The following letter was sent to the board of Spark Networks Inc. (NYSE Amex:LOV) March 8, 2010 in opposition to Great Hill Partners’ bid to acquire the company.
Dear Board Members,
Osmium Partners beneficially owns 6.1% of Spark Networks common stock. We are outraged and deeply disappointed to see that Great Hill Partners (GHP) offered a 5% premium to market to acquire the 56% of Spark Networks that it does not already own, for a paltry 5.2 multiple of enterprise value to heavily depressed adjusted EBITDA. When GHP invested 5 years ago, the valuation equated to $6.95 a share or 11.2x current EBITDA, and after growing EBITDA significantly over that time frame GHP now expects to buy out fellow investors at a multiple of 5.2 times adjusted EBITDA. Recent results are encouraging with Jewish Networks’ subscribers growing 10% over the last two quarters. We believe in a fair sale process that included Match.com, eHarmony, and others potential bidders that the business could sell in the $6-$7 range today.
Spark Networks’ management has in JDate what they term an “iconic” business with a “dominant brand and very high margins” which translates into approximately 92% contribution margins. However, these attractive economics are obscured by management’s investments in the Other Affinity segment, which only has 33% contribution margins. Furthermore, Spark Networks is one of the least efficient operations in the industry, generating only $224,000 per employee versus a peer range of $650,000-$1,000,000. All of the decline in total subscribers over the last three years can be attributed to a management ordered intentional run-off of the General Markets segment. Other factors that have hurt the company’s ability to grow include a 14% price hike on JDate in April 2008, a 50% cut in JDate’s marketing budget, and a large investment in subscale brands with deteriorating economics. Despite all these factors Spark still generates 23% adjusted EBITDA margins.
In our opinion, Great Hill Partners is focusing undue attention on overstated negative factors while ignoring the improvement in subscriber growth in an attempt to acquire our stock at a valuation of less than half of what we think an industry buyer would pay. The current valuation reflects only 4.8x an average of the last four years free cash flow.
We believe management considers JDate an “iconic” business with a “dominant brand” due to the following JDate subscriber attributes (from June 2009 investor presentation):
80% come to the site organically
1/3 of members earn over $100K, 2/3 make over $55K
45% have graduate degrees
94% have college degrees
55% women 45% men
90-93% contribution margins (revenue less marketing)
In summary, Spark is an extraordinary business with extremely high returns on capital, a dominant brand in JDate, a recurring revenue subscription model, and strong user demographics.
Let us review recent history:
- In December 2004 and June 2005 GHP invested $47 million for a 33% stake in Spark Networks at a $143 million weighted average whole company enterprise valuation. On current numbers GHP entry investment was made at 11.2x EV/EBITDA.
- Between 2006 and 2008, Spark used almost $45 million to repurchase shares at a weighted average stock price of $4.20, equating to a 7.4x EV/EBITDA multiple based on 2009 results.
- In January 4, 2008 NY Times reporter Andrew Ross Sorkin wrote an article claiming that eHarmony, Yahoo, and Match.com were rumored to be interested in paying up to $185mn to acquire Spark Networks or $9.05 a share which represents a 16.7 EV/EBITDA based on 2009 results.
- In June 2008, the current CEO bought 70,500 shares at $4.15 a share ($84.5mn enterprise valuation) or 7.4x EV/EBITDA based on 2009 results.
Finally, GHP now expects to buy the 54% they do not own for a meager enterprise valuation of $55 million or 5.2 EV/EBITDA based on 2009 results.
Industry margins and valuation multiples have remained fairly steady over the last several years. Private transactions have occurred at 9.1x EBITDA, which would equate to $5.43 a share, and public market comparables trade at 11.3x EBITDA, which would imply $6.73 a share. We think both implied valuations are understated due to the current inefficiencies in the business. Please see the valuation exhibits below.
In our opinion the company has not done enough to increase its exposure as a public company, such as seek Wall Street analyst coverage, attend conferences, road shows, or do anything proactive to court prospective investors. These actions have been costly; in fact, since GHP has been an investor with a board seat, the value of the company has dropped from $147mn to $62mn.
Why might a strategic buyer pay more than a financial buyer such as GHP?
- From a customer acquisition standpoint the larger the marketing budget the lower the per customer acquisition cost. (Spark Networks’ two largest competitors have 6-9 times the revenue.)
- Match.com’s ownership of People Media and Spark’s affinity brands are typically #1 and #2 in each category they compete in. We believe combining these businesses would be extremely accretive.
- Subscription fees are typically based on regional subscriber concentration; the bigger the network typically the higher the monthly subscription fees. Competitors have significant membership bases to cross sell and significantly grow the various brands while increasing ARPU.
From September to December 2009 we had several conversations with the management of Spark Networks, in which we conveyed our belief that the company was significantly undervalued and that JDate could be readily sold for $6-7 on a standalone basis. Management agreed that Spark Networks’ valuation at the time was “ridiculous,” but said the company was uncomfortable undertaking a formal investor relations program given the drop in subscribers over the years even if the stock was highly undervalued at around 4x cash flow. Nevertheless, management acknowledged that JDate’s value inside of Spark Networks was significantly higher, but they considered taking action to realize this value “uninteresting” and indicated that they were playing for something significantly greater over time. We were frustrated, but as patient long-term oriented investors we agreed that there was significant upside which would be realized over time.
Spark investors have been waiting years to reach this inflection point and in our opinion Great Hill Partners is attempting to acquire our asset without proper compensation including a reasonable change of control premium. How many “iconic” businesses with 92% contribution margins sell for approximately 5x depressed EBITDA or 2x JDate contribution margin? Given ample evidence, we believe Spark Networks is inexpensively valued in the $6-7 dollar range. Therefore, we consider Great Hill Partners’ offer outrageous and grossly inadequate, and intend to aggressively defend our rights as shareholders.
Sincerely,
John H. Lewis
Managing Partner
Osmium Partners
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{ 3 comments… read them below or add one }
I understand what John is saying. On the other hand, I see GHP’s position as well.
A few things that seem to be missing here.
1) Jdate didn’t hit their inflection point because they radically improved the site. I also think 2 quarters of marginal improvement isn’t a true sign of an inflection point. They’re still below their 2006 member numbers. AND to even achieve this so called inflection point, they had to offer DEEP discounts on their monthly fees. Their 4-5% membership growth in Q4 2009 came at a 15% reduction of average revenue per user. Wouldn’t it have been more impressive if their inflection point came from a product improvement, or through advertising instead of just lowering the price?
2) 92% contribution completely ignores the fact that they have other expenses. If I heard correctly on the call, the SEC wants them to remove the contribution line from their statements anyway. There was $5,921 of unallocated operating expenses, some of which must be attributed to their Jewish Networks. That said, it’s still highly profitable because it’s the 800 pound gorilla in the Jewish dating space. The real test though – can JDate grow by spending just 8% of revenues on advertising. If they can’t, then why cheer about such a low advertising spend.
3) Rabid cost cutting over the past number of years has significantly reduced the cost to operate the company. Unfortunately (and ill advised) much of the cutting has come from their operating budget. Considering this is a business where customer acquisition is highly dependent on advertising, it’s no surprise at all that their membership numbers have suffered.
4) Which takes me to the demise of American Singles, it just makes no sense. If they were going to kill the brand, they could have sold it, instead of riding it into the ground. Why would the company wait until the brand was under 10k in members to rebrand it. Should they have thought about that when the brand still had 80-90k in members? Plus, doesn’t this go expressly against their statements from the past 6 quarters of “managing the decline of the brands.”
In short, I think Spark Networks has much bigger issues about whether it goes private, stays public, or splits into multiple companies. They’ve indicated that with the exception of merging their dating platforms into one platform, they will not work on site innovation in 2010. As I see it, the last innovation they did was the creation of the “click” feature.
In closing, I think this is a business based on quality of site, advertising and innovation. At this point, they’re 0 for 3 in my opinion.
I feel our shares are being force purchased at a rediculously undervalued price
Dr. Grant,
If that’s the way you feel, there are 5 lawyers that put out press releases saying that they’re interested in talking with shareholders such as yourself.
A better question for you is what are your thoughts about their General Markets Segment losing approximately 90% of its members since 2005. Or the fact that JDate, their “premier” brand has trouble topping 100k in members. Or that Spark just wrote off $11mm (approximately) from their “other affinity brands” and has said that they’re basically going to focus only on the top brands in that unit and ignore the rest (that’s paraphrased, listen to their quarterly conference call to get the actual wording). Whether the company gets bought or not, these are major issues that will all keep the company’s value lower than it could be.
One person I talked with suggested that a change in management could improve the value of the company.