United Online UNTD
July 09, 2002 - 6:55pm EST by
2002 2003
Price: 10.68 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 430 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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United Online is a discount internet service provider formed by the merger of Net Zero and Juno late 2001. Net Zero and Juno were "free ISP" models which were kind of stupid in hindsight. But they raised a ton of cash from Wall Street which built their infrastructures, and $130 million of that cash is left over on the balance sheet.

So we had two penny stocks merge, both with extremely soft shareholder bases and a "free" business model widely known to be silly. So what are we doing buying this at a 500% gain off the bottom?

Almost immediately after the companies merged last year, management changed the losers game they were in. They told their 6 million non-paying users, "OK guys, we will still provide a free alternative, but we are going to limit free use to 10 hours per month." After a customer hits 10 hours in a month, their account shuts down unless they upgrade to a $9.95 a month subscription.

The result was that hundreds of thousands of members began paying. Yeah, free was nice, but with AOL and Earthlink charging $23.95 and $21.95 repectively, $9.95 for unlimited service is still a great deal. But they left the free offering in place, with a free download on the internet. This generates a flow of new potential paying customers of which they can then upgrade some percentage.

Compared to AOL, Microsoft and Earthlink spending like crazy to attract new customers (and they are finding the market to be saturated), United's new model of customer acquisition is proving superior. It is costing them virtually nothing to grow their customer base by 8 or 9% each quarter.

What makes this stock so interesting is that it has just achieved profitability (defined as free cash flow), and is likely to continue growing. Every new subscriber is additive to free cash flow, and if current trends continue the forward free cash flow multiple is going to get very interesting if some conviction were to build about the future - i.e. a few more quarters of growth.

United Online has a very attractive proposition in an industry that is commoditizing. Their price is half of AOL, Earthlink and MSN. They have a cost structure that can make money at a $9.95 per month price point if they can continue to grow. And their major competitor, AOL, has what, 35 million subscribers at $23.95 a month? AOL will have a very hard time defending against United - what are they going to do? Lower their price? Run that through AOL's income statement - every dollar of reduced price costs them $350 million a month, over a billion dollars a quarter. United should be able to pick off AOL customers for a while with AOL unable to respond. AOL will continue to provide a price umbrella which will allow UNTD to grow. United is small enough (1.6 million paying subscribers) that they can grow significantly without really bothering AOL enough for AOL to want to take the very hard medicine required to defend their franchise.

United Online was in Barrons this weekend as a top pick of a reformed internet analyst. Interesting in that he comes at it from that side, because this is also one of my biggest positions and I am no reformed internet analyst. I'm a traditional Graham value investor hunting for busted growth stocks that are still growing, and trading at cheap prices.

United Online's Business is Doing Very Well
United Online has about 1.6 million subscribers, 138,000 added in the March quarter. There are only two quarters of data since the merger, so there is not a lot to go on here, but so far their guidance has been very conservative - they've beaten expectations big and I suspect they will continue to do so. I don't ordinarily buy stocks based on beating expectations, but this is a growth story where expectations matter, so lets explore what is built into the price. 1.6 million subscribers growing at 138,000 in the most recent quarter is what we know. What does that number mean?

Well first let's note an enterprise value of about $320 million (there's a big pile of cash on the balance sheet). That's $200 per subscriber. Seems pretty cheap on the surface for subs paying $120 a year with that sub base growing and a very scalable business model.

Let's look at the economics. The revenues from a net new subscriber are about $10 a month times 12 months = $120. Taking the March pace of subscriber additions, each quarter they are growing the top line annual sub rate by 138,000. There is some seasonality to this business, so you don't want to extrapolate off a March quarter. So I reduce that to 80,000 a quarter as a run rate. That's below what the company is guiding to and so far their guidance has turned out to be very conservative. 80,000 x $120 = $9.6 growth in the annual revenue run rate next quarter.
The contribution margin of the next new subscriber is about 50%, and given the company's history taxes aren't going to be an issue for a while. I'm thinking free cash flow here. So each quarter the annual free cash flow run rate is increasing by about $5 million. ($10 a month per sub x 12 months x 80,000 new subs x 50% contribution margin x (1- 0% tax rate). Remember, $320 million enterprise value, but starting point is a little above breakeven free cash flow. So the annual free cash flow run rate is going 5, 10, 15, 20 quarterly. Four more quarters of that and we're talking a very interesting valuation, especially because I know they guys I'm going to sell this to are the types that buy on forward free cash flow (which I guess I'm doing here too - not my typical thing) I think my numbers may be quite conservative.

Bigger Picture Valuation
Tech does not equal growth. A growth stock might in the future be defined not as a tech stock, but as a business that is actually growing.

The most intuitive way of thinking about United Online is that this company is positioned to grow - and is in fact growing - in a dial-up internet access market that is probably shrinking over the coming years in favor of broadband. They had 1.6 million paying subscribers at the end of March. At 2 million subscribers I'd estimate they will be able to do $36 million of free cash flow. At 2.5 million subscribers, free cash flow could be in the $65 million range. Enterprise value is $320 million and the company is growing.

Using what I consider reasonably conservative growth estimates over the next three years and then capping the free cash flow run rate at that point at 15 times, discounted at 12%, I get to a valuation of $20 a share, almost double the current stock price. I could argue for a "better case" target price with a 3 in front of it if things go better than conservative expecations.

The business is fairly easy to model, and what you'll find if you do so is a free cash flow machine if things work. The business has negative working capital ex-the discretionary cash (i.e. - spits out more cash the faster it grows), and has enormous operating leverage.

There is one big hidden catalyst. Pricing strategy. Keeping price constant at $9.95 a month (that's all that was in the forward numbers I referred to above) is good enough to get a valuation well north of $20. The real wake-up call on United comes when you ask (and quantify) what happens if they raise the monthly price by two dollars? They would still be at half of AOL's price (and AOL seems to want to raise prices more, though that is going to be tough with broadband at $39.95 and falling). The leverage to a price increase is enormous and I suspect if management's strategy succeeds at growing subscribers for a couple more quarters, they'll raise prices. I think we'd have a homerun with United if they execute a $2 price increase.

The CEO has what might be seen as a checkered past, but he knows consumer marketing and that's the game we're in here. (He also knows how to run up a stock). The CFO is an ex- investment banker who left for the "easy money" of the internet bubble. So we're not dealing with Buffett management here. But their actions since the merger late last year have been strategically brilliant, and they are demonstrating in every way I can see that they are a company that gets it that its time to be profitable. We have talked to them and they know what a shareholder is and we're pretty comfortable with who's in charge.

The risk here is subscriber growth. I have little doubt that dial-up ISP is going to decline in the future - this case is based on United increasing its small market share. They have no credible broadband strategy - that's where the growth in ISP is going to be. This is one of the few stocks I own where I know the quarterly numbers really matter.

My recommendation is to buy UNTD below 12 (and very aggressively if you see it below 10) with an $18 price target that could be raised considerably if a few things go right. Those things will become visible in the next couple quarters.


1) Despite the price increase off the bottom, the stock is still early in the discovery process. (that might sound ridiculous to you given the chart, but just think of what this situation looked like when the merger of two failed $2 stocks took place last October and think who owned the stock then) My case is by no means consensus, and I get the sense the stock is not at all something value investors are looking at. A couple more quarters of decent subscriber growth and this will be a core growth holding because it will be one of very few "internet" companies that is profitable and actually growing.
2) A price increase would be hugely accretive to earnings, and I think we've got a company with hidden pricing power because they are so far below their competition.
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