Why MagicJack Is A Magic Formula Value Trap by Jae Jun, Old School Value

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I don’t have a landline.

And most people I know don’t have one as well unless you are a business.

Everyone has a mobile phone on them and with Google Voice, you can get another phone number.

Then there are all the free VoIP apps that make it so cheap or free to call people overseas.

That’s the trend and one company that has been on the value radar for a long time is magicJack (CALL).

It’s been a magic formula stock numerous times and as it stands, it’s a stinker.

The Cheap Alternative

The product is very simple.

Plug in a small USB device to your computer or directly to the power socket, connect it to the internet and then connect a regular phone to the device.

Quick and easy.

Plus it’s definitely cheap.

The flagship product is $59.95 for the first year and then $35 after the first year.

It’s a good business model where they make money off product sales, subscription fees and prepaid minutes.

Here’s a breakdown of the revenue.

MagicJack
Breakdown of Revenue and Declining Growth

But the warning signs are staring at your face.

When it comes to selecting a phone service, the main qualifying factor is price.

Voice communication is a commodity and so is voice quality.

Users expect to have great voice quality so there is no moat other than being the lowest cost operator.

So if it’s just about price, then compared to regular VoIP services like Vonage or Comcast, magicJack is a no brainer.

The problem is that it’s not the cheapest solution out there.

There are plenty of apps that offer a free way of calling people.

Here’s a short list.

  • Skype
  • Viber
  • Rebtel
  • Tango
  • Kakaotalk
  • fring
  • voxofon
  • talkatone
  • Nimbuzz
  • and there are 42 more page listing of apps

In a way, magicJack looks very similar to the Weight Watchers (NYSE:WTW) story.

  • The product works
  • People who use it love it
  • But it’s losing to free apps

Is magicJack an Ugly Duckling?

A quick look at the income statement shows how ugly magicJack is at the moment.

  • Q1 revenue for 2015 is $25.5m compared to $35.3m last year
  • TTM Operating profit is down to 9.8% compared to 11.7% last year
  • TTM Net margins is -0.2% compared to 3.3% last year

These are numbers that Wall Street loves to follow.

But there are some great signs like

  • a cash balance of $82.9m which makes up 41.4% of total assets
  • no debt
  • just 3.4% of inventory make up total assets

Although the income statement shows losses, the balance sheet shows that it can take several years of hard beatings and still survive.

The cash flow statement shows how cash from operations is higher than net income which is a possible indication that the company is in a healthier situation than it really looks.

A generalization is that if net income is much higher than cash from operations, it’s a warning flag against earnings quality.

Valuation multiples show why magicJack is priced at 6x EV/EBIT.

MagicJack
Typical Value Trap Valuation Numbers

There is no consistency in any of the numbers which makes it tough to value properly.

The best thing to do with the numbers is to measure it against rules of thumb and then move on to the qualitative side of the research to verify whether the company is worth the rule of thumb measurements.

So here are some quick rules of thumbs I use.

  • EV/EBIT < 10
  • P/FCF < 13
  • ROE > 0%
  • CROIC > 13%
  • No debt

MagicJack matches 4 out of 5. ROE is negative which is the only one that clearly fails.

As Seen on TV Fad? Will It Last?

The main product magicJack Go was released and the effect of the product hasn’t trickled down to the financials and growth initiative just yet.

The projected growth is at 30% this year. But keep in mind that the bar has been set very low.

The future 5 year growth estimates are much lower at 16% which is low for a tech company.

And that’s where I’m stuck with magicJack.

The product has been around for a while but most people have never heard of it. The sales of the magicJack devices is declining by huge amounts.

Refer to the table again.

MagicJack

Sales of magicJack devices has decreased by more than 50% in one year.

So it’s stuck in an uphill battle between the bigger service providers and the free apps that people search for so easily.

Because of this situation, magicJack is forced to invest in new products or face the real risk of becoming obsolete.

That’s why if I gave a grade for moat or competitive advantage, I’d give it a 0.

On a numbers basis, magicJack is tempting.

But at the end of the day, this is what I’m seeing.

MagicJack

If I was looking at this stock several years back, I probably would have bought a small position on the basis of the balance sheet.

But why invest time and money into a 25th best idea hoping that management can turn it around.

I’ll let magicJack pass and thank my lucky stars that I didn’t get suckered into this one.

Moral of the Story

  • Value traps are bad
  • Check the numbers to see the true story of business performance
  • Check numbers against management conference calls and letters
  • Stay away from one hit products
  • Not losing money in bad stocks is just as important as making money in good stocks

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