Inflection Research

j2 Communications released Q1 2008 earnings yesterday. They showed continued strong growth for international (44%) and voice (aprox 100%); and re-acceleration in the company’s core US faxing business. The voice service offering gives the company a unified communications online platform. j2’s online service replaces many individuals and small companies fax machines and is increasingly replacing the fax servers in large companies’ data centers. Its unified communication product allows SMB’s to easily outsource PBX and faxing services.

While faxing is a declining service companies and individuals will continue to fax documents for years to come based on several factors such as: legal definition for transmitting documents, such as healthcare and law proceedings, via fax; and processes setup to include faxing for procedures as varied as mortgage applications to dispatching trucks.

j2’s faxing service in the US may never see organic growth above low single digits, but over the next several years it will probably pick up many if not most of its smaller competitors at tremendous valuations. The company should see several more years of free cash flow growth from the faxing services. The future is in the company’s online unified communications offering for SMB’s which is profitably growing over 100% annually.

Based on j2’s closing price of $21.10/share it is trading just under eight times normalized free cash flow for a company growing 10 – 15%. My math and an overview of the conference call are below.

Financial Highlights

• Revenue = $58.6M up *8%
  • Subscriber Revenue = $57.2M up 14%
• EPS = $.35 up *9%
• Repurchased 3.5M shares for $76M (now have 45.2M shares)
• Cash = $181M (no LT debt)
• 1.1M paid DIDs deployed (net adds of 35,000 during Q1, 11.2M DIDs overall)
• Cash Flow from Operations = $27.4M
• Enterprise Value / Normalized Free Cash Flow~ = 8 (calculations on next line)
  
• Normalized Free Cash Flow~ = $19.4M
  • Net Income = $16.8M
  • Depreciation = $3.1M
  • CapEx = $.47M (expect FY 2008 capex of $4M)
  • Expected FY 2008 Normalized Free Cash Flow ~ = $96.9 (assumes 15% net income growth)
• Enterprise Value = $772.7
  • Market Cap = $953.7M (45.2M shares * $21.1/share)
  • Cash & Investments = $181M

*Q1 2007 revenues & EPS reflect one-time $2M in revenues from a patent license fee

~Ignoring share compensation and bumpy non-operational line items such as tax, receivables, payables, etc

Operating Highlights

Individual Web Channel

• The cancellation rate stabilized after six months of increased cancellations due to the 2007 price increase
  • ARPU increased due to increased usage after several quarters of declining usage for credit sensitive users
• eFax continues growing
• Won three 2^nd place Telly awards: B2B advertising, internet advertising, and copywriting/humor
• By the end of May the voice monthly run rate should hit $1M

Corporate Channel

• Now almost 25% of paid DIDs (just over 20% of revenue)
• 7 new large customers^ (now 47 total)
• 350 international customers
• 54 active prospects in pipeline

^ A large customer is a customer with over 1,000 DIDs

International

• Just under 15% of revenue and 10% of paid DIDs (higher ARPU)
• 44 countries covered by fax including new countries Slovakia and Slovenia
• Growth rate = 41%
• Fax growth rate = 25%
• eReceptionist to launch in Western Europe in Q2

eVoice / OneBox

• Approaching 100,000 paid DIDs on May 1, 2008 (vs. 85,000 100 days ago)
  • Average customer buys 3-4 DIDs
• Launched Live receptionist
• Began rolling out voice to text
  • Through 3rd party technology provider
  • Offering voice paid DIDs option to try it for free for one month

Potential Risk

Since 2002, the Congressional Budget Office (”CBO”) has sought charging a tax of $1 annually for each phone line to generate revenue for the federal Universal Service Fund (”USF”). While j2 has been aware of these changes for years legislation appears much closer. Such a change would alter a portion of j2’s business strategy. The company has stated that it would discontinue its “free” service in the US or create a “pass-through subscription” to the “free” subscriber. In either case, j2 would establish direct billing relationships with its “free” customers, which is one of the primary barriers to converting “free” customers to paid subscribers.

For the existing paid subscribers, it is likely that the Company would pass through any tax to these customers just as telephone companies currently do with the various other taxes and surcharges assessed on telecommunications services. This could ultimately have a positive effect as it would spur many free customers to covert to paying accounts and would most likely cause more harm to J2’s smaller competitors.

Disclosure:
I have owned shares in JCOM for years and expect to own them for years to come.