Is magicJack a Netflix or WhatsApp in the Making?

MagicJack (NASDAQ: CALL  ) soared higher after its earnings on Wednesday, giving it 75% stock gains this year due to talks of it being the next Netflix (NASDAQ: NFLX  ) . However, as fund manager Whitney Tilson makes big bets on the company's core business, it might be the growth of another segment, and its attractiveness to companies like Facebook (NASDAQ: FB  ) , that'll create the real upside value.

Tilson makes a bullish bet
Back in February, fund manager Whitney Tilson published a report entitled "magicJack: My Next Netflix," which created quite a stir and has been a major catalyst in magicJack's exceptional start to 2014.

Tilson was known for his early investment in Netflix, but insists that magicJack has the makings of becoming just as disruptive in the wireline phone service industry as Netflix was/is to the cable industry; Tilson's firm now owns 164,000 shares. Furthermore, he makes a good case: The wireline industry includes 70 million households and regular U.S. callers in international markets combined, and magicJack provides service for an unbeatable price of only $2.50 per month.

According to Tilson, market size and price are two characteristics that magicJack shares with Netflix. However, it also has "fixable problems," which Tilson said were attributed to old management, including unsophisticated marketing, an unprofessional website, and spotty customer service, all of which are improving with new management and will create value.

Hard to identify the value
At the time of Tilson's call, magicJack was $13.75, but currently the stock is at nearly $21. Thus, at first glance, it looks like Tilson made a great call. However, with a market cap of under $400 million, magicJack is hardly the size of a Netflix, or a highly disruptive company to the wireline industry.

Moreover, while the company's quarter beat expectations, it's quite difficult to understand why the stock is soaring by 20%. The company's active subscribers fell by 100,000 quarter-over-quarter, now at 3.2 million. In addition, total revenue declined 7.8% year-over-year to $38.2 million, which is hardly a reflection of a Netflix-like company.

Tilson may be right, but
Essentially, Tilson was right in identifying magicJack as having an innovating product that works good and cuts costs significantly, much like Netflix in its industry. The problem is that online content viewing continues to soar while wireline usage continues to fall, as more-and-more consumers use mobile phones for primary use.

With that said, magicJack is yet to show us anything to imply that its core VOIP business will one day thrive with changes to marketing. However, it does have another segment that's soaring in use and popularity, which conveniently fits well with the growth of mobile phone usage.

FREE Calls: A WhatsApp in the making?
MagicJack has an app called FREE Calls, which uses 4G or WiFi to make free calls to the U.S. and Canada; it also includes voice mail. Thus, customers can use FREE Calls without using their mobile minutes, and in its infancy the service has been very popular. Specifically, it ended the fourth quarter with 6.9 million users, a 23% increase over the three months prior.

With that said, Facebook just paid $19 billion for WhatsApp, a company that allows its 450 million users to text for free using data or WiFi, meaning the two services go hand-in-hand, both being a telecom killer. While 6.9 million users is only a fraction the size of WhatsApp, magicJack's app is still growing rapidly and has the same advertising capabilities of any app, by using pop-ups or banners on its home phone screen.

Hence, this growth segment of magicJack's business might very well unlock tremendous upside value in shares of the company, especially as an acquisition target. Facebook is interesting as a potential acquirer because it's in the business of purchasing eyeballs, or users, rather than current revenue. In fact, WhatsApp earned just $20 million last year, but if we gauge the acquisition by current users, then Facebook paid more than $40 per sub. Also, with a free text and call service Facebook would become a very disruptive and even dangerous company to telecom industry, perhaps giving it an edge and allowing for a successful reentry into the smartphone industry.

If we apply a $10 per sub value to FREE Calls, then this segment is worth about $70 million, which then makes magicJack at 7 times earnings look more attractive from a valuation point of view. Not to mention, as FREE Calls continues to grow, an acquirer might find it even more attractive, meaning this is a conversation that could really intensify in the quarters ahead, assuming 20% plus growth is sustainable. And if not acquired, magicJack can begin to roll out ads that could spark growth, thus pushing shares higher.

Final thoughts
Tilson might be right is predicting upside potential for magicJack, but given the demand for services of similar nature to FREE Calls, he might be wrong in which segment of the business creates the upside potential. With 6.9 million users, magicJack has had a successful launch of this service, and if it can continue to grow, and if marketed efficiently, then magicJack might in fact be the next Netflix, just not in relation to its core business.

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