| 2006 | 2007 | ||||||
| Price: | 7.50 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 186 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
| Borrow Cost: | NA | ||||||
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****please note. This was written over the weekend, using Friday's closing price. The stock is down today on no news -- we're not sure why yet. Even at current intra-day prices, DFXN is an attractive short for small investors who can get the borrow.****
This is a recommendation to sell short DFXN. Digital FX International (OTCBB: DFXN) is an online video technology company developing video email, video instant messaging, and video social networking. The company charges premium fees (ranging from $10 to $200 per month) for its services, despite the fact that their offerings are virtually identical to free services from the likes of Apple, Microsoft, Yahoo, Google, AOL, Myspace, Skype, and a host of other companies. Facing such marquis competition, and with no brand name or competitive strengths of their own, the company has come to rely on a multi-level marketing sales model. For the time being, this has been successful – revenues have grown rapidly in 2006, and the current revenue run rate is almost $32 million (based on the last two quarters). However, the vast majority of these revenues are of the “selling the business opportunity” type, not the “selling end users a service they need and use” type. What’s more, the benefits of a high gross margin online business are essentially wiped out by the affiliate commissions, making the potential for sustainable earnings power even more dubious. The market, in a momentary lapse of efficiency, has priced DFXN at $186 million, a valuation that equates to 8.25 times 2006 sales and 137 times operating income. Eventually, this company is likely to be a zero; in the meantime, short sellers can benefit as the company burns through its supply of affiliates and end users from both ends, and as Internet users become more comfortable with the wide range of free video creation and distribution tools available from all of the brand name Internet companies.
A short note on multi-level marketing
At this year’s Value Investing Congress, the reformed felon Barry Minkow (of ZZZZ Best fame) spoke about his belief that the multi-level marketing business was rife with false promises, fraud, and the potential to lose investors lots of money – and thus attractive, potentially, as a short. In particular, he noted the incredible churn rate of affiliates, the over-reliance of MLM companies on revenues from affiliates buying their “franchise,” and the fact that even for affiliates, “the business opportunity is the business opportunity.” That is to say, most affiliates earn their commissions from recruiting other affiliates, not from selling end users a service they need or use. Minkow’s presentation contained this testimony from a 20 year MLM veteran, which Minkow found on the home page of a self-help guru by the name of Luke Setzer:
Selling
a product-based deal is fine, but the idea of marketing a business opportunity
to prospects when we know the numbers is not ethical for us. In its purest
form, MLM is a viable method of marketing if its focus is on products and not
primarily the business. Selling the dream of financial independence with MLM is
a mirage for 90+% of distributors. The MLM industry statistics are that on
average only 10% of distributors
get
a commission check each month. Of that 10%, 80% do not make enough to sustain
themselves as a full-time income. The distributor churn rate is terrible.
Any
way you cut it, MLM statistically does not work for 90+% of those involved. And
those who make the big bucks are in a more elite group--usually 1/10 of 1% of
all distributors. We found that we could not ethically sell the MLM dream of
financial independence for all. It is impossible. For me to get $10,000+ a
month, I have to build this on the backs of all the users, consumers, and
little people--the ones who buy their $100 a month of whatever and don't get a
check. This money flows upline to distributors and back to the company from
people who don't make their monthly qualifications.
http://attitudeadjustment.tripod.com/Essays/MLM.htm
While one can argue the finer points of this thesis, it
should be self-evident that MLM works best for products with strong brands and
some sort of exclusivity and usefulness – think
The company
Digital FX International offers a variety of services, all built around the idea of user-generated video and using video as a communication tool.
A customer cannot simply sign up for HelloWorld or FirstStream, as they would on a site like Myspace. They must be sold an account package from a company affiliate. Fees start at $9.95 per month for consumers, and scale up to $39.95 per month, with more expensive plans for business end users. Bear in mind that these are costs for end users, not for affiliates. Details of the fee structure are available here:
http://www.vmdirect.com/root.custom/vmd/US/become_a_customer.html
For this monthly cost, DFXN provides users the following services. More expensive plans come with a richer feature set and fewer restrictions on bandwidth and storage usage.
Ultimately, these services have no competitive advantage. We’ll go through each one individually.
The last point – that virtually no one is actually using HelloWorld – is an interesting one. Alexa.com, a service run by Amazon, is a useful free tool for measuring the usage and growth rates of competing web services. The numbers it produces are not exact, but for our purposes, show very useful trends. The following graph shows a six month trend for page views per million Alexa users on HelloWorld.com
http://www.alexa.com/data/details/traffic_details?q=helloworld&url=http://www.helloworld.com/
Alexa doesn’t allow for linking directly to more advanced graphs, but you can add Myspace.com and Youtube.com to the graph by using the text boxes at the bottom of the chart. Click on the Page View tab, and you’ll be able to compare page views across all three sites – HelloWorld, Myspace, and Youtube. You’ll see that each site gets hundreds, if not thousands, of times more traffic than HelloWorld.
A quick trip over to HelloWorld.com tells a similar story.
Clicking on the “helloMembers tab” allows you to search for members. We did a
simple search for women aged 18 to 30 located in
The affiliate business model
New affiliates must purchase “starter packages” that enable them to sell accounts to end users and to enroll other affiliates below them in the pyramid. Starter packages run from $69 to $1999, with recurring, monthly service fees starting at $49 per month and escalating to $199 per month for the “Chief Executive” package. The company’s affiliate
compensation scheme is one of the most Byzantine financial documents I’ve ever read, but for the purposes of our discussion, it’s enough to point out that only those affiliates who sign up for the $999 starter package (plus a $99 per month service fee) and up are eligible for the best benefits that come with signing up additional affiliates below them. The various packages are explained on this web page:
http://www.vmdirect.com/root.custom/vmd/US/affiliate_packages.html
Affiliate sales are a very high margin source of revenue for DFXN, as the cost of goods sold consists almost exclusively of a webcam bundled into each package. All the other components of the package – training CDs, membership in Helloworld.com – cost the company virtually nothing to deliver.
As you might expect, the company’s affiliates are very web savvy, and there are dozens, if not hundreds of sites maintained by VM Direct affiliates. Searching Google for “VM Direct” will turn many of them up, and you can see from the sites they maintain that they focus the vast majority of their efforts on selling the business opportunity, rather than selling the end users valuable and useful services.
The financials
On the surface, Digital FX would appear to be in the midst of a remarkable growth spurt. Here’s the statement of operations from the most recent 10QSB.
|
In
thousands, except share count & EPS |
|
Nine months ended 09/30/06 |
Nine months ended 09/30/05 |
|
Revenue |
|
16,232 |
2,876 |
|
|
|
|
|
|
Cost of revenue |
|
3,272 |
808 |
|
|
|
|
|
|
Gross profit |
|
12,960 |
2,068 |
|
|
|
|
|
|
Commission expenses |
|
7,582 |
1,236 |
|
Other opex |
|
4,328 |
1,772 |
|
|
|
|
|
|
Operating income |
|
1,050 |
(940) |
|
|
|
|
|
|
Forex loss |
|
635 |
-- |
|
Other expenses |
|
46 |
18 |
|
|
|
|
|
|
Pretax income (loss) |
|
369 |
(958) |
|
|
|
|
|
|
Net income |
|
201 |
(958) |
|
|
|
|
|
|
Shares |
|
24,831,236 |
19,917,435 |
|
|
|
|
|
|
EPS |
|
0.01 |
(0.05) |
Clearly, the sales growth has been excellent. But as the numbers above make clear, commission expenses paid to affiliates eat up much of the cash flow that the company generates, revealing just how low quality most of this revenue is. In fact, the risk factors section on the 10Q reveals even more about the nature of these revenues. We quote:
NINETY FIVE PERCENT OF OUR REVENUES FOR THE NINE MONTHS
ENDED SEPTEMBER 30, 2006 HAVE BEEN DERIVED FROM SALES TO OUR MULTI-TIER
AFFILIATES, AND OUR FUTURE SUCCESS DEPENDS ON OUR ABILITY TO CONTINUE THE
GROWTH OF OUR AFFILIATE BASE, AS WELL AS TO EXPAND OUR SUBSCRIPTION AND
ADVERTISING BASED REVENUE MODELS.
To us, this is the definition of a bad business – the company is making 95% of its sales by charging initial and recurring monthly fees to their affiliate marketers, who in turn have proven incapable of selling the company’s low value, premium priced services. As these affiliates churn out – the company doesn’t disclose their affiliate count or churn – that source of 95% of revenues will disappear with them.
Additionally, much of the growth in 2006 was the result of a one-time change the company made to its compensation package. DFXN amended the affiliate rewards available to purchasers of the low cost $69 starter package, making them ineligible for the recurring income and bonuses that accrue to members as they sign up additional affiliates into their network. To be able to build such a network, users must now purchase the more expensive packages ($999 and up with $99 per month in ongoing service fees payable to the company). As the company discloses in their 10Q, in 2005, 53% of affiliates purchased the lowest cost package, but in 2006, spurred by the changes to the compensation model, only 28% of affiliates purchased the low cost model. With many affiliates paying $69 to $199 per month on these more expensive packages (and generating virtually zero income on the additional expense, as evidenced by the affiliate/end user revenue mix), we view this benefit as a one time change that’s unlikely to be repeated.
The Valuation
The company has provided guidance for full year 2006 and 2007 revenues and income. 2006 revenue should be $22 million, and the company projects $50 - $60 million in 2007 revenue, with operating margins of 10% to 15%. Year to date operating margins are about 6%, the number we’ll use for our 2006 full year estimate. For valuation, we’ll simply use the market cap, since the company has no excess cash and no long term liabilities.
|
In
thousands, except share count & EPS |
|
2006 |
2007 base case |
2007 high case |
|
Revenue |
|
22,500 |
50,000 |
60,000 |
|
|
|
|
|
|
|
Operating margin |
|
6% |
10% |
15% |
|
Operating income |
|
1,350 |
5,000 |
9,000 |
|
|
|
|
|
|
|
Shares outstanding |
|
24,831,236 |
|
|
|
Stock price |
|
$7.50 |
|
|
|
Market cap |
|
$186 million |
|
|
|
|
|
|
|
|
|
Price to sales |
|
8.25 |
3.72 |
3.1 |
|
Price to op income |
|
137 |
37.2 |
20.66 |
Clearly, no company with such a terrible product and revenue model should trade at a valuation anywhere near the price of DFXN. Furthermore, we expect the company to fail to achieve 2007 guidance, due affiliate fatigue and the defection of the few end users to free services like Myspace, Youtube, Skype, etc.
Given the competition the company faces – and the fact that all competitors offers their service for free or close to it – we expect DFXN to eventually go bankrupt, though that could take years. In the meantime, investors can profit on the short side from (i) valuation correction, (ii) failure to meet 2007 guidance, (iii) greater investor awareness of the company’s story, and (iv) a rapid deterioration in the company’s fundamentals when they finally wear through the patience and the wallets of their affiliate base.
The management and the background
Craig Ellins and Amy Black founded DFXN in 1996, and since then it has operated under a variety of different names, including Razorstream, VM Direct, and now Digital FX International. For the first nine years of the company’s history, they produced no meaningful revenues and funded the company’s operating losses by constantly selling stock in private placements. In 2004, they received an investment from Richard Kall, a network marketing guru, who prodded the company to adopt its current revenue model. Kall, who is now the Chairman, is featured very heavily in the company’s marketing, which touts him as a “legend” in the network marketing business for having “taken six companies to the top” and bringing “his quick-witted storytelling ability and family-valued culture to the company.” He appears to have written a book or two and to speak at industry events, but he sure doesn’t look like a legend to us:
http://www.vmdirect.com/root.custom/vmd/US/our_company.html
Ellins and Black – who are married to each other – do not
inspire a lot of confidence as public company executives. Before founding DFXN
a decade ago, Craig Ellins was a founder in the late 80s at the Shop Television
Network, an also-ran to Home Shopping Channel and QVC that filed Chapter 11
during the 1990s. His wife, Amy Black, previously was president of a small
tutoring and educational software business. She spent most of her career as a
Management inspires zero confidence, but they don’t appear to be perpetrating any kind of fraud. Rather, they’re just a bunch of small time entrepreneurs who are completely out of their depth competing with the likes of Google and Microsoft and Yahoo, and certainly not capable of effectively guiding a $180 million Internet company.
Conclusion
Digital FX International offers a service with zero differentiation. They sell it for premium prices, despite the fact that their competition – which is a who’s who of the Internet and software industries – offers competing services mostly for free. They have no proven ability to sell to end users; rather they rely on affiliates for 95% of their revenues. The management team has no track record of competing on these levels or of building a successful business. In the long run, this company is likely to go bankrupt as they alienate their affiliate base and succumb to their competition. In the meantime, the stock could go down by over 50% to a more reasonable valuation for such a low quality enterprise.
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