Is iSelect a value trap?

Five words you never want to see on the ASX announcement feed are ‘Trading update and CEO resignation'. 

We upgraded iSelect to Speculative Buy in early 2016 but, after two years of floundering results, we decided to lock in a 37% gain last month and downgraded to Sell. The stock has fallen 61% since then, with most of the drop occurring yesterday after the company slashed its profit forecast and warned investors of deteriorating business conditions. 

iSelect's Health division is losing customers faster than you can say ‘marketing mishap'. The number of sales leads in the final two weeks of March were down 17% compared to the prior year and those in the first few weeks of April were down 21%. Things are getting worse.

This continues the trend seen in the interim result, where the number of unique visitors to iSelect's websites had fallen by half a million. ‘For a company whose value is driven by the number of eyeballs it can attract, that's a football field-sized red flag' is how we put it. Management says no improvement in the health insurance market is likely until mid-2019.

Along with the struggling Health division – which accounts for half of total revenue – the company's Energy and Telco segment is also in trouble. Overall leads were flat but the conversion rate was below forecasts. 

Management is pointing the finger at poor marketing but this doesn't seem to be the whole story. At the interim result in February, management blamed marketing being ‘too focused on digital channels' rather than traditional media such as television advertising. Now it's blaming ‘changes in the marketing mix, particularly reduced search engine marketing'. First it was too focused on digital – hard to imagine given this is an entirely digital business – and now it's not digital enough. 

All this is despite record-high marketing costs, which are up 33% compared to last year. The company has more than halved its guidance for 2018 operating profits to $8m–12m, down from $26m–29m, due to the higher marketing costs and declining revenue.

Any large cut to profits is concerning, but that several dissimilar business segments are having troubles makes it all the worse. Though unable to put our finger on specifics, we suspect the problems at iSelect run deeper than marketing – which might explain why the chief financial officer, chief marketing officer, and head of corporate affairs have all recently left the business. And chief executive Scott Wilson resigned yesterday. 

But Wotif...

iSelect may currently have a large slice of the Australian comparison industry but there are few barriers to entry. Several direct competitors already exist, such as Choice and Canstar. Overseas goliaths could also push for a larger share of the market, and there's the ever-present threat of Google or new competitors entering the industry with a free service.

iSelect's business model relies on favourable relationships with suppliers, such as Medibank and Origin Energy. Key providers could side with a competitor or push for lower commission rates, which is more likely if iSelect loses its prominence.

We've seen this story before. With few barriers to entry and little in the way of customer captivity, Webjet and Wotif.com went from market darlings to sitting ducks when larger websites like Expedia decided to muscle in.

What's more, iSelect's insurance and energy niche is under growing pressure from rising churn rates. Customers aren't sticking around as long as they used to, preferring instead to continually switch to cheaper policies as the old ones expire. 

That may seem like a good thing for iSelect, whose business is to find cheap policies for customers, but it probably means falling future commissions from the insurers and energy retailers. If, say, a customer only stays with Medibank for one year instead of ten, it's making less money from that customer, so the insurer is less likely to pay up for that lead in the first place.

iSelect faces three immediate hurdles: (1) If website views and sales leads continue to fall, its brand value will evaporate; (2) If lapse rates in the insurance and energy industry remain high or rise further, it will have a hard time increasing commissions and revenue; and (3) If competition in the comparison website space continues to rise, iSelect will need to spend more money to attract customers. The latter point makes us particularly wary of the gross margin, which has already halved over the past seven years due to increasing competition and higher customer acquisition costs.

Until you reach

The question now is whether you should buy, hold or sell at today's share price. 

A month ago we split our valuation into its speculative and tangible components. iSelect's balance sheet is still in good shape, so the company is unlikely to go bust. As of 22 April, the company had no debt, $21m of cash and $124m of receivables from trailing commissions. There were also $27m of other trade receivables as of December, so we'll assume these remain as well – it's unlikely iSelect's business partners are suddenly opting to pay cash. 

The company does have other liabilities, however, such as trade payables, unpaid wages, and unpaid tax liabilities. These totalled $64m as of December, so we'll assume they're roughly the same. That leaves us with around $108m of tangible book value, or 50 cents per share. 

Tangible assets, though, are a funny thing. In theory, this figure represents what the business might be worth in liquidation, suggesting a rock-bottom valuation. In practice, tangible assets are often only tangible until you reach for them. It's unlikely that iSelect could offload its receivable assets without selling them at a discount or incurring some impairment charges along the way. Also, fees received from some insurance and broadband providers have clawback provisions if the referred member cancels their policy early, so the value of the receivable can change over time.

While iSelect's tangible book value may not have changed much over the past month, the speculative component of our valuation has. The company is losing customers hand over fist. If things continue to worsen, the company could swing from meagre profits to losses. Some of the value in the receivables could be gobbled up by operating losses before management closes shop. Under this dire scenario, the stock might be worth only 22 cents or so. 

Adrenaline

On the cheerful side, if the business recovers, at today's share price we get the current book of trailing commissions roughly at par, plus any future profits. Who knows, one of iSelect's competitors may even extend a takeover offer that attributes a high value to iSelect's brand and customer list. It isn't impossible to imagine a bid of 80 cents or more if the bidder forecasts a turnaround in lead generation and improving commission rates by joining forces. To be sure, though, this is an ultra-optimistic view – in such a fast-evolving online industry, when a brand dies, it's unlikely to come roaring back. 

You can see a range of different scenarios playing out in the table above. These should only be considered in the short-term, though, because – to be frank – it's anyone's guess where iSelect will be 10 years from now.

With iSelect's share price at $0.48 and resting in the middle of our range of valuations, it doesn't look screamingly cheap. Even after the steep share price falls, we'd sooner be sellers than buyers. However, for the adrenaline junkies out there, there may be value on the table if the company can fix its operating problems and win back lost customers. 

Things could move quickly from here and iSelect offers little protection to investors beyond its existing book of receivables. Given the increasing risks it's also hard to pin down a price at which we'd be happy to buy the stock again. With a current market cap of only $100m or so, it's time to move on to bigger and better opportunities and we're CEASING COVERAGE.