Stamps.com STMP
December 06, 2003 - 9:30am EST by
pgu103
2003 2004
Price: 7.54 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 250 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Stamps.com (STMP) is an under-followed internet company that serves a huge target market and is in the process of rolling out new products right now that have tremendous potential. The company has not hit an inflection point but is likely to in the next year. The downside is limited (by virtue of a large cash balance), the valuation is reasonable and the option value (upside) is huge.

Background

STMP went public in June 1999 at $11/share and did a follow-on offering in December 1999 at $65. The company quickly acquired high dollar office space and cut incredibly stupid marketing deals with the likes of AOL. Oh, and their product, postage provided through the internet, didn’t really work as advertised. The .com era brought plenty of early trial users and all but a handful of them churned before the trial period was over. The basic problem with the product was that you were required to print both the address and postage on the envelope at the same time, A major inconvenience resulted from the fact that each address had to be individually input into a very cumbersome program. The thought of keeping dual Outlook and Stamps.com databases scared off most people. If that wasn’t enough, there was a further problem getting the postage to print correctly.

During 2001, STMP found religion and ousted all of its top management and brought in new management and immediately laid off over 30% of its workforce. The new management acted quickly to get out expensive real estate leases, consolidate space, further pare back staff—basically used some common sense. The cash burn went to almost nothing. One problem remained…the product still stunk.

New Product

In July 2002, the Postal Service granted approval to STMP to offer a product called NetStamps. NetStamps allow users to print postage on sheets of special stickers in any dollar amount and then use the stickers like regular stamps without having to separately input any addresses (e.g., you can now handwrite an address and then place a NetStamp on the envelope). It is literally like printing a regular stamp from your desktop. Until the postage is printed, the stickers have no value. STMP is the only company that has this product. Development of NetStamps took several years and STMP has several patents on the process. For someone else to replicate NetStamps, they would have to come up with a different process and then start from scratch with the Postal Service on approval. STMP does not know of any competitors in the pipeline and thinks it is highly unlikely that someone could develop a process that wouldn’t infringe on at least one of STMP’s patents. One obvious benefit of NetStamps is that it creates a consumable (blank sticker sheets) that can only be purchased from STMP.

Users can print from as little as one stamp at a time to as many stamps as they want. The program is internet driven and extremely user friendly. Yes, I am a STMP customer and would highly recommend it to anyone. I usually print 25 .37c stamps at a time so I can just peel one off and put it on an envelope as needed.

After announcing NetStamps in July 2002, STMP did not even begin marketing the product until early 2003—they wanted to make sure they had the product right. Even then, the company primarily tested various marketing approaches and channels. The management team is very conservative. The company is going to start ramping up the marketing which should create a domino effect as more people use the product, word of mouth will likely be a powerful marketing agent. Speaking of word of mouth, has anyone on this board heard any buzz about Stamps.com since the internet bust? I doubt it and therein lies the opportunity.

Another very popular product is the Shipping Label. These are very convenient for mom and pop sellers on Ebay, Amazon marketplace, etc. In fact STMP cut a deal with Ebay to be integrated with PayPal so that the seller could click an option to print a shipping label as part of the transaction. Ebay, being the 800 pound gorilla, tried to retrade the deal and STMP balked and has subsequently sued Ebay. This doesn’t prevent any Ebay users from using STMP, the product just hasn’t been integrated with PayPal etc. for a one-stop shop. The growth in the Shipping Label product has been impressive and the internet auction market remains a natural market with huge potential for STMP.

Economics

Ok, all that sounds great but will this company ever make any money? The basic economics right now are subscriber acquisition costs of $69 with the NPV of a Power Plan user conservatively estimated by the company to be $220 and Simple Plan user NPV estimated to be $70. Power Plan users constituted 70% of the new user adds during the most recent quarter. Power Plan users typically pay roughly $20 a month to STMP for the service and consumables, Simple Plan users pay $5. Gross margins have been in the 60% area with much room for improvement.

Average monthly churn is 1.8% after the 29 day trial period. Approximately 20% of the customers churn during the trial period. Another way of saying that is that 80% of all customers who try Stamps.com end up as user. In order to calculate the NPV of a user, STMP projects lifetime revenue less direct costs and discounts the cash flow back using a 25% discount rate. The average life of the current user on book is 3.5 to 4 years.

Where does the product go from here?

The number of small/medium size business (i.e., less than 100 employees) totals 42 million. STMP had 313,000 users as of September 30, 2003. Approximately 25% are Power Plan users and this percentage should increase dramatically going forward as exhibited by the subscriber mix in the most recent quarter. With the focus on Power Plan users, STMP expects the acquisition costs to increase to the mid-$70s per subscriber. STMP is going start ramping its marketing in the 4Q but is very cognizant of monitoring ROI.

Starting this year, Microsoft is integrating Stamps.com into its Word 2003 and Outlook 2003 programs. When users go to print envelopes, they will see an option to print internet postage. Current STMP users simply enter their password (I did this the other day and it was seamless). Non-users have an option to register for a trial. With 100 million registered users of Office products, a very low penetration into the Office users could dramatically increase STMP’s subscriber base. STMP pays a fee to Microsoft for each new user acquired through this channel but there is no further sharing of economics.

In my opinion, as STMP’s user base grows, word of mouth advertising will be a significant contributor to customer acquisition. I think I have gotten one piece of mail from another Stamps.com user. NFLX has said that its biggest marketing agent is simply word of mouth (as an aside, a NFLX sub generates $20 of monthly revenue, has an acquisition cost of ~$35 and churns at over 5% per month. NFLX has a little over one million subs, a market cap of $1.1B and a heck of a lot more competition than STMP).

As far as competition for STMP, the primary competitor is the Pitney Bowes postage meter. The only internet postage offered by PB is ClickStamps which is similar to STMP’s original product where you have to input addresses for each item you wish to mail (i.e., the product that stunk). I’m sure many of you have a PB meter in your office. The cost per meter generally runs $30-50 per month including consumables. In addition, PB rivals Bloomberg in the “just try to cancel our contract” category. You must inform PB in writing that you wish to cancel 60 days before the end of the term of the contract or it automatically renews for another year.

Valuation

STMP has cash of $165 million $3.63 per share and no debt. Accordingly, the enterprise value is $86 million or $1.89 per share. STMP has historically been a buyer of its stock although it did not buy any in the most recent quarter. See below in risks discussion.

On an LTM basis, STMP generated $ 21.2 million in revenue and ($7.8) million in EBITDA. True cash flow is masked by the investments made in subscriber acquisition costs that are all currently expensed. If you look at revenue less COGS less all G&A, cash flow from the subscriber base equaled $2.6 million on an LTM basis and $5.8 million on a run-rate basis.

Thus, STMP sells for 15x run rate cash flow for a business that is just now starting down the runway. I think my calculation of $5.8 million is conservative given that it allocates all G&A to the existing business and none to marketing. The only sell-side analyst that follows the company, B. Riley & Co., thinks the cash flow from existing users is $8 million on a run rate basis. This would put the enterprise value at 11x cash flow. STMP has over $250 million in NOLs so I doubt they are going to be a taxpayer for the foreseeable future.

If you value the company’s customer base using the company’s NPV per user, the EV is about $34 million (remember 25% of the current base is Power Plan users). EV/total current user base equals $275 per user.

The main valuation point, I think, is that the company has barely begun to penetrate its huge addressable market and the business model is highly scalable. The difference between user NPV and acquisition cost leaves a lot of room for error. The real question is what is the option value of this company? In the right hands or properly managed, it could be huge. Downside is limited by the hefty cash balance and minimal cash burn.

Another valuation consideration is the question of what is STMP worth to someone else? A short list of possible acquirers would inclue Pitney Bowes, Microsoft, InterActive Corp., JCOM and the U.S. Postal Service. It is really not in PB’s best interest to buy STMP as PB’s meter business is highly profitable for them and promoting NetStamps would certainly cannibalize that business. At this point, PB seems content to just try to make STMP’s life hell (see below). As for the other mentioned candidates, Microsoft is the most likely in my view but I wouldn’t place too high of odds on it happening.

Primary Risks

Pitney Bowes filed a patent infringement against STMP in 1999 (shortly before STMP went public) alleging a patent violation against PB’s ClickStamp product. The case is scheduled to go to trial this coming spring. Assume that STMP loses, the only impact would be on STMP’s original business (yes, the one that stunk) which constitutes 20% of STMP’s business and is going lower as a % of the total.

One major additional point is STMP filed a countersuit alleging a patent violation by PB in its METER product. This is a $4 billion business to PB. This case is also scheduled to go to trial in the spring. It is very difficult to imagine that PB would let this go to trial given the potential downside to them (IGEN/Rouche anyone?). It’s my belief that the most likely outcome is that a settlement will be reached whereby PB drops its suit against STMP and also agrees to pay STMP some royalty for the meter patent. Of course, my view was developed though discussions with STMP. Maybe the royalty is wishful thinking but it is certainly a realistic possibility.

With such a large cash balance, it’s possible that management does something stupid. Discussions about how to best return cash to shareholders have been ongoing (e.g., one-time dividend, stock buy back, etc.). However, until the PB litigation gets resolved, I don’t think we’ll see any major announcement regarding plans for the cash. Fortunately I think the PB litigation gets resolved in the spring time. In the meantime, the company still has its stock buy back authorization.

Catalyst

New products
New marketing initiatives
Resolution of litigation and shareholder friendly use of cash
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