For a great description of the company’s history and customer economics (which haven’t changed much) here is a link to pgu103’s writeup on December 6, 2003 (stock price: $7.54):

http://www.valueinvestorsclub.com/value2/Members/view-thread.asp?id=1233&more=dtrue

Given the depth of pgu103’s write-up and the great detail provided in the company’s 10-K and on their website http://investor.stamps.com/ I will keep the background section short.

Stamps.com® is the leading provider of Internet-based postage solutions operating with 2 reportable segments.

PC Postage Service (78% of rev). The U.S. Postal Service-approved PC Postage service enables users to print information-based indicia, or electronic stamps, directly onto envelopes, plain paper, or labels using ordinary laser or inkjet printers. The service requires only a standard PC, Internet connection, printer and their free software which can be downloaded from the Internet or installed from a CD-ROM. The majority of new customers signing up for service pay a monthly convenience fee of $15.99 with fees ranging from $4.49 to $24.99. The company also sells mail supplies and insurance with revenue reported in the PC postage segment.

PhotoStamps® (22% of rev). PhotoStamps is a patented form of postage that allows consumers to turn digital photos, designs or images into valid U.S. postage. The product is available via a separately-marketed website at www.photostamps.com with 20 stamps for $20 and decreasing prices per stamp for larger orders.

Competiton:

On the PC postage side their 2 primary competitors are Endicia.com and Pitney Bowes.  Both companies have had several iterations of their online offerings (discussed in 10-k) with little success.  Stamps.com’s offering in this area is superior due to brand recognition, a tighter integration with Microsoft Office, and Pitney Bowes’ incentive to not cannibalize their postage meter business.  Based on U.S. Postal service estimates Stamps.com has an 85% market share of the online postage subscription market.

The Internet postage subscription market has significant barriers to entry.  All products must complete extensive testing by the US postal service and this process took stamps.com 2 ½ years alone.  As of right now the company is not aware of anyone else undergoing this process.

The PC postage business also competes with Pitney Bowes’ traditional postage meter business.  However, the stamps.com product costs $15.99 a month compared to an average postage meter of $50 per month.

The Photostamps business also competes with Pitney Bowes who has partnerships with Fuji and Zazzle.com beginning in January 2007 and July 2005 respectively.  Stamps.com estimates they had a 78% market share of customized postage stamps in 2006.

NOL’s:

As of December 31, 2006 the company has $270 mil in NOL’s which equated to deferred tax assets of $103 mil but you won’t find a deferred tax asset on the balance sheet.  This is due to the fact the company has conservatively used a valuation allowance to offset the entire NOL.  I calculated the PV of the NOL at $61 mil by assuming the company would use the NOL over the next 10 years with a discount rate of 10%.  No matter what assumptions you want to make the NOL is extremely valuable because the company likely won’t be paying taxes for at least another 10 years.  Another interesting point on the NOL is that it will become impaired if a shareholder acquires more than 5% of the company.  This 5% limit has probably discouraged larger institutions from taking a position in the stock, and also leaves stamps.com as one of the small caps today without a private equity buyout premium.    

Street Concerns:

Wall Street has hammered the stock (taking it from close to $38 in May 2006 to close to $14 today) due to concerns of slower customer growth and increased marketing spend.  My argument is that one does not need to make heroic growth assumptions to come up with an undervalued stock.  In addition, the stamps.com management team has clearly warned that 2007 would be a year of slower growth as the company revamped and increased investment in their marketing program in order to deliver long-term membership growth.   See the commentary below:

“In March of 2007, we will reach the four-year anniversary of our direct-mail channel investment ramp, and our knowledge of the performance of this channel has continued to grow each year. In 2006, we refined our methods for accurately allocating credit among our various channels, and that analysis showed that our cost per customer acquired in direct-mail was better than previously thought. At the same time, with four years of actual data, we can now more accurately predict our long-term lifetime values of our customers.

Based on our analysis in this area, we think the lifetime value of a direct-mail customer is more than two times higher than the current cost of acquisition. Based on that outstanding return, we plan to increase our investment in this channel by 50% or more in 2007. Note that the growth in this area represents a long-term investment in the business that will pay dividends for several years to come, but it will cause some depression to 2007 earnings.

Further, we plan to drop a large amount of direct-mail in the first quarter of 2007, as we feel it is a period of time that many small businesses are open to our message. Despite the short-term earnings depressions in Q1 and in 2007 as a whole, we feel that this is the right move for the long-term growth of our PC Postage business.” Q42006 Call

“First in our 2007 PC Postage strategy, we plan to increase our investments in all of our existing profitable marketing channels wherever we can. In particular, we continue to refine our understanding of our return-on-investment from the direct mail channel, and based on the most recent returns we plan to increase our investment in the direct mail channel by 50% or more during 2007. This may cause some depression to 2007 earnings, but we believe that is a good long term investment that we expect will pay dividends for several years to come.” 2006 10-K

“First, we told you that we planned to increase our investments in all of our existing profitable marketing channels wherever we can. Based on our analysis last year, we think the lifetime value of a direct mail customer is more than 2 times higher than the cost of acquisition. Based on that outstanding return, we told you that we plan to increase our investment in this channel by 50% or more in 2007.

We dropped a significant amount of direct mail in the first quarter. Note that the benefit of this direct mail spend will mostly hit future quarters. Early indications are that our cost per acquisition in direct mail continues to be very attractive, even with the dramatic step-up in volume. Despite the short-term earnings depression in the first quarter, and for 2007 as a whole, we feel that this increased investment level continues to be the right move for the long-term growth of our PC Postage business.” Q12007 Conference Call

The main impediment to Stamps.com’s long-term growth is getting the message out about the value proposition of their PC postage business in relation to the Pitney Bowes. A couple of quarters of slower growth as the company ramps and refines marketing does not alter the significant long-term opportunity the company has to increase it’s market share

Margin Opportunity

The company’s Photostamps business currently represents 22% of revenues but has been operating at losses or break-even levels.  This is therefore masking the improving profitability of the PC postage business.  Assuming the Photostamps business has always been operating at break-even gives you the following OM’s (backing out stock comp expense for apples to apples) vs. reported numbers.

So on an apples to apples basis the OM of the PC postage business (78% of rev) increased 560 bps in 2006 over 2007.  As reported by the company, the PC postage business has 80% gross margins with little incremental costs to service a new customer. Other than marketing (32% of sales and an increasing expense at company’s discretion) the company should be able to leverage r&d expense, and g&a as PC postage sales increase. In addition, if the company can get the Photostamps business to 10-15% EBIT margins as has been suggested by analysts, there will be between 220 and 330 bps of margin expansion.  So overall there appears to be an opportunity for meaningful margin expansion but I haven’t included heroic assumptions in my valuation section below.      

Share repurchase

One of the major concerns in pgu103’s previous write-up was what the company would do with their $165 mil in cash.  Since then the company has been a prudent allocator by paying a special one time dividend of $77.7 mil and only repurchasing their stock when they believed it was undervalued.

2004: No repurchase, $77.7 mil dividend

2005: $2.3 mil repurchase

2006: $26.7 mil repurchase

2007: As of the 1Q earnings release on April 19^th the company had repurchased $5.3 mil of stock and had $32 mil or over 10% of their market cap authorized.

Valuation:

The company has provided 2007 guidance of $87-$97 mil ($84.6 mil in 2006) in rev and EPS of $0.67-$0.77 ($0.69), numbers which I have used in the model.  In 2008 and 2009 I have tried to use very conservative assumptions about growth rates, margins, share repurchases, and FCF multiples. 

1) Downside Scenario ($17.47 stock price, 10.1% annualized return)

- Rev growth slows from 12% in 2007 to 4% in 2008 and 2009 (note: company’s long-term guidance is for 15-20% rev growth)

- The company gets no leverage and FCF (including interest income and tax benefit) remains constant at 23.6% of sales

- The company lets cash build on the balance sheet and does not repurchase shares or pay a dividend

- The company trades at 12x trailing 2009 FCF (including tax benefit but not interest income)

2) Base Case ($23.30 stock price, 23.5% annualized return)

- Rev grows 12% in 2007 and 10% in 2008 and 2009 (note: company’s long-term guidance is for 15-20% rev growth)

- The company gets no leverage and FCF (including interest income and tax benefit) remains constant at 23.6% of sales

- The company utilizes their annual FCF to repurchase 5% of their shares

- The company trades at 15x trailing 2009 FCF (including tax benefit but not interest income)

3) Upside Case ($28.40, 33% annualized return)

  - Rev grows 12% in 2007 and 15% in 2008 and 2009 (note: company’s long-term guidance is for 15-20% rev growth)

- The company gets 100 bps of FCF conversion expansion annually from leverage and Photostamps becoming profitable

- The company utilizes FCF to repurchase 5% of their shares annually

- The company trades at 15x 2009 trailing FCF (including tax benefit but not interest income)