jebmo’s posthaven

IDT Corporation (NYSE:IDT) is an entrepreneurial holding company founded in 1990 by Howard Jonas, which has over the years been involved in a variety of business ventures including calling cards, shale exploration, debt collection, wireless spectrum, media and comic books among many others.

Howard’s bread and butter has been investing in a collection of misunderstood or underfollowed assets cheaply and selling them at nosebleed valuations. His notable successes have included selling IDT’s stake in Net2Phone to AT&T (NYSE:T) for $1.1 billion in 2000 and more recently, the sale of Straight Path Communications (NYSE:STRP) to Verizon (NYSE:VZ) for ~$3.2 billion (STRP was spun out of IDT in 2013 and holds 5G wireless spectrum licenses).

After several successful spin-offs, it looks like there will be one more on the horizon for IDT. IDT plans to complete its transformation into a pure play telecommunications and payments company in Q4 2017 by separating its remaining non-core assets. The basket of assets to be spun off consists of (1) the real estate assets, (2) investments in early stage pharma and around $60 million of cash to fund future investments. The pure play IDT will consist mainly of its telecom and payment services (“TPS”) business and smaller UCaaS (“United Communications as a Service”) and Consumer Phone Services segments.

The best way to value IDT is as a sum of its various parts, which we refresh here ahead of the upcoming spinoff.

Cash

IDT has around $146 million in cash after adjusting the unrestricted cash balance of $132 million for the dividend paid in Q2 ($5 million), sale of 1mm shares to Howard Jonas ($14 million), and cash received from the sale of the Gibraltar Bank ($4 million). As mentioned previously IDT will be sending around $60 million of cash with the spinoff to invest in pharma, which we include with pharma below.

We arrive at ~$40 million of cash at Telecom after excluding the ~$60 million in cash that will go with the spinoff and ~$45 million in minimum cash to service the deferred revenue liability. To be conservative, we assume that the $40 million will be spent on growth capex over the next 2-3 years to build out the BOSS MVNO and payments businesses and do not give IDT any credit for excess cash at the core TPS business.

Real Estate

IDT’s real estate assets include its 18-story 500,000 SF office building in Newark NJ, HQ and associated 800 car parking garage, an operations facility in Piscataway, NJ, and a 12,400 SF condominium interest in Jerusalem, Israel. IDT’s focus is not on the real estate so we don’t see management creating a ton of value here other than to possibly re-mortgage the Newark HQ building to raise more cash for the pharma business.

The main asset here is the Newark HQ building (520 Broad Street) and parking garage, which generates revenues of around $2 million per year. IDT acquired the Newark building in 2008 for $50 million and it fell into disrepair after flood damage. IDT spend around $10 million in FY2015 to renovate four floors (of the 18) so that it could move back into the building.

The Newark building is carried on the books at ~$46 million and assessed at $20 million in public NJ Property Tax Records. The neighboring Verizon Bell Tower (540 Broad Street / 436,000 SF) was sold to a developer for $16.5 million in 2016 for a residential conversion compared to an assessed value of $38 million.

Based on our due diligence, the Newark building is not currently tenantable and a developer would have to invest at least $30 million into the property so we think that it should be worth in the ballpark of ~$10 million or less. The Piscataway facility was assessed at $3.5 million for NJ property taxes and we assign this a value of zero. $10 million for the real estate gives us $0.40 per share in value.

Pharma

IDT has invested $10 million in a 50%-owned subsidiary, CS Pharma, which has raised an additional $10 million in funding from outside investors for pharma and biotech investments including the hedge fund manager, Michael Steinhardt. To date, CS Pharma has invested $10 million in a clinical stage oncology therapeutics company Rafael Pharmaceuticals (fka Cornerstone Pharmaceuticals) in the form of a convertible note.

IDT also holds warrants to purchase a stake of up to 56% in Rafael Pharma at the lower of a 70% discount to the valuation of the next capital raise or $1.25 per share in an IPO. It would cost around $60 million to exercise these warrants, which would be at a valuation of ~$100 million (for 100%), which is roughly the amount of cash that IDT will be sending to the spinoff.

At first, the pharma investment seems totally random but we think that it is another example of Howard Jonas buying a cheap lottery ticket. As a bit of background, Rafael Pharma was founded in 2001 by Dr. Robert Schorr (President & CEO) who also coincidentally happens to be a rabbi. The Company’s lead anti-cancer drug CP-613 from its Altered Energy Metabolism Directed (AEMD) platform targets the mitochondria of cancer cells to choke off the energy supply and inhibit reproduction.

CP-613 is currently being evaluated in 15 Phase 1 to Phase 2 clinical trials as a single agent and in combination with standard drug therapy for hematological malignancies and solid tumors. Rafael Pharma was poorly managed and about to run out of funding last year before completing the Phase 1 clinical trials when Howard Jonas convinced IDT and other investors to provide the needed cash. In March 2017, the Company had a breakthrough when the FDA gave CP-613 the go-ahead for Phase 2 clinical trials for patients with acute myeloid leukemia (AML) and pancreatic cancer.

Phase 2/3 clinical trials for AML and pancreatic cancer are very costly due to the difficulty in obtaining a large enough sample size of patients in advanced stages, which requires conducting trials at multiple hospitals. We think that Rafael Pharma will have to spend at least ~$100 million on Phase 2/3 clinical trials for CP-613.

In a May 2017 WSJ interview Howard Jonas stated that “Drug developer Cornerstone Pharmaceuticals Inc. is taking up 90% of his time” and that with his windfall from selling STRP to Verizon, he no longer has to search for partners to fund development of the drug and can write the checks himself. The fact that $60 million of IDT’s cash is being funneled to fund future investments in Rafael Pharma and that Howard is willing to pony up the cash for future Phase 2/3 clinical trials of CP-613 tells us that as an insider, he is extremely bullish on the prospects of the company.

The important thing here is that the warrants were issued to IDT before Rafael Pharma completed the Phase 1 clinical trials – the valuation of other biotech companies has typically increased by 2-3 times after releasing positive Phase 1 results. We think that a good comp for Rafael Pharma is Calithera Biosciences (NASDAQ: CALA), also a clinical stage oncology company whose leading drug CB-839, a glutaminase inhibitor, is currently being evaluated in Phase 1b and Phase 2 clinical trials. CALA is pre-revenue and has a market cap of $482 million with around $164 million of cash (EV of $318 million).

If we go by what IDT has invested so far plus the cash that IDT plans to invest, the total value of cash plus pharma is $70 million ($2.80 per share) with a free option on whatever premium the market would like to attribute to the Phase 1 clinical trial results.

Telecom and Payments

IDT Telecom is a leading provider of prepaid communication and payment services through its retail division and one of the largest providers of international voice termination services through its wholesale division. IDT buys minutes on the wholesale market at a contracted price and quality and resells them on the wholesale market to other carriers and on the retail market via traditional calling cards and PIN-less calling card services.

The wholesale and retail divisions complement each other and IDT has been able to aggressively price termination services in part due to large volume of traffic generated by its retail business. IDT is the 6^th largest carrier and largest US-based carrier of international minutes terminating ~27 billion minutes annually across its wholesale and retail businesses.

Wholesale Telecom (TTM Revenues: $580 million / ~41% of revenues): In the wholesale segment, IDT acts as a carrier to Tier 1 carriers and MNOs providing termination services for long distance calling in more than 170 countries. IDT enters into buy-sell agreements with different carriers, terminating their customer’s traffic in exchange for terminating IDT’s wholesale and retail traffic with their customers.

There are a couple of key trends to note in wholesale. First, termination rates charged by Tier 1 and other providers of international long distance traffic have been on a declining trend due to the liberalization of telecom markets around the world. Second, the higher revenue routes are not necessarily the highest margin because termination costs are also higher so growing wholesale revenues in higher priced routes could often result in lower gross margins.

Third, the growth rate of international voice traffic as a whole is stagnating due to the rise of OTT voice and substitute communication services, which have zero termination costs. This has been facilitated by increased broadband connectivity, which has improved the overall quality of VoIP calling.

The wholesale business is competitive and low margin so scale is important - IDT is a fairly large player in wholesale terminating ~19 billion voice minutes annually. In wholesale, IDT generates $580 million in revenues with gross margins in the high single digits (~9-10%).

Retail Telecom (TTM Revenues: $622 million / ~40% of revenues):

As traditional calling cards have died out, IDT’s main source of retail revenues is derived from BOSS Revolution, a PIN-less calling card service targeting immigrants through a network ~40,000 physical locations (bodegas, convenience stores) for top-ups. BOSS would win out over Skype if the caller is unbanked and if the caller and/or call recipient does not have access to cellular data or Wi-Fi. Otherwise there would be no reason to use BOSS versus free OTT calling apps (Skype, WhatsApp).

In fact, BOSS offers free calling over Wi-Fi/data within the BOSS app to compete with OTT services. Today, IDT’s retail customer base is pretty sizeable with 2-3 million customers and IDT terminates ~9 billion minutes annually in retail. IDT did around $622 million in retail revenues and earns gross margins in the mid-teens

IDT’s main problem is that its core BOSS PIN-less calling card service product seems to be in structural decline. BOSS fundamentally competes with free OTT calling services (Skype, WhatsApp) and will eventually disappear as broadband penetration increases in emerging markets.

Retail revenues could be further pressured in markets where termination costs go to zero making it economical for mobile carriers to offer cheap unlimited international calling - this has already happened in Mexico with the deregulation of the wholesale market forcing IDT to dramatically cut calling rates to Mexico from $0.055/min to $0.019/min in July 2016. After factoring in the full impact from Mexico, retail revenues have been declining sequentially at 3% q-o-q, which would translate to an annual decline of ~12%.

Payment Services (TTM Revenues: $235 million / ~16% of revenues):

IDT leverages its retail customer base and strong distribution channel to immigrant communities to offer payment services including mobile airtime top-up (IMTU), international money transfer (BOSS), and POS solutions for retailers (National Retail Solutions).

Over 90% of payment services revenue is from IMTU, which IDT began offering ~13 years ago. Basically, IMTU is a quasi-remittance service that allows US customers to buy prepaid airtime minutes to load balance into a family/friend’s cellphone in another country. IDT makes gross margins of around ~9-10% on IMTU. IMTU is now a mature business and is expected to grow in the low single digits.

The real driver of growth in payments going forward is expected to be international cash money transfers over IDT’s BOSS Revolution platform and POS solutions for retailers. Money transfer and POS solutions have higher gross margins of ~30-50% but it will take a couple of years for them to meaningfully contribute to the bottom line.

UCaaS (TTM Revenues: $28 million, 2% of Revenues):

UCaaS mainly consists of the legacy cable telephony business with growth driven by Net2Phone cloud hosted PBX calling and IP PBX SIP Trunking solutions for SMEs. UCaaS does gross margins of around ~60% and EBITDA margins of around ~9%. Net2Phone currently has 17,000 seats and IDT believes it can get to 100,000 seats by 2019 at $20/seat/month ($200 ARPU), which would be $20 million in revenues and $2 million of EBITDA at ~10% margins.

To summarize, the core telecom business is declining because of the challenges in retail. At the same time, IDT is pursuing several growth options, which may or may not be successful:

• BOSS MVNO
• International Money Transfer
• POS Solutions for Retailers (National Retail Solutions)
• UCaaS

We think that the most impactful of these growth options the BOSS MVNO. The BOSS MVNO, which will be launched in Q1 2018, will offer cheap calling plans based on usage at sub-$20 per month rates vs. the $40+ fixed rate plans offered by mobile carriers. IDT has several key ingredients in place to launch the MVNO with limited incremental investment:

• Branding – IDT will leverage its existing BOSS brand
• Customer base – IDT has a retail customer base of 2-3 million, which have phone plans from other providers and make calls through BOSS
• Network - Sprint has already agreed to host IDT’s MVNO
• Usage / payments/ billing – IDT has payments capabilities in place and has been spending heavily to build out infrastructure to track usage, which has been a sizeable portion of the growth capex spend

The BOSS MVNO is similar to Ting, which also offers completely unbundled pay-per-use pricing and was launched on the Sprint network in 2012 and has 250,000 subscribers. If ~10% of IDT’s retail customers switch to the BOSS MVNO, this is annual revenue of around $70 million and incremental EBITDA of around $30 million off the bat assuming ~40-45% gross margins (in line with Ting) as most of the G&A spend overlaps with existing retail and payments businesses.

This would be a great return on investment assuming IDT is spending around $10 million in capex annually to develop this. However there is a lot of competition in this space and a graveyard of failed MVNOs.

Taking stock of the situation, we expect the TPS business to generate $36 million of EBITDA in 2017 after corporate overhead and giving zero credit to the MVNO initiative, which could be potentially sizeable if successfully executed. With the core retail business declining at ~10% per year due to the factors mentioned earlier, we estimate a working capital hit of $6 million mainly from lower deferred revenues. IDT has guided to $20 million of capex for 2017 and $23 million for 2018.

The current level of capex spend is elevated due to investment in various growth initiatives including the BOSS MVNO. Looking back historically, IDT’s maintenance capex needs for telecom have been much less at around ~$8-10 million. We estimate ~$40 million of growth capex over the next couple of years, which we deduct from excess cash as a sunk cost without including any incremental EBITDA growth.

This gives us a “run rate” FCF of $20 million for TPS. IDT is not expected to be tax payer due to its sizeable stock of foreign and US NOLs. Just looking at the core cash flows of TPS and with a lot of the excess cash going to the spin-off, it looks like the current dividend of $19 million per year is not sustainable. Given the risks, we would be willing to buy the core TPS business at a ~20% FCF yield, which would imply a value of ~$100 million for Telecom or $4 per share with the MVNO launch as a “free option.”

Potential STRP Lawsuit

Despite the $16 million settlement between IDT and STRP, which included the sale of STRP’s IP portfolio to IDT for $6 million (which was then sold by IDT to Howard at the same price), there is currently a class action lawsuit by an investor group (JDS1 LLC) holding $32 million of STRP stock to invalidate the settlement. As a result IDT may still potentially be on the hook for STRP's sizeable fine from the FCC ($100 million plus 20% of the sale proceeds of $3.2 billion) after being in violation of its duty to build out infrastructure rather than just hoard spectrum licenses.

JDS1 LLC is alleging that in order to avoid the potentially hefty indemnification obligation stemming from IDT’s 2013 spin-off of STRP, Howard Jonas coerced STRP’s board into settling the liability for only $10 million as part of the side deal to sell the IP assets to IDT. From the merger proxy, it was clear that Howard Jonas was only willing to support a deal where IDT would be relieved of the indemnification obligation post-closing.

The 2013 separation agreement has conflicting language as to whether IDT is liable but this could be a sizeable risk for IDT if the class action goes through. Although this will probably be settled for a lot less than the headline amount, our view is that IDT wouldn’t have disclosed this in an 8-K (link here) if it was insignificant or zero probability.

Putting it all together

Factoring in a sizable margin of safety, we’d be willing to pay around $7 per share for IDT and $6 after discounting the additional risk related to the STRP class action. At this fairly conservative valuation, you get the core TPS business, which is in decline at a 20% FCF yield, plus free options on the BOSS MVNO and other growth initiatives at TPS plus a lottery ticket on the pharma business.

IDT Telecom ~$100 million or $4.00 per share at a 20% FCF yield

(-) Additional discount for STRP Lawsuit ~25%

Value of IDT Telecom (after discount for STRP risk) = $3.00 per share

Real Estate ~$10 million or $0.40 per share

(+) Early Stage Pharma + Cash ~$70 million or ~$2.80 per share

Value of Spinco = $3.20 per share

Total = ~$6.20 per share

With IDT currently trading close to $15, we think that a lot of optimism is already baked in based on Howard’s past successes. We think it's better to wait until after the spin-off to try to buy the pieces of IDT at a significant discount.

The core TPS business is likely to sell-off significantly on any announcement of a dividend cut, which we think is very likely as the current dividend of $19 million per year is not sustainable with the investment in growth.

Although we feel that IDT’s valuation is full at current levels compared to where we would be willing to buy in especially given the potential litigation risk related to STRP, we think that shorting the telecom stub is too risky given the cost of paying 1-2 quarterly dividends, uncertainty around the exact timing of the dividend cut and that the BOSS MVNO may positively surprise early next year with a meaningful contribution to top line and EBITDA.

As a ~$70 million market cap company, the pharma/real estate spin-off is likely to be unattractive for current IDT investors who are clipping a 5% dividend, which may create the opportunity to buy this at a sub-$50 million valuation. Given Howard’s bullishness and time commitment to this investment, we’d jump at the chance to invest in the spinoff very cheaply.

This article is part of Seeking Alpha PRO. PRO members receive exclusive access to Seeking Alpha's best ideas and professional tools to fully leverage the platform.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.