It is important for investors to pay attention to year-to-year changes in the language used throughout a company’s 10-K, as changes the company’s lawyers force it to insert can reveal vital clues about the company. Don’t take my word for it, Jim Chanos says it.
Examining J2 Global Inc (NASDAQ:JCOM) ’s 10-Ks over the past few years shows an interesting history of changes to the Item 1A. Risk Factors section.
The biggest change that caught my eye is the addition of a new risk factor for the 2006 10-K about customers disputing credit card charges.
If we experience excessive fraudulent activity or cannot meet evolving credit card company merchant standards, we could incur substantial costs and lose the right to accept credit cards for payment and our subscriber base could decrease significantly.
A significant number of our paid subscribers authorize us to bill their credit card accounts directly for all service fees charged by us. If people use our services using stolen credit cards, we could incur substantial third-party vendor costs for which we may not be reimbursed. We also incur losses from claims that the customer did not authorize the credit card transaction to purchase our service. If the numbers of unauthorized credit card transactions become excessive, we could be assessed substantial fines for excess chargebacks and we could lose the right to accept credit cards for payment. In addition, credit card companies may change the merchant standards required to utilize their services from time to time. If we are unable to meet these new standards, we could be unable to accept credit cards. Substantial losses due to fraud or our inability to accept credit card payments, which could cause our paid subscriber base to significantly decrease, could have a material adverse effect on our business, prospects, financial condition, operating results and cash flows.
Do a quick Google search for the terms “efax cancellation,” “myfax cancel account,” “efax ripoff,” or something similar and read the reports or watch the recordings of users trying in vain to cancel the service. After you see those, it’s not a surprise that the above language would have been added to the 10-K. My guess is credit card companies received complaints about unauthorized billings from frustrated users unable to cancel their service and put j2 Global on notice that if they had continued complaints, j2 would no longer be able to accept credit cards. j2’s lawyers then forced the company to disclose this fact in a roundabout way in the 10-K. Since this language is still in the 2011 10-K, it would be safe to conclude that the chargeback issue has not been resolved.
The company also added another gem about credit and debit cards. Starting in 2009, it appears just below the above disclosure.
Increased numbers of credit and debit card declines as a result of decreased availability of credit and/or a weak economy which continues to experience heightened levels of unemployment could lead to a decrease in our revenues or rate of revenue growth.
A significant number of our paid subscribers pay for their services through credit and debit cards. Weakness in certain segments of the credit markets and in theU.S.and global economies, which continue to experience heightened levels of unemployment, has resulted in and may continue to result in increased numbers of rejected credit and debit card payments. We believe this has resulted in and may continue to result in increased customer cancellations and decreased customer signups. This also has required and may continue to require us to increase our reserves for doubtful accounts and write-offs of accounts receivables. The foregoing may adversely impact our revenues and profitability.
The company also changed how it disclosed risks around growth. In 2005, the company had what looked like your general, generic disclosure that it might not be able to continue to grow. Nothing alarming here. Every company has some form of this in its 10-K.
We may be unable to sustain growth.
We may not be able to sustain growth on a quarterly or annual basis in future periods. Also, we cannot assure you that we will be successful in executing our growth strategy or that achieving our strategic plans will enable us to sustain the levels of profitability we have experienced in the past. Failure to successfully execute any material part of our strategic plan or growth strategy could significantly harm our business, prospects, financial condition, operating results and cash flows.
But for 2006 the disclosure changed to this much more detailed one.
In order to continue sustaining our growth, we must continue to attract new paid subscribers at a greater rate and with at least an equal amount of revenues per subscriber than we lose existing paid subscribers.
We may not be able to continue to grow or even sustain our current base of paid customers on a quarterly or annual basis. Our future success depends heavily on the continued growth of our paid user base. In order to sustain our current rate of growth we must continuously obtain an increasing number of paid users to replace the users who cancel their service. In addition, these new users must provide revenue levels per subscriber that are greater than or equal to the levels of our current customers or the customers they are replacing. We must also retain our existing customers while continuing to attract new ones at desirable costs. We cannot be certain that our continuous efforts to offer high quality services at attractive prices will be sufficient to retain our customer base or attract new customers at rates sufficient to offset customers who cancel their service. In addition, we believe that competition from companies providing similar or alternative services has caused, and may continue to cause, some of our customers or prospective customers to sign up with or to switch to our competitors’ services. These factors may adversely affect our customer retention rates, the number of our new customer acquisitions and/or their usage levels. Any combination of a decline in our rate of new customer sign-ups, decline in usage rates of our customers or decline in customer retention rates may result in a decrease in our revenues, which could have a material adverse effect on our business, prospects, financial condition, operating results and cash flows.
I am guessing this is the year the company saw subscriber growth begin to drop off precipitously and embarked on its quest to buy subscriber growth. Indeed, the disclosure explicitly mentions acquiring new subscribers via acquisition.
Those two risk factor disclosures regarding growth were the first risk factors the company disclosed in each 10-K. Then for 2007 the company abruptly switched gears and led off with the following.
Weakness in the financial markets and in the economy as a whole has adversely affected and may continue to adversely affect segments of our customers, which has resulted and may continue to result in decreased usage levels, customer acquisitions and customer retention rates and, in turn, could lead to a decrease in our revenues or rate of revenue growth.
Certain segments of our customers – those whose business activity is tied to the health of the credit markets and the broader economy, such as banks, brokerage firms and those in the real estate industry – have been and may continue to be adversely affected by the current weakness in the credit markets and in the broader mortgage market and the general economy. To the extent our customers’ businesses have been adversely affected by these economic factors and their usage levels of our services decline, we experienced and may continue to experience a decrease in our average usage per subscriber and, therefore, a decrease in our average variable revenue per subscriber. In addition, continued weakness in the economy has adversely affected and may continue to adversely affect our customer retention rates and the number of our new customer acquisitions. These factors have adversely impacted, and may continue to adversely impact, our revenues and profitability.
The company was now blaming the economy for results, rather than its increasingly strained fax business. The economy blame game continues as of the latest 10-K.
Lately j2 has taken to rebranding itself as a cloud computing company. The company makes reference to developing its brands and other usual marketing nonsense. (In all fairness to j2, most companies’ marketing and brand strategies are nothing but b-school buzzword gibberish.)
Our growth will depend on our ability to develop our brands and market new brands, and these efforts may be costly.
We believe that continuing to strengthen our current brands and effectively launch new brands will be critical to achieving widespread acceptance of our services, and will require continued focus on active marketing efforts. The demand for and cost of online and traditional advertising have been increasing and may continue to increase. Accordingly, we may need to spend increasing amounts of money on, and devote greater resources to, advertising, marketing and other efforts to create and maintain brand loyalty among users. In addition, we are supporting an increasing number of brands, each of which requires its own resources. Brand promotion activities may not yield increased revenues, and even if they do, any increased revenues may not offset the expenses incurred in building our brands. If we fail to promote and maintain our brands, or if we incur substantial expense in an unsuccessful attempt to promote and maintain our brands, our business could be harmed.
The funny part (besides the fact that the company thinks its customers are loyal to its brand rather than the fax phone number they can’t port that is plastered all over their business marketing materials) is that because j2 isn’t actually a cloud computing company, it’s still forced to disclose that it is, in fact, sadly, a fax service company.
We rely heavily on the revenue generated by our fax services.
Currently, a substantial portion of the overall traffic on our network is fax related. Our success is therefore dependent upon the continued use of fax as a messaging medium and/or our ability to diversify our service offerings and derive more revenue from other services, such as voice, email and unified messaging solutions. If the demand for fax as a messaging medium decreases, and we are unable to replace lost revenues from decreased usage of our fax services with a proportional increase in our customer base or with revenues from our other services, our business, financial condition, operating results and cash flows could be materially and adversely affected.
We believe that one of the attractions to fax versus alternatives, such as email, is that fax signatures are a generally accepted method of executing contracts. There are on-going efforts by governmental and non-governmental entities, many of which possess greater resources than we do, to create a universally accepted method for electronically signing documents. Widespread adoption of so-called “digital signatures” could reduce demand for our fax services and, as a result, could have a material adverse effect on our business, prospects, financial condition, operating results and cash flows.
Also of interest is the company’s new for 2011 disclosure of several tax related investigations to which it is subject.
We may be subject to examination of our income tax returns by the U.S. Internal Revenue Service and other domestic and foreign tax authorities. We are currently under audit by the California Franchise Tax Board (“FTB”) for tax years 2005 through 2007 and by other state taxing authorities for various periods. The FTB has also issued Information Document Requests regarding the 2008 tax year, although no formal notice of audit for 2008 has been provided. The Company is also under audit by the IRS for tax year 2009 and has received verbal notice from the Canada Revenue Agency regarding an audit of value added sales taxes for tax years 2009 through 2011. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our income tax reserves and expense. If our reserves are not sufficient to cover these contingencies, such inadequacy could materially adversely affect our business, prospects, financial condition, operating results and cash flows.
That is all for the first part of our exposé on j2 Global. In part two, which will be coming out shortly, we will look at how the difference between the length of time the company amortizes acquired customer relationships and the length of time the average customer uses the company’s service as implied by the disclosed monthly churn rates. Then stay tuned for part three where we will look at the how the company accounts for the many acquisitions it has made over the past decade.
By Ben Strubel of Strubel Investment Management, LLC
Disclosure: No positions, but we may initiate a short position in JCOM in the next 72 hours.