major reasons for the continued popularity of fax includes:

The belief that fax is more secure than email, while being immune to malware and ransomware;
Fax providing a paper trail due to transaction reports and call logs for legal discovery
Fax is cheaper compared to expensive alternatives like secure email
Regulation, especially for healthcare, legal and government
Fax signatures are a generally accepted method of executing contracts

In a word, the key factor is the belief that fax is more secure.

To make fax more convenient, eFax, or internet fax, was invented so one can use the Internet to send faxes, eliminating the need for phone lines, long distance charges and stand-alone fax equipment.

In relation to reason 5 above, the first risk factor listed in j2 Global’s 10k highlights the threat of a potential universally accepted method for electronically signing documents to their efax business. However, even if such a method exists, it does not necessarily mean the documents can be transferred securely through emails.

As such, I believe fax is actually more durable than what most assume on face value.

Importantly, as j2 Global’s DM segment is growing a lot faster, at mid teen percentages, versus low to mid-single digit for their BCS segment, revenue contribution from efax should continue to decline. In FY2017, the Company’s revenue attributable to online fax declined to 29%, dropping from 57% in 2013.

Digital Media

Prior to the advent of the Internet, the predecessors to Digital Media were durable businesses because newspapers and magazines were the main sources of information. Given the phenomenon Buffett dubbed “Survival of the Fattest”, changes were also hard to come by since it was costly to support a new format or publication without an existing subscriber base.

The Internet made both of the above constraints less insurmountable, providing alternative information channels and lowering the cost of attracting eyeballs. This has brought about tremendous change in media. Traditional media who do not adjust themselves accordingly are going extinct. Since it is a lot easier to disseminate information digitally or even go viral with social media, new information outlets proliferated. Even a single person with creativity and video editing skills can create a YouTube channel with hundreds of thousands of subscribers. The question of durability is can a digital media business retain readership in the age of rapid digital change?

The major means of readers reaching websites include: 1) Search engine results, 2) Feed on social media and 3) Active sharing from friends. New entrants usually rely on word of mouth to gain popularity. Nevertheless, as new entrants pile in, it gets more and more difficult to gain readership or viewership based on novelty alone. Without word of mouth, you must then spend more money on search engine results to gain viewership. This is why I believe the threat from new entrants is actually declining. The bigger worry is losing readers’ interests, especially if you are unable to adapt to changes in tastes or unable to keep creating new content.

In other words, competition should gradually be turning to be based more heavily on marketing and content creation expense. Scale is thus becoming paramount. Players with an existing subscriber base also have advantages at sustaining readership. Once people are subscribed to a media outlet through social media, they rarely unsubscribe to them. For instance, the most followed and popular YouTubers are all the first wave of people to do so. To start a tech review YouTube channel now and beat, say, Unbox Therapy in popularity is nearly an impossible task.

My point is: If your digital media property is already established, with millions of followers across social media, as long as you manage your operation in response to changes in tastes and interests, you have a decent chance of owning a durable business.

Moat

Business Cloud Service

Like most business software services, j2 Global’s BGS segment has competitive advantages derived from switching cost and the resulting customer retention. Their portfolio of businesses in this segment include online fax, virtual phone system, online backup and disaster recovery solutions, email and email marketing services. All are services integrated in the daily work flow of businesses. In theory, this should engender high retention rates.

The Company didn’t disclose cancel rates until 2014. Defined as cancels of small and medium businesses and individual Cloud Business Customers with greater than four months of continuous service, the average monthly cancel rates had been constant at 2.1% since 2014. That implies an annual retention rate of roughly 75%. This rate is decent.

There is a chance the retention rate would improve in the future. In the latest earnings call, j2 Global highlighted improved cancel rate that led to sequential growth in revenue and EBITDA without the aid of M&A in the corporate fax segment from Q3 to Q4, a historically weak quarter. This was a first since 2010 and likely a result of gearing more toward compliance-oriented businesses, especially healthcare, which represented 44% of all new US Corporate Fax customers, up from 22% a year ago. In Q4 2017, 60% of their corporate fax revenue is derived from compliance-oriented verticals, up from 50% just a year ago.

The Company has the strongest market position in online fax, especially in the individual and SME market. Due to its first mover advantage in the online fax market, j2 Global has accumulated a number of key patents. Historically, j2 was accused of employing tactics of accusing other players of patent infringement, before acquiring the players after they depleted their financial resources. j2 Global has certainly made numerous acquisitions, building up their online fax properties and consolidating the industry. In 2007, a competitor that filed suit against them estimated that j2 Global had 90% of the online fax market (likely referring to the SME and home office market).

Their flagship product is eFax, one of most well-known and feature rich providers, with features like mobile apps e-signature capabilities, HIPAA compliance and unlimited fax storage. This has allowed eFax to charge a higher price than the competition. eFax’s market positioning is the strongest in individual Internet fax services. In 2012, it had 39.8% of the individual market, compared to just 4.4% for the second leading supplier, and 12.7% of the corporate market, trailing only Open Text’s 41.5%. Even the giant in corporate fax market had to do business through j2. In 2012, j2 sued Open Text for patent infringement. The case was settled a year later where Open Text agreed to pay j2 Global $27 million in exchange for a fully paid up license to the licensed j2 patents for fax software and services sales to enterprise and corporate customers. Open Text also agreed to pay j2 a running royalty for a license to licensed j2 patents for sales of fax software and services to individual and small office/home office customers.

Furthermore, owning a variety of brands for online fax makes it difficult for any new entrants to get into the market. This is because of Google and the way their PageRank system works. Essentially, j2 Global can push its properties’s ranking higher in the search result by placing hidden and visible links to their own properties. As Google now dominates general search and j2 Global dominates search results of “Online fax” on Google, it makes j2 Global the dominant search result for “Online fax”.

Not to be overlooked is the fact that the biggest battle ground will be on capturing market shares from traditional players. The value proposition of online fax over traditional fax seems obvious. You can eliminate costly long-distance charges and cost related to traditional fax machines, such as cost of a physical fax machine, paper, ink cartridges and so on. Being able to send fax from your smartphones also greatly improve the portability as you are no longer bounded by a fax machine. Most importantly, online fax could improve security further, since you do not need to worry about your documents printing on someone’s shared fax machine. Sending fax through emails with advanced encryption methods also allow online fax to remain secure.

Despite all the above advantages, j2 Global recently estimated that analog fax still represents 80% to 85% of all faxing, with over 40 million fax machines still in use. As the trend of migrating to cloud services in fax continues, j2 Global should continue to be one of the biggest beneficiaries.

Digital Media

The competitive positioning is not as clear in DM. However, it is reasonable to believe the positioning could be good enough. Many of the digital media properties owned by j2 Global have brand names that goes back to the inception of the Internet age. Examples include PCMag, IGN, AskMen. When it comes to acquisition, they also only focus on market leaders. All of their properties operate within certain verticals, offering specialized content.

As mentioned in our discussion in the “Durability” section, I believe scale advantage, in terms of spreading marketing and content expense, as well as having an existing subscriber/user base, are key to the digital media business. It is too difficult to examine each of j2 Global’s digital media properties individually. Yet, looking at all of the digital media properties as a whole, we can clearly see this portfolio of companies have reached sufficient scale already. Adjusted EBITDA margin has averaged 35% since 2014. Some of the media properties are still growing rapidly, especially in terms of operational metrics, despite being among the market leaders already. For instance, Ookla, the clear leader in Internet speed testing, saw a 28% YoY growth in its mobile app installation in Q3 2017, passing the 300 million app download milestone. IGN, a leading website for video game and entertainment media, recorded platform subscriber growth of 38% YoY in Q4 2017, with their total social following reaching 30.7 million.

Quality

Both segments have fantastic business economics.

Business Cloud Services has a gross margin of 80%, while Digital Media’s gross margin reaches 90%. Despite having a lower gross margin, the operating margin is higher for BCS due to a much lower operating expense ratio. BCS’s adjusted EBITDA margin has averaged above 50%. With 80% of revenue derived from fixed subscription fees, the predictability of the BCS segment is also higher than most businesses. Some BSC customers also pay for the services one year in advance, creating deferred revenue for j2 Global.

In addition to having high margins, both businesses, as you can expect, have low tangible asset requirements. I estimated the average invested capital from 2015 to 2016 was a mere $20.5 million. This is against average net income of $140 million.

Given the minimal tangible asset needs to operate or grow the business, j2 Global has mainly deployed all the free cash flow the business generates to acquisitions. As such, even though the core business has wonderful economics, it is the return on investments j2 Global gets from their acquisitions that we should pay attention to.

A quick check is to look at invested capital including all intangibles. The figure jumps to $1.4 billion, with the return dropping to just below 10%.

We examine their acquisition track record in the following section.

Capital Allocation and Growth

J2 Global has been a story of growth through acquisitions. From 2000 to 2017, total investments amounted to $2.25 billion. Since 2001, j2 Global had made 158 acquisitions, growing from an employee base of 100 to 2,300. This means over 9 deals annually for 17 years. The result had been pretty impressive. From 2001 to 2017, revenue grew 24% per year, while Adjusted EBITDA grew 46% per annum. The Company only began to pay a dividend in 2011.

Slide 5 of their presentation at the Deutsche Bank 24^th Annual Media, Internet and Telecom Conference, showcases the Company’s modus operandi in acquisitions. It mainly involves small acquisitions to drive revenue (through cross-selling) and cost (through eliminating duplicative functions) synergies, achieving better scale during this market consolidation process. They categorize their potential acquisitions in four buckets: 1) Rollup acquisition; 2) Geographic expansion; 3) Service expansion and 4) IP purchase. They conduct regular dialogue with potential targets up to three years prior to acquisition. And they have a ROI target of more than 20%. This means they prefer some level of distress in the acquisition candidates. In addition, they always look at whether the acquisition is scalable with the ability to do future tuck-in M&A.

Their track record shows that they have been a disciplined buyer.

In their latest investor presentation for Q4 FY2017, slide 22 describes their investment activities since 2013 in more details.

From 2013 to 2017, a total of $1.57 billion were committed to acquisitions and capital expenditure. In this period, Adjusted EBITDA increased by $242.5 million. This suggests a pretax and unleveraged return of around 15% without considering full benefit from acquisitions made in 2017.

Breaking down the investments into the two segments: $572.8 million was invested in the BCS segment, with a resulting cumulative increase in Adjusted EBITDA of $102.2 million. This is a return of 17.8%. $1.1 billion was invested in digital media, which led to a $141.9 million increase in adjusted EBITDA, or a return of 13%.

More recently, the new CEO Vivek Shah said that their goal is to purchase assets at around 5x to 6x EV/EBITDA after synergies. This implies the aforementioned ROI target was a pretax and pre-interest cash return concept.

This aligns with their track record in the past 4 years. Importantly, this Adjusted EBITDA figure adds back share-based compensation and acquisition-related integration costs. Assuming it is correct to add back 100% of the acquisition-related integration costs, I at least feel it is necessary to treat share-based compensation as true expense. Share-based compensation has been around 5% of Adjusted EBITDA, and capital expenditure another 6%. Let’s suppose they can continue to buy assets at an effective EV/EBITDA multiple of 5.5x, the return (flipping the multiple) will then be 18%. Taking away share-based compensation, capital expenditure and provisions for tax at a rate of 25% means they could generate an after-tax unleveraged return of 12%. This yield should also grow organically, maybe from as low as 3% to the high single digit.

The key question may be whether they can continue to do so in the future. But this is an impossible question to answer with any certainty. What we can know is if it is possible. I think the answer is yes. There are still room for consolidation in both the BCS and DM segments.

For BCS, the market for backup cloud is still very fragmented. j2 Global mentioned that they see 80% to 90% of the companies in the industry being smaller than their units, which in a whole is only generating $110 million in revenue.

In DM, the market is still growing quite rapidly as the transformation in media and commerce from offline to online continues. j2 Global can expand into other verticals or consolidate the market further in the verticals they are already in. For instance, they now own the second biggest player, Everyday Health, in the health care digital media space. There are another 4 players below them each having unique visitors of above 20 million. They could vastly improve Everyday Health’s position against WebMD with such acquisitions.

The real worry is if management will lose discipline and overpay for assets. The track record sited above was accomplished by Hemi Zucker, who stepped down as CEO by the end of 2017. The new CEO Vivek Shah, however, also has experience in making acquisitions. In fact, Vivek was the person who had the idea of turning around Ziff Davis and partnered with Great Hill Partners to purchase Ziff Davis from bankers after the Company just went out of bankruptcy. He has since been CEO of Ziff Davis, responsible for turning around media company, repositioning the business in the age of digital media. Great Hill Partners purchased Ziff Davis for $27 million in 2010. They acquired 7 companies in the next two years. Add-on capital from Great Hill brought Ziff Davis’ total investment to approximately $50 million. In the first year under Shah and Great Hill, Ziff Davis made $11 million in revenue and $1 million in EBITDA. By 2012, it had $50 million in revenue and $11 million in EBITDA. They then sold Ziff Davis to j2 Global for $167 million in 2012. Shah stayed on as CEO of Ziff Davis, further increasing Ziff Davis’ revenue to $539 million by 2017 through more acquisitions. The new CEO definitely has ample experience in M&A.

Former CEO Zucker will still be affecting j2 Global’s fortune in another way. After his departure from j2 Global, Zucker has now joined OCV Management as a managing principle. OCV Management was cofounded by the Richard S. Ressler, who is currently serving as Chairman of the Board of j2 Global and has been a director since 1997. OCV Management is a venture capital firm that makes investments from $5 million to $40 million in companies that have revenue of more than $2 million. Zucker was the person that suggested j2 Global as an investment to Ressler. OCV then made a $7 million investment in jfax.com (the predecessor to j2 Global) in 1997.

Here is the part that is more controversial. As Zucker joined OCV, j2 Global made a commitment to invest $200 million in an investment fund, with a 6-year investment period, and managed by OCV. j2 Global will pay the standard fee of 2% management fee and 20% performance fee. On one hand, this can be seen as a conflict of interests, feeding the Chairman and ex CEO a big chunk of capital where they can earn management fees. On the other hand, this creates the opportunities for j2 Global to participate in further value creation by a manager with a successful track record. The way j2 Global explains this commitment is that this broadens their investment universe into areas that are not appropriate to do within their own structure. In fact, they had try to establish j2 Venture internally back in 2012. However, due to human resource constraints, they scrapped the idea. As standard in the venture capital space, j2 won’t give $200 million to OCV immediately. They will only provide the capital as OCV finds transactions. Their current expectation is to provide $50 million to $60 million a year over the next 4 years. The Company expects they can still pay the dividends and continue their regular M&A program in the meantime.

Value

I will use two approaches to value j2 Global.

Let’s start with the comparable and sum-of-parts approach.

BCS generated $579 million of revenue and had an Adjusted EBITDA margin of 53% in 2017. A direction comparison may be hard to find, as it is unusual for a cloud service company to have such high margins. Nevertheless, this comes at the expense of lower growth. In his last earnings call, Zucker explained that they could have grown faster in their cloud backup business if they are willing to accept much lower margins, as a handful of their competitors are willing to. But they prefer having very high margins and slower growth instead. This means the growth will mainly come from M&A in their cloud backup space. Their core fax and voice businesses are growing more nicely at low to mid-single digit. But overall, organic growth is likely in the low single digit range. Open Text is the dominant player in corporate fax. Their main business is enterprise information management software. It might be a good comparable to look at. In 2017, Open Text has an operating margin (GAAP) of 15%, with an enterprise value at 5x its revenue. j2 Global’s cloud businesses may have lower growth, yet their GAAP operating margin is at 39%. It is difficult to justify Open Text should trade at a higher revenue multiple even if it has much better growth prospect. At 5x revenue, j2 Global’s BCS segment would have an enterprise value of $2.9 billion. Faster growing cloud businesses with growing margins, such as Adobe Systems, are awarded with revenue multiple as high as 13x by the market.

There are a number of comparables we can look at for the digital media space. Starting from the hottest companies in this space: Vice Media, the highest valued digital media company, raised $450 million from TPG, at a valuation of $5.7 billion. Their target revenue was $805 million for 2017. This suggests TPG valued the company at 7x revenue. BuzzFeed, another popular digital-first media, last fetched a valuation of $1.7 billion in 2016, also around 7 times its then revenue. Both of the above companies are still private, so we have no data on their margins. We can look at WebMD for a case with more detailed financial figures. It was listed in 2005 and were bought out by KKR in mid 2017. KKR paid $2.8 billion for WebMD who generated $705 million in revenue for 2016. The revenue multiple was thus around 4x. WebMD’s revenue grew 10% annually from 2012 to 2016. Their operating margin expanded from 0% to 24% in 2016. To make for easier comparison, WebMD’s Adjusted EBITDA margin was 33% in 2016. j2 Global’s digital media asset had Adjusted EBITDA margin of 32%. If we value this group of assets at 4x revenue as well, it will have an enterprise value of $2.15 billion.

In total, the estimated enterprise value of j2 Global will be $5.05 billion. j2 Global has around $600 million in net debt. This means the equity value of j2 Global should be $4.45 billion. With 48.4 million shares outstanding, our appraisal suggests a share price of $91.9.

Alternatively, let’s take a look at our usual free cash flow plus growth approach. Applying the latest 3-year average free cash flow margin (both on revenue and on EBITDA) to the latest revenue and EBITDA respectively, we get a free cash flow estimate of around $290 million to $312 million. We will use $300 million. In the past 5 years, the Company has paid out 27.5% of free cash flow in dividend. J2 is more opportunistic with their share buybacks. Let’s assume they will return 30% of their free cash flow to shareholders each year. The rest they put it into acquisitions. As discussed, should we believe management can keep buying assets at an effective EV/EBITDA multiple of 5.5x, we can expect the investments to generate 12% of after tax unleveraged return. Putting 70% of your free cash flow into such opportunities will grow your overall free cash flow by 8.4% (12% x 70%). This is on top of the organic growth of the business, which conservatively should at least track inflation. This means overall growth could be above 10%.

It is normally difficult to value a stock if you believe it can grow free cash flow by double digit for a very long time. Instead, we can look at what j2 Global should be worth if they don’t utilitze 70% of their free cash flow into acquisitions but return all to shareholders. We can expect j2 Global will increase its share count by 1% to 2% annually due to share-based compensation. If we conservatively expect organically the combined company can only grow at 4%, to achieve a total return of 8% per share, we would need to get a free cash flow yield of 6%. (8 – 4 + 2 = 6). This equates to a 16.7x free cash flow multiple. This suggests a j2 Global that doesn’t make acquisitions should be worth $5 billion. And if it can reinvest capital at a return of 12% after tax, free cash flow should grow faster and therefore the Company should be worth more. At $5 billion, this valuation method suggests a share price of $103.3.

Misjudgment and Conclusion

We have made many assumptions on j2 Global to come up with our valuation target. Examples include online fax remaining relevant in the long term, their digital media properties keep attracting visitors and trusting management on non-GAAP figures (such as acquisition related costs being truly one-off). The most important assumption, however, is that management will stay disciplined and only invest when the opportunity can generate at least 12% after-tax return. Doubtless, this is the biggest misjudgment one can make about j2 Global.

We can only rely on track record to make this judgement. The track record of management has been great. Not only are they disciplined, they are also opportunistic. One recent example is their fire-sale purchase of Mashable at below $50 million in Nov 2017. Mashable was valued at $250 million less than two years before j2 Global’s purchase.

But as we have been told often: Past performance is no guarantee of future results. This is especially true for investment performance. The reliability of predicting future return of opening a new Dunkin Donuts store in the US based on historical results is magnitude higher than that for future results of an investment manager. This is why to an investor who value certainty highly, such as Geoff, has found it difficult to invest in companies that rely on roll-up strategies. And of course, after the Valeant fiasco, serial acquirers have gotten a lot less popular

Yet, if you are an investor who is comfortable with betting on jockey stocks, or companies that rely on management to keep making intelligent investments, I believe j2 Global is currently attractively priced. Unlike Valeant, j2 Global is not over reliant on leverage. Net debt is currently at $600 million. Adjusted EBITDA from the BCS segment alone is more than $300 million in 2017, with acquisition related integration cost being less than $1.4 million. From this perspective, j2 Global is a lot safer than Valeant was.

The stock will really get my attention if it drops toward $60 per share.

Reading Materials

http://fortune.com/2015/10/29/ziff-davis-vivek-shah/

https://www.infoworld.com/article/3060612/security/why-email-hasnt-killed-the-fax.html

https://enterprise.efax.com/blog/the-top-10-reasons-companies-continue-to-fax-in-2017

https://blogs.opentext.com/fax-volumes-organizations-growing/

https://www.opentext.com/campaigns/infoexchange/enhance-agility

http://www.lawtechnologytoday.org/2017/12/fax-machine-v-efax/

https://www.biscom.com/gartner-reports-cloud-fax-citing-renewed-interest/

https://www.faxcompare.com/efax

https://bebusinessed.com/online-fax/nextiva-vs-efax/

https://www.arizton.com/market-reports/online-fax-market