Small Cap Stocks

I’ve been following MAIL since mid-2008 and 2010 was surely a volatile year for the company’s shares. Fears over the loss of Google caused a sharp decline in the shares, but as speculation of a renewal surfaced and a final deal was consummated, the shares rallied sharply.

Despite the recent rally in the shares, I think MAIL still has room to appreciate (Current Price: $8).

What Has Changed?
As referenced above, the company renewed its agreement with Google late in 2010, removing the primary risk for the shares. In addition, the company today announced strong guidance for 2011, indicating that even with growth initiatives it expects to earn nearly $8 million in 2011 with double-digit top-line growth. Finally, there is a huge bubble ongoing in private Internet companies that trade on private exchanges. I fully expect this private bubble to seep into public markets in 2011, where many Internet companies trade a ludicrously low valuations when compared to their private peers. Interestingly, the private companies that have soared in value, do not have long operating histories and are by many measures much riskier than their public counterparts.

So why the bubble in these private companies? As always, illiquidity combined with limited financial disclosures and dealer controlled pricing, have all led to complete insanity. But, the bubble is not ready to pop yet, given the only recent entry of Goldman into the private exchange trading business via its Facebook investment. Moreover, as the bubble continues to inflate the huge discrepancy between private and public valuations simply cannot be sustained as this would lead to significant M&A activities as the private companies acquire or merge with their undervalued public counterparts. So overall, expect huge investment gains in “undervalued” public internet companies, like MAIL, in 2011.

Risk
The main risk I see for MAIL is the depletion of their growing cash pile (last quarter at around $32 million) on a silly acquisition at an inflated value. Since many private Internet companies are now valued absurdly, this is a salient risk. However, since investing in MAIL nearly two and half years ago, I have been quite impressed with management’s interest in shareholder value, as evidenced by the company’s previous dividend policy and strong record of free cash-flow. So I am somewhat confident that the largest shareholders of MAIL will be quite prudent in their acquisition strategy and I see it as unlikely that the Adlers will hurt the value of their shares with an overpriced acquisition. Their history with the company surely shows a careful consideration of shareholder value and capital.

Reward
Given the valuation of similar private companies, I see no reason why MAIL should be valued at its current discounted price of about 5X EV/FCF. I expect the stock to appreciate significantly as the public markets adjust to bubble valuations in the private sector and as more investors rush to take advantage of “cheap”public Internet plays.

Disclosure: Affiliates of Envoy Global Research, and its principals, own shares in MAIL. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

I first wrote up Incredimail (MAIL) back in July 2008, when the stock was at around $3, and sported a negative enterprise value. Since then MAIL has appreciated dramatically, as the company continues to report strong earnings growth, and perhaps more importantly return excess capital to shareholders via consistent dividend payouts. However, I still believe MAIL at current prices (current price: $8), is incredibly mispriced, and is one of the best values I can find in any Internet advertising business, both public or private.

Today, MAIL reported it’s Q3 results, which again exceeded estimates, despite what is seasonally usually a slow quarter. Management has already increased guidance for the year, and based on today’s number, and considering that Q4 is generally the strongest quarter for Internet advertising businesses, I am confident that MAIL will still exceed their current guidance for fiscal 2009. The numbers at MAIL are currently as follows: 9.8 million shares, zero debt, and and $26 million in cash (adjusting for the future dividend of around $4 million or $0.40 a share). This equates to an enterprise value of $50 million, set against EBITDA of $13 million+ estimated for this fiscal year, for an EV/EBITDA multiple of around 4.

This valuation appears to be extremely low for an online Internet advertising business that generates revenue via Google Adsense. My own personal opinion is that Google Adsense is one of the best businesses I’ve seen in a long time, since it requires nearly zero ongoing cap-ex, or incremental fixed costs. One simply monetizes website traffic via Google’s PPC program and receives payment from Google on a monthly basis. It is a veritable cash machine, as reflected in MAIL’s margins.

I find it interesting that the nature of GOOG’s monopolistic, and highly profitable, online advertising model is very apparent to investors in GOOG, as reflected in GOOG’s high valuation multiples. However, for some reason, companies, like MAIL, that actually generate the business for GOOG (i.e., the partner sites), remain at incredibly low valuations that are generally applied to old media companies with significant leverage and negative growth. I do not think this type of valuation discrepancy between GOOG itself and a major partner site, can last long, as MAIL would make for a very attractive acquisition for a larger Internet advertising business. I also believe that since management of MAIL has already proven themselves to be shareholder-friendly, that they will pursue some sort of value-enhancing transaction should MAIL’s stock price continue to trade at a depressed level.

Disclosure: Affiliates of Envoy Global Research, and its principals, own shares in MAIL. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

As we predicted in an earlier post, MAIL would easily beat its guidance for 2009. Today, MAIL announced that it expects to exceed $9 million in EBITDA in 2009, up from previous expectations of $7 million, and up from virtually nothing last year.

From a valuation standpoint, despite MAIL’s rise the year, the stock still appears very cheap. On an enterprise value (after subtracting cash), the company is valued at about $35 million. This is against $9 million in EBITDA, or about a 4X multiple. This is extraordinarily inexpensive for an Internet advertising business, with many of the comparable companies trading at significantly higher multiples, despite slower growth than MAIL and greater financial risk. Even at a modest 10X multiple, MAIL would be valued at $12, or about double the current price.

Disclosure: Affiliates of Envoy Global Research, and its principals, own shares in MAIL. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Introduction

As we’ve noted in the past, we at Envoy love a good software turnaround story. The high margins and low capital needs of many software businesses, can lead to impressive earnings recoveries and explosive capital gains in the event that the company’s operations are realigned in a strategically correct manner.

IncrediMail (NASDAQ: MAIL), an Israeli provider of mostly free email and instant messaging (IM) software, is the latest software business to really grab our attention. After a management reshuffle, the company has focused more keenly on improving monetization of its core offerings, while simultaneously trimming corporate costs. The success of IncrediMail’s new strategic direction was made crystal clear in the firm’s recent financial results for Q1 2009.

After a long stretch of delivering pretty modest profits and some small losses, IncrediMail announced very robust first quarter earnings. Revenue rose 34%, but at the same time operating expenses fell 32%. The result was $2.5 million in operating profit, compared to a $900,000 loss in the prior year. Management had previously been guiding for $5 million in EBITDA for all of 2009. That target has since been raised to $7 million in operating income, which in our opinion remains a very low hurdle.

In addition to this improvement in profitability, we’re also intrigued by IncrediMail’s debt-free balance sheet, and the company’s plans for its excess cash. One encouraging move was the company’s share buyback, the first phase of which was recently completed. Even more appealing is the institution of an annual dividend policy, with a proposed $0.50/share one-time dividend now working its way through the Israeli court and regulatory system.

To get a better handle on the changes that have recently driven the stock to 52-week highs, as well as what lies ahead for the company, we recently checked in with Jeff Holzmann, President of IncrediMail.

Envoy Global Interview

Envoy Global Research (EGR): Can you briefly describe your main free software products, who the target customers are, and how you currently generate revenue from these products?

Jeff Holzmann (JH): Our flagship product, IncrediMail Xe, is a free e-mail client that enables users to customize their e-mails with a wide range of graphics, sound, and multimedia content. The program, with an active user base of over 7 million, offers a simple interface which appeals to less computer-savvy users. Our demographic for that product tends to skew female, with 69% of users over the age of 32. From IncrediMail Xe, users can pay to upgrade to the more fully-featured IncrediMail Premium.

Other offerings of ours include Magentic and PhotoJoy, both of which allow desktop enhacement through things like wallpaper, widgets, and screensavers. HiYo — our “rising star,” if you will — is a free add-on to instant messaging clients like MSN Messenger. HiYo offers unique animations, sound effects, winks, nudges and a wide selection of emoticons to enhance the users’ chatting experience. This program has seen over 5.5 million registered downloads since its introduction late last year, and is popular with a younger, more tech-savvy demographic.

Basically, we generate revenue in four different ways. The product sales via upgrades to premium software are straightforward enough. But, we also generate ad revenue by displaying banners on our website and in our free software. In addition, we have brand licensing and promotion arrangements with operators of third party websites. Finally, and most importantly, the vast majority of our revenue is generated via search queries, which is monetized with cost-per-click advertising (CPC) thru programs developed by major search engine providers like Google and InfoSpace.

EGR: Can you please describe the major transitions that Incredimail has gone through over the last few years?

JH: There have been two major shifts, one involving management and the other being a big change in our revenue strategy.

First, with regards to management, the reins were passed from Yaron Adler to his cousin and co-founder Ofer Adler in early 2008. Whereas Yaron was interesting in pursuing several new growth areas, Ofer has refocused on the core opportunity of driving search revenue via our free software offerings. This has allowed the company to reduce headcount, discontinue less promising business efforts, and really hone in on our fastest-growing source of revenue.

On the strategy front, our sales efforts used to focus primarily on upgrading our users from the free products to the premium offerings. Perhaps 2% of users would upgrade, and 98% would stick with the free software. Not the best model, perhaps, but it’s the one we IPO’d with, and we did generate nice profits from that business. In late 2006 though, the company began experimenting with Google’s AdSense program to try and monetize those other 98% of our users. Google quickly became a very important partner for us, and their AdSense program has been the main revenue driver for our company ever since.

EGR: How exactly does the Google relationship work?

JH: What happens is that the user downloads our software for free. Then, during installation, we give her the option of setting her home page to a very basic, Google-powered search portal called MyStart. This is very similar to when people download the Firefox browser, and their start page becomes a Google powered search portal. 86% of people downloading our software choose this Google-power search option homepage.

When the user searches the web by starting from our Google-powered start page, text ads will appear alongside these searches in Google, and other search providers, like Infospace. Advertisers pay Google and Infospace for these ads on a pay-per-click basis. Google, in turn, shares those advertising revenues with partners, like Incredimail, who help drive search traffic to Google. Collectively, our users are conducting over 100 million searches, or queries, per month.

Revenue from search surpassed our product sales in 2007, accounted for more than half of total revenue in 2008, and hit 71% of sales in the most recent quarter. There are no direct costs associated with these sales, resulting in extremely high gross margins for the company.

EGR: Since your revenue is a function of the number of people who download your free software products, how do you market these products and generate downloads in a cost-effective manner?

JH: There are various ways to market free software on the Internet. The basic strategy for most companies is to buy online advertising via keyword pay-per-click programs or banner ads. While we have done that in the past, and continue to engage in media buying activities to promote new products like HiYo, our main marketing strategy is a viral one. By that I mean that we rely on our users to bring in additional users, whether that’s friends, family, or whomever those users communicate with using our software.

So for example, say you send out an IncrediMail email with some animations that your cousin finds really entertaining. He sees a link at the bottom of the e-mail, and clicks through to download a copy of his own. A similar principle is at work with our HiYo instant messenger add-on. If you don’t have HiYo installed, and a HiYo-created instant message pops up, it informs you that you can only view the special emoticons included in your friend’s IM if you download the add-on yourself. This self-propagating marketing mechanism works quite well for us, and costs next to nothing.

EGR: So your search business has been growing fast, with this cheap viral marketing driving downloads. Why, then, did the company’s operating profits stay relatively flat until just recently?

JH: This is a function of a few factors. First, as I mentioned, the company was chasing several different market opportunities under the former CEO, and the related expenses have only recently dropped away. Second, the search monetization process takes time to fine tune. The more time we spend working with partners like Google, the better we get at maximizing search revenues from our free software downloads. Third, as I mentioned, we chose to do some media buying to support the HiYo launch last year. That marketing spend saw no offsetting revenue initially, as we didn’t begin monetizing the program immediately. However, since the beginning of 2009, we’ve significantly reduced the media buying and let the viral marketing take over. Now that HiYo has this momentum in place, we are able to start ramping revenue from the product without much additional expense.

Basically, the dramatic growth in profits we recently reported is the result of a transition to a new cost structure, a new revenue model, and the monetization of a new product. The results of these changes are reflected in recent financial results, but the success didn’t happen overnight.

EGR: Looking beyond the monetization of HiYo, can you outline the ways that IncrediMail intends to sustain topline growth in future years? Is that primarily driven by new software products?

JH: New products are certainly an important part of that equation, and one example of that would be our desktop enhacement program, PhotoJoy, which is currently in beta, but we believe will have mass appeal.

But, let’s not ignore our current slate of offerings, however. With product upgrades, such as the forthcoming IncrediMail 2, we can both retain existing users and bring additional customers in for the first time. We expect both new and upgraded products, after some initial marketing support, to quickly move into a position where they can drive search revenue with little associated ongoing cost.

Finally, we think there is substantial opportunity to potentially acquire other small software companies that have an interesting free software product, but may not have the needed corporate infrastructure to develop a large scale and profitable business around these downloads.

EGR: On the financial front, we noticed that your company recently announced a one-time dividend, as well as an ongoing annual dividend. Can you please explain the rationale behind this decision as well as where the company now stands in terms of delivering the dividend?

JH: Yes, concurrent with our year-end results in March, the Board announced a new annual dividend policy that will pay out at least 50% of annual net income, beginning with fiscal 2009. Soon afterward, the Board also approved a $0.50 per share dividend to be paid for fiscal 2008.

This policy is a result of listening to our investors, many of whom have asked why we are sitting on so much cash. In fact, at one point last year, the value of our stock was well beneath the level of cash sitting on our balance sheet. We definitely do not need that much cash to run this business, and we therefore think it is a shareholder-friendly move to dividend out our extra cash. With our CEO and other insiders holding a large amount of stock, management is of course receptive to any steps that will maximize total shareholder returns over the long run.

Now, as an Israeli company, the dividend enactment is somewhat more complex than many of your readers might be used to seeing. For the 2008 dividend, we have to obtain the approval of the Israeli court, due to the size of the proposed payout, which slightly exceeds our net income for the year. We expect to receive approval within a few weeks.

We are also waiting to see the level of withholding tax to be levied by the Israeli tax authorities. Basically, our tax structure will likely change because of the dividend, and we’re guiding for a 31% effective rate, like we reported in the first quarter, going forward.

EGR: What should investors look out for over the next 1 to 3 years to gauge success at IncrediMail?

JH: Investors should look for continued growth in revenue, allowing for the usual seasonality of our business due to Internet usage trends. Combined with strict cost controls, we should produce solid bottom-line results. Expenses will always be front-loaded when it comes to the launch of a new or upgraded product, but I believe HiYo will demonstrate that those are dollars well spent. Expect us to continue developing new products to complement our existing lineup, as well as upgrades to our most popular products like IncrediMail and HiYo. Both activities will keep people downloading our software and engaging with the products, and that in turn will drive search revenue.

EGR: Thanks for your time, Jeff, and best of luck.

Conclusion

After nearly a year and a half of transition, it appears as though IncrediMail is set to continue growing significantly in the years ahead. In the coming quarters, revenue ought to rise at a solid rate, but the most dramatic difference will be seen on the bottom line. With expenses cut to current low levels, we expect a series of very favorable year-over-year earnings comps. Our earnings model also suggests that operating income could potentially surpass management guidance.

With the first quarter results, the market has only just started to recognize why Incredimail’s business is so attractive. The company has very low incremental costs, in terms of R&D and marketing, to support existing products. As such, the resulting search revenue is extremely profitable, and the cash being thrown off by this streamlined operation is now being put right into shareholders’ pockets via the annual dividend.

Despite the recent run up in the stock price following Q1 results, we think Incredimail is still virtually unknown to most investors and therefore still has significant upside potential should our expectations for continued robust results in 2009 prove accurate.

Disclosure: Affiliates of Envoy Global Research, and its principals, own shares in MAIL. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.