Focus Article: magicJack VocalTec Ltd. (CALL)

magicJack VocalTec (CALL) $22.66

The Company:

magicJack is a small device that can be plugged into a USB port and allows unlimited calling from regular phones. The device was created by Dan Borislow and sold through a company called YMAX Communications.

VocalTec Communications was founded by Lior Haramaty and Alon Cohen, who also invented the Audio Transceiver that enabled the creation of Voice Over Networks product and eventually the VoIP industry. In his article, ‘The voice over IP insurrection’, Om Malik mentioned, ‘Two entrepreneurs barely out of their teens, Lior Haramaty and Alon Cohen, founded VocalTec Communications in 1993 based on the promise of packet voice technology they observed as members of the Israel Defense Force…. the idea of commercializing packet voice did not occur to anyone until the arrival of Lior and Alon‘.

YMAX Communications went public in July 2010 through a reverse merger with VocalTec and the stock has had a great run from the post merger price of $8.25 to current levels. Mr. Borislow was appointed President and Chief Executive Officer of the combined company upon the consummation of the merger. The combination of patents that VocalTec held and softphone/softswitch technology that magicJack owned was one of the drivers of the merger.

The company sold over nine million majicJacks and has the use of over 30 patents. In 2011, the company introduced magicJack Plus. To use the original magicJack device, one had to be plug it into a computer connected to the internet, but the magicJack Plus connects directly into a router or a broadband modem.

The new device costs $69.95, versus the $39.95 price for the original magicJack. The first year of service is included in the purchase price of the device and renewal after the first year is $29.95 or $99.75 if the subscriber pays for 5 years. The company is selling the product directly (it is hard not to come across one of their infomercials on TV) as well as through partnerships with retailers like Best Buy, Amazon.com and Walgreens.

Strong sales of magicJack Plus helped the company cancel a proposed stock offering and the company has instead asked the board to reinstate its stock buyback plan with a $20 million commitment. As indicated in our daily report last week, the company recently forecast revenue growth of 20-30% in 2013 and expects to earn between $2 to $2.50 per share before “extraordinary items”.

Business Statistics & Financials:

In 2011, the company generated $110.45 million in revenue and posted a small GAAP loss of $836,000. While revenue declined year-over-year, net loss also declined and cash flow from operations was higher at $25.33 million. Since subscribers pay for service up-front, the company has to recognize the revenue over the period of the contract and hence carries a line for deferred revenue on its balance sheet.

The company spent $32 million on advertising and just $2.7 million or 2.4% of revenue on R&D. Provision for doubtful accounts (read refunds) was unusually high at $16.4 million.

For the first quarter of 2012, the company expects revenue of $37.4 million and earnings of $7.8 million or $37 cents per share before any adjustments. Excluding adjustments, the company expects to earn approximately 26 cents per share compared to 8 cents per share in Q1 2011. Revenue in Q1 2011 was $30.8 million, indicating revenue growth of 21%.

Although the company looks very interesting on the surface, a number of red flags showed up as I dug further into magicJack. While the company reports the total number of magicJack’s sold (over 8 million in an April 9, 2012 press release and over 9 million in an April 16, 2012 press release), it does not break out the number of new subscribers nor does it report on churn amongst existing customers. Without metrics like the cost of acquiring new customers, average revenue per existing customer (ARPU) and churn, it is difficult to analyze a telecom business.

Competitors:

One of the major competitors for majicJack today is netTalk, which is a similar device and can be used to make unlimited calls and also has the facility of number portability just like magicJack. On April 4, 2012, magicJack filed a lawsuit against netTalk for patent infringement.

Insider Buying:

Three insiders purchased stock on the open market over the last six months as listed below. You can view a list of all insider transactions for magicJack VocalTec here.

Risk Factors:

1. While the company does not report churn rates amongst existing subscribers, the number of customers canceling the service is probably high based on the high provision for doubtful accounts. The other possibility is that the company is recognizing revenue up-front during the 30 day free trial period it offers and  puts aside money to refund customers who decide to cancel the service before the end of the trial period. Both these possibilities do not instill confidence in the business.

2. The company appears to be doing a great job with advertising and converting people but is not doing much to bolster customer retention as evidenced by the lack of quality customer service. Their website seems to one huge advertisement and it took a lot of digging for me to figure out the renewal costs following the first year of service.

Conclusion:

magicJack has addressed one of the main concerns of its customers (keeping a computer turned on all the time to use their service) with their new magicJack Plus device and as a result is seeing strong adoption and growth. Having a founder CEO who managed to grow the business to $100+ million in revenue is also a positive factor in my book.

While magicJack’s growth and valuation are attractive, the red flags I noticed do not give me as much confidence as I would like. Moreover with positions in both Vonage (VG) and ShoreTel (SHOR), I already have positions covering both the consumer and business side of VOIP and I do not want to add yet another company in the same segment to my portfolio.