J2 Global Communications
JCOM Thoughts - Q2 CC and Beyond

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By platoish
August 22, 2006

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This is a cross post from the Hidden Gems boards. I wanted to share my thoughts and hopefully elicit some commentary from the good folks that follow this company, but don't necessarily want to shell out for the paying service.

It's taken me awhile to get this all on paper. I've been following the internal options audit and hoping to see it to its conclusion before writing this, but I'm not sure it will be concluded quickly and decided to go ahead and post. They have at least ball-parked the expenses. The short sellers and "run at first hint of trouble crowd" have done their damage and the obligatory 20% haircut has occurred. I'll have quite a bit more to say on this topic at the end of this post. First, I want to go over the Q2 earnings release and give some observations from the Conference Call. One thing I think is cool, is that JCOM solicits e-mail questions from shareholders on the call and answers them.

As far as performance goes, JCOM delivered another strong quarter, hitting the top end of revenue guidance, and right on the money for earnings. They did a 2 for 1 split during the quarter, so I'll try to not let that mess up any of my numbers. They are also doing a share buyback program, but this wasn't discussed on the call and since the 10Q hasn't been filed, I don't have an update. Revenues for the quarter were $44.4M (up 27% YOY) and excluding stock comp expense EPS was $0.28 (up 22% YOY). The non-GAAP numbers are useful for comparing to last year when stock comp wasn't included. Stock-based compensation expense was $0.02 for the quarter, lowering GAAP earnings per share to $0.26. That makes it the 37th consecutive quarter of sequential revenue growth and the 18th consecutive quarter of sequential operating income growth. Both of these are very impressive numbers. The strong revenue growth was due to having a good quarter for patent licensing revenues and the fact that their corporate channel sales force performed above plan. For those of you not familiar with the company, they get a small percentage of their revenue from licensing their IP to other service vendors and this form of revenue is lumpy in nature. They added 50K+ net paid DIDs for the quarter, making it four straight quarters that adds were at this level. They currently own 15.4M DIDs of which 11.4M are subscribed, the remainder in stock for future customers. They now have a presence in 2000+ cities in 31 countries. They added Hungary and Greece this quarter.

Let me toss in a quick aside. JCOM is a metric happy company if I've ever seen one. They measure and report more performance numbers than any company I've ever followed. I'm sure to the uninitiated; some of what follows will be unintelligible. I've given up on explaining everything about this company on each post in the interest of brevity. And you know that brevity for me is a relative term. Feel free to ask any questions that you want and I'll try to clarify. Another idea for the shy would be to search this board for other JCOM posts and I think you'll be able to piece the story together.

Gross margins increased to 79.3% from 78.8% last quarter. Scott thinks they should be able to get this to 80% or above by the end of the year and maintain those levels. They take a hit here as they add new countries, because they add in the costs of services before they start seeing revenue. As they get bigger, they will more easily absorb these costs of expansion. Non-GAAP Operating Margin increased to 43.4% from 42.3% last quarter. Their net cash increased by $12.6M to $174.9M over the course of the quarter. Free cash flow, which they define as net cash from operations minus capital expenditures was $11M for the quarter.

Each quarter on the call, they highlight one part of their business for added discussion. This quarter it was an easy choice and they picked the Enterprise Sales Channel. This is probably their newest focus and they have been emphasizing it both in their internal capital allocation, as well as in their pitches to investors. They believe it offers great growth opportunities going forward. This is a difficult channel to sell into and they have been refining their approach over the last several quarters. They define this channel as customers that require more than 500 lines (DIDs). The sales pitch here is basically talking a giant corporation into outsourcing their fax services and doing away with all the fax server hardware in their data centers. They believe they are gaining some traction and really like what they see. Within this channel, they are beginning to see real interest in Europe and have increase their European staff from one to three. They landed their largest initial corporate contract this past quarter. It is for >10K DIDs and is for one of the Big 4 worldwide consulting firms. This company has 120K employees, so the potential for expanding the minimum DIDs is very real. They also made gains with their previously largest customer. This customer originally signed on for 7K lines, upped it to 10K last year, and now has raised it again to 20K lines this quarter. This customer is a large accounting firm. The number of DIDs in use by their Enterprise customers is 54% above the contracted minimums. They have 59 new customers in the 1000+ DID range currently in their pipeline (up from53 last quarter), 17 of which are in Europe. Even with these two large customers, they still don't have a customer that makes up more than 1% of their revenues. In the three years they have been pursuing this business, they have increased their staff by 33%, while increasing the DIDs in use by 300%. They currently have 2 customers with over 10K DIDs, 24 more customers with over 1000 DIDS, and 61 using between 500-1000 numbers. They provide fax outsourcing for 31 customers who are in the Fortune 100. Other Fortune 100 companies have departments that use their Web-based services.

Last quarter they talked about some price increases that they were running trials on. They updated this topic. Currently they charge $12.95 per month for their basic individual line pay service. They will be raising this to $16.95 per month for new customers in late September. They had been trailing $15.95 and $16.95 and saw no material difference between the price points, so opted for the higher level. They realize this will depress new sign-up levels at least for a while, but believe the decrease will be a smaller percentage than the 27% price increase. They also have noted in the past that this slowdown is only temporary, until the new price is established. They are adding some additional functionality to this package to justify the increase. They will give added storage, longer archiving and potentially some limited outbound service to the package. They didn't get too specific here because of competitive reasons. They are now assessing if, how, and when to pass this increase onto their existing current customer base. They have made no decisions in this regard as of yet, pending study results. Whatever they decide to do, the process will happen over a six-month or longer schedule. They talked about possibly starting with their high volume users who spend more on the variable part of the bill than the fixed part. This is something they assess every three years or so and are in that phase now. Last time they raised everyone from $9.95 to $12.95. After six months, they had an 85% retention rate. The 15% decrease in users was more than made up for in the 30% price increase. At this time none of this affects their small/mid business, small enterprise, or large enterprise channels. Those are all multi-line deals and are priced as a package. The large corporate contracts charge on the order of $4/line/month for the fixed portion of the service. Currently 60-70% of their DIDs are for individual accounts. Another technique they are considering is to allow individuals to stay with the low rates if they sign up and pay in advance on an annual basis. These folks wouldn't get the increased functionality, but would get to keep their pricing. We'll find out more about this on the next call.

The obligatory questions concerning the Universal Service Fee issue were raised. Not much new here. They are not planning any pre-emptive attempt to monotize any of their free DIDs. Scott did mention an interesting aspect of their newest acquisition. Almost lost in all of this was the announcement of the acquisition of Send2Fax, a small South Carolina-based fax service provider. The acquisition was deemed immaterial and no terms were disclosed. Scott did say that they operated a tiered variety pricing structure starting at $1.25 per month. They will be experimenting with this a little in case USF issues force them away from the free line model.

I want to finish this off by talking about options back-dating as it pertains to JCOM. As you probably know, JCOM brought up the subject during the call, and only said they were working on analyzing this at the request of their auditors, Deloitte and Touche, and that they believed they would have their study complete in a couple of weeks. About 10 days later, they issued an 8K saying they would miss the 10Q filing deadline because they had found some things to look at further. They said the additional compensation expense uncovered would not exceed $2.1M for the 6-1/2 years since their IPO and not exceed $80K for the first half of 2006. They are going through the formal process of requesting a hearing with NASDAQ to avoid delisting. This should give them a couple of month's breathing room to get up to date with the SEC on their 10Qs.

While I think these options backdating practices need reform, I don't want to automatically paint all offenders with the same brush. Their may be characters out there that get fined, jailed, and/or barred from corporate management for life. They probably deserve it. This is a much more complicated issue than the media promotes. The way to look at the data is constantly changing. The SEC is basically relying on the Public Company Accounting Oversight Board (PCAOB) to set the guidelines in how a company should look at past actions. New guidelines were sent out on the Thursday before this conference call. Let's look at the damage. I haven't gone through the last six plus years of reports, so I will confine my thoughts to the six month figures. Let's set the scene first before we get into the specifics. They issued 100K options in Q1 on a split adjusted basis. Most of these are to new employees and part of the job offer. They haven't filed the 10Q for Q2, obviously, because they are now aware of the situation and are trying to figure out how to conform the data to the evolving standards and formats that the government is moving towards. I'm just going to assume, for lack of better information, that they issued another 100K options in Q2. So, if 200K shares is a good estimate so far, when we look at their estimate of $80K additional compensation expense, I calculate that the average option was miss-priced by $0.40 per share. If all the mispricing was directed to a couple of new hires, then I would question what they thought they were doing. If however, it is accumulation supported by all the options offers, then I think it's mice nuts. They should pay the Federal Piper and move on. They gave a couple of examples of how the guidelines have changed. I have personally been involved and managed in companies that routinely offer options as part of the job offer package. Let's say a potential candidate asks "I like the options part of this offer, what is the strike price?" The right answer is � "The closing price on the day you start." What if instead, the BOD directed it to be X.YY for the next three months? Or rather, the HR person put in writing that it would be X.YY because that was the current day's closing price. All I'm trying to say is that if the average difference we're talking about is $0.40 per share on a $25 stock, I'm relatively sure there is not a big controversy to explode.

JCOM has undertaken this effort on their own at the behest of their auditors and has found some issues. I feel certain that they have the numbers under control, don't they always. I believe this may be an opportunity to increase ownership, but here I sit watching and holding. There is a palatable cloud around this issue and it is clouding my judgment as to whether an opportunity is at hand. I'm coming to the opinion that some of these options tainted companies will become the brilliant investments of the future, but until one of the "I discovered it myself" companies comes full circle, we'll never know for sure. Be careful out there.


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