You might be forgiven for blithely dismissing FTD Companies (FTD +0.00%) and its online flower brethren, 1-800 Flowers (FLWS +2.82%), as just another no-moat e-tailer, unworthy of your hard-earned dollars or a second thought. I did the same, fundamentally misunderstanding the high-return, moaty cash flow dynamics of its business. FTD Companies is not just another flower-hawker: Instead, it's a network of florists -- more closely resembling eBay (EBAY +0.48%) or Amazon's (AMZN +3.78%) third-party services, as I'll describe below -- operating in an oligopolistic industry.
A recent spin-off from the serially under-managed United Online (NASDAQ: UNTD), I believe FTD's poised to get its due as the investing public properly appreciates the quality (and earnings power) of its business, management engages in value accretive share repurchases, and if we're lucky, FTD revisits its private equity roots. At just 12 times my estimate of next year's free cash flow, FTD represents a compelling value -- and that's why I'm buying a position equal to 3% of my Real Money Portfolio's capital.
A sweet smell
On its face, FTD resembles yet another e-tailer, but in fact, it's quite different. Operating under the FTD and Interflora brands, FTD connects the flower-buying public with one of its 40,000 local member florists in the U.S. and U.K., all unified by the very recognizable Mercury Man logo. Arguably speaking, its business is not flower sales, in the technical sense, but providing a platform to facilitate said transactions.
To give a sense of the mechanics: Suppose a somewhat irresponsible son wants to buy flowers for his mother, because he's forgotten to buy a gift that requires actual forethought. Of importance, son lives in California and his mother happens to live in Connecticut, making it a little harder to call the local florist. He hops on FTD, and nabs a dozen roses. Upon receipt of the order, FTD directs it to one of its local network florists, who fills and delivers it to mom. Crisis averted for son, at least somewhat.
In this transaction, and across a given year, FTD makes money two ways. First the company takes a cut from each sale, and bears a portion of the cost. Second is membership fees for the privilege of network participation, part of which is a flat fee and part tied to volume and dollar value of transactions.
Implicit in this model is a unique, hard-to-replicate network effect. Because flowers are such a highly perishable, fragile good, an online seller of flowers needs a nationwide network to fulfill orders in a timely manner, or it risks spoilage and less-than-pretty flowers. Therefore, those networks with the most florists and customers benefit from a certain virtuous cycle. Florists, eager to attract consumers, are more apt to pay for network participation. Customers, confident there's a local vendor who can fulfill the order, are more likely to place orders through the incumbent. That's how, and why, FTD more closely resembles eBay and Amazon: FTD, in its capacity, isn't explicitly about delivering flowers so much as it is providing a medium for exchange.
The result is something of a winner-take-all dynamic, where the online flower marketplace is dominated by four vendors: FTD, 1-800-Flowers, Liberty Media's (LMCA +0.00%) Proflowers.com, and Teleflora. That's unlikely to change on account of the inherent challenges associated with building a nationwide network of vendors.
A secret garden
As noted above, I'd wager FTD's distinct qualities remain under-appreciated by the investing public. That's poised to change, driven by a recent spin-off from languishing parent United Online and the possibility for large share repurchases.
FTD comes of age: For the past several years, FTD's been a ward of the United Online, whose history is one of throwing good capital after bad within its core business -- a declining dial-up Internet segment. Suffice it to say, it wasn't a great strategic fit, and arguably, FTD didn't get the love it deserved as part of United.
With the recent spin, FTD's no longer strapped with its former parent's albatross. I'd expect that, given the benefit of a few more quarters as a public company, FTD will take the pattern of many a spin-off -- at first less appreciated and gradually more loved -- as the company realizes typical post-spin efficiencies and the market comes to appreciate its cash flow and unique capacities.
Part of that discount may owe to its financial statements, which distort its cash earnings power. FTD doesn't look the part of a cheap stock, at least on earnings, because it's saddled by fairly large non-cash amortization expenses, comprising 4% of sales and two-thirds of operating profits -- a consequence of acquisition accounting from United's 2008 purchase -- which should decline substantially after 2014. Its cash flow, though, remains robust and unaffected. For perspective, FTD trades at 47 times trailing earnings, and only 12 times my estimate of free cash flow.
The gift giver returns: As this is a highly cash-generative business with low reinvestment needs, on account of its capital-light model, I'd expect -- and want -- management to repurchase shares when the price is right. At last quarter's end, management announced intentions to do just that, authorizing a $50 million share repurchase. The market received this announcement with decided malaise, and understandably so. I think management's low-balling. The company can repurchase at least $100 million worth of shares across the next two years, and possibly up to $150 million. At today's prices, that'd represent a very attractive use of capital.
Though I'd prefer to see management repurchase shares, I wouldn't be surprised to see some cash devoted to repaying FTD's $220 million debt load. I wouldn't dismiss this move as out of hand either. This is because I'd interpret that as precursor to a possible buyout, which could be great for investors at the right price. There's good reason to believe a buyout is possible. FTD has a long history with private equity firms, taken private by Leonard Green in 2003 and Perry Capital in 1994. Their interest is understandable: FTD throws off cash, possesses a fortified competitive advantage, and benefits from strong barriers to entry. Paying debt today clears the deck for a leveraged buyout at some later date. Somewhat coincidentally, now-CEO Robert Apatoff possesses a brief history with a consumer goods-focused private equity firm.
A special flower: For some time, market watchers have fretted over the prospect of promotional market-share grabs, upstart competitors, and so on. I'm not worried. Despite consistent concerns over competition, FTD's sales, margins, and returns on capital have remained remarkably stable for the past several years. The company's also been the subject of DOJ, FTC, and Attorneys General investigations, which generally speaking, is a decent indication of competitive strength.
With Amazon's foray into the flower biz, the market's on tiptoes yet again. I don't discount the risk, but I don't yet see reason to worry. For one, FTD's results have hardly hiccupped. Longer term, the challenges associated with building a nationwide supply chain in fresh goods, like food or flowers, are exceptionally high, as highlighted by Amazon's challenges in its Amazon Fresh venture. The strength of FTD's network, and that of other incumbents (who also aren't interested in cutthroat competition), should keep Amazon at bay.
What it's worth, and what I'm watching
At 12 times free cash flow, FTD shares are pretty cheap. I'd expect the company to grow its revenue at 3% to 4% for the foreseeable future and for operating margins to gradually expand to 14%, on account of the business' natural operating leverage, pricing power within its network of florists, and the sort of found efficiencies recently spun-off companies typically realize. Throw some share repurchases in the mix, and I think FTD shares are worth north of $50 a stub. Expect free cash flow to consistently outstrip earnings, on account of large amortization charges and the company's negative net working capital model.
I'll be a watching a few things qualitative and quantitative. First and foremost is competition. While I think the risk is muted, for reasons mentioned above, irrational price-focused competition may emerge.
Also worth watching, management's willingness to make deals. Where competitor 1-800-Flowers has diversified into related goods, like gift baskets and wine, I'd like to see FTD stick to their core competency: flowers. That's where the cash is. I'll also be keeping an eye on revenue mix. Because the U.S. florist count has been declining for some time, FTD's mix of service revenue -- fees associated with using its network -- may decline. I'd expect this to be offset by higher fees from existing florists and higher transaction volume, but it's a careful balance. FTD can't charge too much, but it also wants to, and should, take its pound of flesh for the benefits it's accruing from its network.
The bottom line
FTD possesses many of the characteristics of a very attractive investment -- a still under-appreciated spin-off with a highly cash-generative model and solid competitive advantages, and numerous means of juicing its already robust free cash generation.
Investors should come out of this one smelling sweet. That's why I'm buying shares today, and I recommend you do the same.
