Spark Networks (LOV) - A 50-cent Dollar

Spark Networks (LOV, Financial) - A 50-cent Dollar

I first came across this company after reading a presentation by Whitney Tilson (Trades, Portfolio) of Kase Capital for the Value Investing Congress in 2013. See his presentation here. He has been adding to his stake as recently as during Q4 of 2014, where he increased his stake by over 30%. As of his latest 13F filing, it represents 4.4% of his portfolio.

Company overview
Spark Networks owns and operates more than 30 niche-focused online properties designed to build community, including more than 20 online personals sites such as JDate.com, ChristianMingle.com, SilverSingles.com and BlackSingles.com.

Spark Networks also has Offline & Other Businesses which complement their online websites. JDate.com was founded in 1997 and has become the leading online community for Jewish singles and is responsible for more Jewish marriages than all other online dating sites combined.

The two biggest contributors to revenue are Christian Networks (Christian Mingle) & Jewish Networks (JDate) with Q4 2014 revenue at $8,215,000 and $5,502,000 respectively. Their two biggest competitors are Match.com and Okcupid, other competitors include Meetic, Tinder & eHarmony.

Spark Networks also operates four different media properties: Believe.com, Faith.com, DailyBibleVerse.com, ChristianCard.net. These sites are aimed at ultimately driving customers towards ChristianMingle.com. I think this is a clever strategy as it widens the businesses' competitive 'moat' and may have untapped profit potential in the form of - paid subscriptions options, greater ad revenue generating capacity, although ad revenue is a small contributor to their bottom line.

JDate is the cash cow of the business, it has steady revenues and profits, its profits have been able to fuel the high growth of ChristianMingle, which has now reached a strong level of customer awareness approx 80% in the US.

Industry trends

• Favorable population growth
• Increasing adoption of the internet and mobile devices
• Advances in online discovery and communication technology
• Increased recognition of the benefits of online dating
• Growing popularity of niche-oriented sites.

The points above are from Sparks Investor Presentation.

Management

As a result of the recent proxy contest in mid 2014, there was a radical change in the board & management composition. This is partly why the stock is so depressed. There are now six new directors on the Board, a new CEO & CFO. Since the change in management, there has been an expense & workforce reduction, to increase operating efficiency and get Spark back to profit. The majority of this initiative is complete, there has been a drastic change in profitability - Q4 2014 brought EPS of $.16c, the company has had negative EPS since 2010. The Management team seem focused on bringing some financial discipline to the firm.

A recent statement by Michael McConnell, Executive Chairman, gives us a good idea about the new management's attitude “I believe the opportunity to profitably grow our business is significant and we are prepared to execute on strategic growth initiatives that meet our return on capital hurdles. Further, the team is operating with a sense of urgency and commitment to drive improvements in all areas of the business. Importantly, I am confident in the resilience and resonance of our brands within our targeted communities.”

Senior Management Profiles

Michael S. Egan - Chief Executive Officer. Mr. Egan is joining the Company from Internet Brands, Inc., where he served in a number of capacities since 2008. He has most recently served as its Senior Vice President and Group General Manager of the Home, Careers, Money and Health Divisions. From 2003 to 2008, he served in several capacities at Yahoo! Inc., including Senior Director – Business Lead, Sponsored Search & Mobile; Senior Director – Content Strategy & Operations; and Director – Global Content Quality. Prior to his time at Yahoo! Inc., Mr. Egan was a consultant at Bain & Company, Inc. Mr. Egan received his B.A. from the University of California, Santa Cruz and his M.B.A. in Finance and Strategy from the UCLA Anderson School of Management.

Gregory J. Franchina - Chief Information Officer. Greg Franchina has served as our Chief Information Officer since June 2007. Mr. Franchina has over 24 years of technical and operational experience. From January 2007 to May 2007, Mr. Franchina worked as an independent consultant. From November 2005 to December 2006, Mr. Franchina was the Chief Information Officer and Vice President of Operations for Spot Runner, Inc., an Internet-based advertising agency. From July 1998 to November 2005, Mr. Franchina was the Chief Information Officer and Vice President of Operations for WeddingChannel.com, Inc., a provider of online wedding planning and bridal services. Mr. Franchina holds a B.S. in Computer Science from The College of William and Mary.
Robert W. O'Hare - Chief Financial Officer. Mr. O’Hare is joining the Company from Square, Inc., where he served as Corporate Finance & Investor Relations Lead since 2013. From 2010 to 2013, he served as Director of Financial Planning & Analysis at Pandora Media, Inc. He worked as an investment professional with Spectrum Equity Investors and Spitfire Capital and began his career in investment banking at Thomas Weisel Partners.

All profiles are taken directly from Sparks website.
Insider Ownership

According to its latest filing, Insider Ownership is at 18%. One of the interesting points that Osmium Partners raised in its letter to shareholders during the Proxy vote was - “Each of our highly qualified nominees, either as direct owners of Shares or as participants in our Funds that hold Company shares, has individually more outright capital at risk than the Board and management as a whole, excluding options the Board and management have received at no cost to them” Osmium Partners letter to shareholders. As with most Tech firms Stock Options are an important contributor to Director compensation. As of 31st Dec '14, Osmium holds almost 14% of the common shares outstanding.

Financial Strength

Financials as of December 31, 2014
Revenue: $61.6 million
Net Income: $-1.13 Million
Debt: No outstanding debt.
Cash & Cash Equivalents: $11.7 million
FCF: $-3.86 million
Market Cap: $99.1 million (23.Apr.15)
Enterprise Value: $88.66 million (23.Apr.15)
No. of shares outstanding: 24.4 million
Share price: $4.00 (23.Apr.15)

One reason why I chose to invest in this company while the stock was depressed was due to its very strong financial position. Since Spark had no debt, it couldn't go bankrupt. I felt that its efforts at building ChristianMingle had high uncertainty but not high risk, if it worked out, the payoffs would be huge! If it didn't, it could scrap ChristianMingle completely and still have JDate which still has had contribution margins of approx 90% for the past 12 years! Alone, JDate is worth more than what the company is trading at today.

I believe that Sparks' financial situation is about to improve greatly over the short term. I expect that we will see margins improve across the board. Due to various factors, primarily competitive, ChristianMingle has never had the same margins as JDate, so I don't expect that we will see the same margins as the pre-ChristianMingle era of 60-65%. I think Gross Margins of 50% are realistic.

Also, as at December 31, 2014, Spark had gross net operating loss carry-forwards for income tax purposes of approx. $35.2 million & $46.1 million available to lower future federal & state taxable income, respectively, which expire beginning in the years 2020 for federal purposes & 2018 for state purposes. This will have a positive effect on earnings in the short-term as they have 3 & 5 years to use them.

Catalysts

• Acquisition - Given its current depressed valuation, and the fact that it dominates niche areas, a competitor will find that an acquisition is going to find it both more cost & time effective than building a competing site. I believe a likely acquirer is IAC/InterActiveCorp (that own Meetic, Match, Okcupid & part of Tinder). If I was IAC with $990 million dollars in cash on my balance sheet and saw a competitor trading well below its intrinsic value at $99 million, I wouldn’t let that pass me. Given its valuation & marketability, this would be a savvy purchase by a Private Equity company.
• Buyback - Under the terms of their revolving credit facility, Spark have authorization to purchase up to $5 million worth of common stock. Last year, the Company repurchased 271,117 shares of common stock at a weighted average price of $5.50. All stock repurchased was retired. Their cost of credit is LIBOR + 2% which, given current valuations, makes a buyback viable, but I believe not very probable in the short term.
• Successful Strategy Change - Decrease in Direct Marketing for Christian Mingle, increasing ARPU for ChristianMingle. New Technology investment etc.

Risks

• The recent major change in board & management may have a negative effect on the company's performance due to disruption and the time needed to understand the business & its situation.
• Aggressive cuts in marketing expenditure, primarily on ChristianMingle could prove to be costly. The site doesn't have the same level recognition or history that JDate has within its niche, therefore is more reliant on marketing to increase/keep subscribers. As ChristianMingle is serving a community up to 30 times the size of JDate, I fear it hasn't yet been able to benefit from the Network Effect that JDate currently has.
• Sparks primary competitors are much bigger, they have more resources to invest in Technology & Product Development. I believe that this poses increasing challenges for a relatively small online dating company. Here are ‘Customer Star Ratings’ from Google Plays' App Store, I believe it shows that Spark Networks Apps are not on par with others: JDate App (2.8/5) & ChristianMingle App (3.1/5) vs. Competition - Zoosk (4.1/5), Tinder (4/5), Okcupid (4.2/5), Match (3.8/5). That being said, the CEO has said investing in Product & Tech was going to be an important element of their Strategy in 2015.

Valuation

I am using DCF to value the firm using these assumptions below:

EPS: $ .64c
Growth Rate in the next 10 years at 8%
Terminal growth rate: 4%
Years of terminal growth: 10
Discount rate: 12%

We get a Fair Value $ 8.30, that's a Margin Of Safety of over 50%. A 50 cent Dollar! Without factoring in the $ .48c cash per share! Though a lot of these numbers are arbitrary, I believe the EPS ($.64c) & growth rate (~8%) figures are conservative, ChristianMingle will be the primary growth contributor due to the size of its market and its growth stage, while JDates' growth, is likely to remain flat.

I believe ChristianMingle is one of the primary reasons the stock is cheap, there is uncertainty about whether the investment is really paying off, also will the business be able to generate profits when marketing spending & pricing stabilizes. If we take ChristianMingle out of the equation and value what is left, we get the following:

Cash per share of $ .48c
JDate value per share $ 5.00 (based on a multiple 5x contribution rate)
ChristianMingle (CM) value per share $ ?
Other offline & online businesses $ .41c

Total value per share (minus CM) $ 5.89 per share. That's a 32% premium over the current price without factoring in one of their primary businesses!

Conclusion
So here we have an established, easy-to-understand business that comprises of a Cash Cow, which is worth more than the trading price of the entire company & a Rising Star that has 80% customer awareness within a massive market. It trades at 50% discount (conservatively). It has no debt & a ton of tax deductions to put against future earnings. A motivated Board & Management team with ‘skin in the game’.

Sparked your interest?

Additional disclosures
I currently hold a position in Spark Networks.