The Present Value of NetZero

We asked the financial analysts at rationalinvesting.com to model NetZero, expecting to find it would fall through the floor. Instead, they found that, given certain assumptions about market conditions, if NetZero can raise about $100 million and continue to grow through about two more loss-making years, it will survive. What follows is their analysis.

The numbers used in this analysis are available in an Microsoft Excel file here. (If the file does not open, try this link. The file may not open at all in Netscape.)

by Manish Aurora
of rationalinvesting.com

NetZero, Inc. provides consumers with free access to the Internet while running advertisements in a window on their screens (in addition to any banners on the pages they visit). It has more than four million registered users out of which 50% are active. Advertising is built into ZeroPort, the firm's custom navigation tool, and LookSmart.com, its internet portal. The firm announced that its software will be packaged with the Oracle backed New Internet Computer, or NIC, a $199, simple, affordable Internet appliance for quick and easy e-mail and Web access. NetZero's Linux-based Z3 software will be bundled with the NIC for a minimum 1-year period. It is launching free Internet access service in Canada this fall, along with a Canadian portal, expanding its reach to more than 3,000 cities across North America.

NetZero was the earliest provider of free Internet access. Now it has competitors — from Kmart to Alta Vista to Juno. And while NetZero is a large player — it has more than four million registered users — fewer than half were "active" in the latest quarter. Translation? Many subscribers use the service in limited form. That has raised questions about whether NetZero can ever make money. So far, their revenues are growing sharply as advertising continues to shift to the web. This shift is constrained by the learning curve of advertising managers used to the traditional media and careful about not harming brands online. So we believe an ad-based revenue model is not inherently inferior to a subscription-based one. If anything, it should be appealing to newcomers who are not tied to the email addresses of subscription based ISPs. They may, however, represent a less attractive demographic.

The company also aims to profit from a variety of distribution agreements of software including one with Qualcomm, owner of 10% of its stock, for the Eudora email client. Other agreements include homepage construction (homestead.com) Rocketcash (transactions on the web without credit cards) co-branded ISP services (Global Sports, quepasa, etc) access to Aetna's network physician website, Intelihealth.com (aimed at consumers), ThinkLink, a variety of messaging services, and a Cisco education program.

Pricing the stock
The aim of this exercise is to reasonably project the Free Cash Flow (FCF) of NetZero and discount it to the present on a per share basis resulting in the stock's Present Value. Free Cash Flow is the cash income or outflow of a firm, including capital expenditures required but ignoring non-cash charges. Please take a look at the accompanying spreadsheet. We place drivers of risk at the top left, and the resulting values to the right.

The 10 Year Treasury Yield, the foundation of any discount rate, is currently 6.5%. Historical Returns of Stocks Above Treasuries are assumed to be 5.5% (stocks are 5.5. percentage points higher than treasuries). This number is higher for small caps but we keep it uniform and play with the beta to tune risk further. Beta is the correlation of a stock's returns with a proxy of the entire market e.g. Russell 2000. It defines the risk of the stock as the ratio of its monthly volatility to that of the index. We cap our Beta at 2 (a Beta of 2 means that the stock is twice as volatile as the market). The reason is a substantial amount of day-to-day volatility in internet stocks is a recent phenomenon and its effect on long term risk is very unclear. Even 2 is a very high beta, and reflects the bankruptcy risk priced into NetZero. The firm needs another $50 million of financing before it turns cash flow positive, and seems to be using partnerships in Canada and elsewhere to avoid asking the public markets for cash directly.

Growth Retention is the change of the growth rate from year to year. For the mathematically inclined, this is the second derivative of revenue. Using a fixed number allows us to project (a slowdown in) growth without making any judgment calls. The current year's estimate may be altered based on news or management statements, but we calculate future years as a mathematical function of past growth. We assume 63% for NZRO. This methodology is an innovation of www.rationalinvesting.com.

Terminal Growth is driven by growth rate retention but can be entered explicitly. It is the long term growth rate assumed in the model to price the stock. This should be in a band around nominal GDP growth (currently 5.5%). We allow for higher than GDP terminal growth for the very rapidly growing firms, but we rarely allow firms to maintain double digit growth.

We then focus on the Terminal Cost Structure of the firm, trying to see where comparable firms are and what the most likely scenario of costs is going forward for that firm and that industry sector. All costs and capital expenditures are projected as a percentage of revenues. We are predicting a terminal Free Cash Flow margin for NZRO at about 20%.

The question we ask ourselves is "What sort of returns would attract investment into this sector? What sort of margins can this business sustain?" For a product that requires several years of negative cash flow to create and has continuing high branding costs, a 20% margin seems reasonable. The second question is "What sort of cost structure is required to continue to grow this firm? Which expenditures drive revenue? What capital expenditure will be required to sustain infrastructure?" And we ignore non-cash costs except one.

The non-cash cost we pay attention to is equity issuance. Most Internet firms are raising cash by selling stock. They are also paying employees in equity, because they are unable to offer the stability of larger firms. So a projection of equity issuance is an important variable. We usually project retention of share issuance at half the retention of revenue growth.

The resulting difference between revenue and cash costs gives us the FCF of the firm going forward. When the FCF and the terminal value of the firm are divided by the projected number of shares outstanding and discounted using Treasury + 5.5% * Beta, or 17.5% in the case of NZRO, we get the Present Value of the stock. The terminal value is calculated using the formula for a growing annuity. In the case of a high growth firm bleeding cash, terminal value represents the majority of the value of the stock.

This modeling exercise can yield many surprises and has helped validate a lot of business models. NetZero is a classic example: it is currently bleeding cash but eventually may have a reasonable FCF margin. It is trading below model value primarily because of the liquidity risk i.e. if there is a downside surprise it may be unable to raise cash to continue to fund itself, but for now it is sitting on $100 million. If the firm continues to execute, resulting returns will be high because not only will the stock rise to reflect the performance, it will also rise to reflect declining risk and lower expected returns i.e. its 'multiple' will expand.

—End