Robust profitability, stable cash flow, healthy growth prospect, and attractive valuation are the key criteria for stock investing. J2 Global Communications (JCOM) is such a quality investment that offers all those merits. In this note, I will walk you through my investment analysis that supports my bullish view on the stock.
Business Overview
Founded in 1995, J2 is a technology company that provides cloud and digital media services to business and individual customers. The firm has two business segments - Cloud and Media (see slide below).
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The Cloud segment offers a variety of office cloud services to business clients. Under the Direct Inward Dial (DID) category, J2's products include eFax, MyFax, Fax.com, and SmartFax that enable business users to send and receive faxes through their email accounts. The firm's voice products including eVoice and OneBox help customer establish a virtual phone system with various enhancements. In the Non-DID category, J2's FuseMail and Campaigner products provide customers email, archival, perimeter protection, as well as enhanced email market solutions. The firm also offers data back-up CRM customer relationship solutions through KeepItSafe and CampaignerCRM. The Cloud segment derives its revenue mainly through subscription fee and patent licensing.
J2's Media segment operates two portfolios of web properties under Ziff Davis and IGN, respectively. Ziff Davis' web properties primarily provide trusted reviews of technology products, technology-oriented commentary, professional networking services, and online deals for business and individual customers. IGN operates IGN.com and AskMen.com, which offer leading gaming and men's lifestyle information services, respectively. The Media segment generates revenue primarily through selling display advertising, logo and copyright licensing, as well as customer and business leads.
Stock Overview
J2 has a market capitalization of $1.9B. The stock has steadily climbed by almost 66% over the past 60 months and is currently trading at its 5-year high of $42.30 with a 2.3% dividend yield (see chart below).
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Growth Strategy & Financials
As the Media business was recently acquired in November 2012, J2 generated a majority of its total revenue (97%) from the Cloud business in 2012. Despite the fact that the fax and voice cloud service market is fairly matured, J2 has managed to achieve a CAGR of 11.4% over the past 5 fiscal years through organic growth and numerous acquisitions (see chart below).
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J2's growth strategy has long been focusing on maintaining superior business margin and steady cash flow conversion. The robust cash flow then would be spent on M&A activities that help the company expand into adjacent markets where J2 can leverage its existing competencies to generate accretive return. The cash return from the acquired business and existing operation would again be invested in new acquisitions, forming a lucrative M&A cycle.
J2 has managed to sustain a very steady and robust margin trend over the past 5 years (see chart below). The company has also been able to convert at least 80% of EBITDA to operating cash flow every year (see chart below). Given the fairly matured fax and voice cloud businesses, the limited capital expenditure allows J2 to produce significant free cash flow. In the 5-year period, J2's levered free cash flow margin averaged at 40.3%, which is almost on par with its average EBIT margin of 41.9% (see chart below).
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With the efficient cash-generating cycle, J2 has completed a total of 27 tuck-in transactions over the past 5 years, and the firm was able to produce at least a 20% annual return on equity in each year (see charts below).
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Acquisition of Ziff Davis and IGN
In November 2012, J2 made a modestly transformational move by acquiring Ziff Davis, a digital media company that operates various websites providing technology-oriented review, commentary, and networking services. The company further expanded its presence in the digital media space by acquiring IGN in February 2013. The two transactions were aimed to improve J2's growth profile and ultimately strengthen the company's cash flow position to better service the M&A cycle.
By the end of 2013, J2 expects the Media segment to represent approximately 25% of the revenue mix and the company's overall margin to be slightly lower in the near term due to the higher fixed cost for the Media business. But given that the segment remains in an early growth phase and digital media is a secular growth space as opposed to the existing fax and voice cloud businesses, the margin profile is forecasted to improve over time as the Media revenue grows.
In a company presentation in May 2013, J2 provided a few updates on Ziff Davis' recent performance (see slide below) and IGN's integration status. Both Ziff Davis' web visits and page views have increased markedly by 19% and 30%, respectively, in Q1 2013 on a year-over-year basis. Its revenue has ramped up by 22% in the quarter and EBITDA has risen substantially by 152% year-over-year. On the IGN side, all of the originally planned IGN integration has been executed successfully, which includes divesting some non-core assets as well as reducing headcounts and other non-staff costs.
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Upside Driver 1 - Ample Liquidity for Continued Acquisitions
The stellar stock performance over the past 5 years is believed to be largely driven by a series of J2's M&A activities as J2's management has demonstrated its ability to pursue accretive transactions and implement business integration as planned. Going forward, I expect J2 to continue having ample liquidity to sustain the current acquisition pace, which allows the company to gradually shift away from the matured fax and voice businesses.
I have performed the following quantitative analysis with some conservative assumptions to demonstrate J2's acquisition firepower:
1) Currently, the consensus estimates predict J2 to generate EBITDA of $230.3M and $245.3M in 2013 and 2014, respectively. To establish my own EBITDA assumptions, I discounted the consensus estimates by 3% and only considered $223.4M and $237.9M as my estimated EBITDA for 2013 and 2014.
2) Given the fact that J2 has managed to improve its EBITDA to levered free cash flow conversion rate somewhat steadily from 79% in 2008 to 89% in 2012 (see chart below), it would be reasonable and conservative to assume an 82% conversion rate for 2013 and 2014, which is near the low end of the 5-year historical range.
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3) Under those assumptions, J2 would generate $183.2M and $195.1M in levered free cash flow in 2013 and 2014, respectively, which would be available for acquisition, dividend payout, and share repurchase.
4) J2 paid out a total dividend of $40.3M and bought back approximately $60.3M value of shares in 2012. The dividend per share has been growing at an annualized rate of 12% since 2011. By fixing the dividend growth rate and assuming a 3% growth in share repurchase, the total capital return would consume about $108.5M and $117.0M of the total free cash flow in 2013 and 2014, leaving $74.7M and $78.0M cash available for M&A activities in the two years.
Essentially, the above analysis suggests that J2's existing operations would be able to generate sufficient funding to support medium-size tuck-in acquisitions without impacting the capital return plan. In addition, J2's other funding sources include an ample cash pile of $294M as of March 31, 2013 and a $40M revolving facility which has not been drawn. Moreover, the company currently has a net cash position of $49.2M. Given J2's robust cash generating capability, the company would be able to assume additional debt at a reasonable cost, giving J2 a strong financial capacity to go after some larger transformational deals.
Upside Driver 2 - Significant Valuation Upside Potential
Despite the strong price run-up in the past 5 years, I believe the stock remains cheap as the company's future growth potential has not been fully priced in. Even with a 5-year price appreciation of 55%, J2's trailing P/E multiple is now just slightly above the 5-year historical average (see chart below).
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The stock's forward P/E multiple has expanded by 20% over the past 6 months from 11.9x to 14.3x, which may seem to be significant. However, considering the facts that the company's consensus revenue, EBITDA, and EPS estimates for the current and next fiscal years have all experienced very substantial upward revisions over the period and that the firm's consensus 5-year earnings growth estimate has also been raised from 7.6% to 10.8%, the 20% multiple expansion is completely warranted (see charts below, sourced from S&P Capital IQ).
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Further, although the forward multiple gap between J2 and S&P 500 Index has narrowed from 12% to 6% over the 6-month period (see chart below), the below-market valuation still looks very compelling as I believe J2's current fundamentals and growth potential should reasonably command an above-market valuation provided that 1) J2's 5-year consensus earnings growth estimate at 10.8% is notably above the average estimate of 8.2% for the S&P 500 Index; 2) J2's various operating metrics including profitability margins, ROE, ROIC, and free cash flow margin are markedly above the market averages; and 3) J2's current dividend yield is in line with the S&P 500's average and the stock price is also supported by the buyback program.
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I also performed a 10-year DCF valuation to gauge the various assumptions that are implied by the current share price (see DCF template below).
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To yield a share value close to the current price of $42.30, the following key assumptions were incorporated in my model:
1) Revenue growth rate was assumed to decline from 4.6% in 2014 to 1.5% in the terminal year, representing a 10-year CAGR of just 3.0%. It is noted that J2's management has indicated the company's organic growth would likely to be around 8% year-over-year over the medium term, while the current model assumption is substantially below that expectation.
2) EBITDA margin was assumed to be constant at 43% from 2015 to the terminal year. This margin assumption was also much more conservative than management's expectation that the margin will potentially expand over time (currently at 46.5% as of March 31, 2013 on a trailing 12-month basis) as a large portion of the Media segment's cost is fixed while the segment revenue would continue to grow.
3) Depreciation and tax rates were forecasted based on their historical percentage to the total revenue.
4) Capital expenditure as percentage of the revenue was assumed to rise from 2.5% in 2013 to 7.0% in 2019 to account for the case that J2 may increase spending to boost the Media segment performance. The ratio was then modeled to decline to 4.0% in the terminal year. It is noted that the ratio estimates are considerably above the historical range.
5) Net working capital investment was projected based on its historical relationship with the total revenue.
6) A WACC of 10.7% was used. The assumptions used in the calculation were conservative. For example, a 3.5% company specific risk premium was added to account for the financial projection risk (though a number of them were already very conservative).
Apparently, the current share price has not priced in any upside resulted from future acquisitions. Even for the organic growth case, the current share price has only baked in a very conservative scenario.
Upside Driver 3 - Dividend Hike and Increased Share Repurchase
Due to the strong cash flow generation, J2 initiated its first dividend of $0.20 per share in August 2011. Since then, the dividend payment has been raised 7 times and by 20% to the current $0.24 level. As the Cloud business continues to generate steady cash flow with additional contribution from the high-growth Media segment, it is expected that management would continue raising the dividend and size of share buyback. Based on my liquidity analysis discussed previously, the probability that J2 would sacrifice the dividend growth for continued M&A expansion is likely to be low as the firm is currently sitting on a large cash balance and also has an ample borrowing capacity.
Conclusion
J2's strong profitability and cash flow generation allow management to continue executing the organic and M&A expansion strategy. As the current share valuation has not yet matched the company's fundamentals and growth prospects, I would strongly recommend buying the shares at the current level. My target share price of $52 is 23% above the current price and is derived from a revised DCF model with more reasonable revenue, EBITDA, and capital expenditure assumptions (see DCF model below). Based on the consensus next 12 months EPS estimate of $2.99, my $52 price target implies a forward P/E multiple of 17.4x. Factoring in J2's consensus 5-year earnings growth estimate of 10.8%, the stock's 5-year PEG ratio of 1.7x remains below the S&P 500's average of 1.8x (calculated with 15.1x forward P/E and 8.2% long-term earnings growth estimate). It should be noted that my $52 target is still not reflective of any future M&A upside, and as such, potential return could be even higher.
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All facts and data used in the article are sourced from S&P Capital IQ, company financial filings, and company presentation unless otherwise specified.
Disclosure: I am long JCOM. 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.
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