London-based digital content provider Zoo Digital (LON:ZOO) shares fell almost 50% in early trade today after the latest update, which cited the bad words ‘significantly below expectations’. As a company who valuation was high because of the expectation on growth rather than current profits, the share price reaction was strong:
This does not tell the whole story: the share price moves in this company have been large. In August this year they topped out at over 170p, giving a 300% increase for anyone invested since the start of 2018, and many, many more times for anyone involved before that. While the recent declines may be large, any early holders would still be in massive profit.
The large valuation and interest in the shares lie with what the company does: it provides ‘cloud-based localisation and digital distribution services’ for the entertainment industry, which in real terms means provision of subtitles and dubbing services. The market for this is wide open, with the number of combinations of programs and languages only infinite, with the only deciding factor being if any media company wish to purchase it.
The company have been around for a while but only recently have turned their hand to localisation services. In prior incarnations they published video games and interactive DVDs. A latter move into subtitles saw them pick up an array of high-profile clients such as Apple, the BBC and Netflix.
In terms of business performance, as in common with many growth companies profits have been sacrificed for revenue growth, which has been extremely impressive: 2017-2018 saw the biggest jump in revenues. This was largely associated with the large share price jumps we have seen in the past year.
The warning comes out in a morning RNS:
Although trading in the second half began encouragingly with the previously-reported disruption to localisation revenues having normalised, together with the Group continuing to secure a number of appointments as a preferred vendor with major media companies, the second half performance has been affected by the loss of a single, material localisation project that was scheduled to begin and be completed during the period. This was due to reasons wholly unrelated to the Company. Furthermore, revenues associated with processing legacy DVD and Blu-ray titles in the second half will be significantly lower than anticipated as the overall market decline in this area has accelerated more quickly than envisaged.
The company have helpfully translated what this means in figures, although it is not quantified what the final result will be.
Accordingly, the Company now expects revenues for the second half to be comparable to those in the first half, and therefore to be approximately 10% below full year expectations. The Group expects to be profitable and cash generative in the second half, but in view of the largely fixed cost base of the Group and the higher margin associated with DVD and Blu-ray processing, Adjusted EBITDA* for the full year will be significantly below expectations. The Group expects to end the financial year with a cash balance broadly in line with that at the year ended 31 March 2018.
The cash balance was $2.4m at the end date last year, which if held this year represents a good gain on the interims ($0.9m).
It is hard not to get excited about the prospects for Zoo. Companies such as Netflix and Amazon’s video service are only going to grow in popularity, and successful, high quality translations of programmes only allows them to increase their product offering. In addition, the number of films appearing on DVD is increasing all the time, giving a constant supply of material for Zoo to work on.
The question will be whether operations can be done to the benefit of shareholders. As the warning implies, there are only a limited amount of large media companies, and therefore some customers may account for a large amount of revenues. Whilst the reasons for a loss of contract might not lie within Zoo, it could lie elsewhere, for example an in-house service. Quite often ‘jam tomorrow’ does not translate into returns.
In real terms the company are awaiting the step up in volume to use the operational leverage to deliver high levels of profits. And it does not seem they are far away, although today’s announcement perhaps puts the profitability point back in time. They are profitable on an adjusted EBITDA basis, but items such as share-based payments, finance costs and amortisation and deprecation are heavy and cannot be ignored. Development costs for software are capitalised but are incurred regularly.
There are potential dilutive effects for shareholders, as the recent solution to the cash demand was to use equity as a tool:
There are some $3.5m dollars of convertible loans sitting on the balance sheet, which are expensive to service: carrying a 7.5% coupon rate and were convertible at 48p. Given the incredible share price rise last year, some $500,000 was cashed in. With the share price the way it is at the moment it is likely that the loans will not be converted.
However, there are several other options that can be exercised (some of which have been already):
Customer concentration is a real risk: the last report states that the largest customer represents 34% of sales, and the second largest, 24%. As we can see in the profit warning today, even a slight impairment to one of these has real detrimental effects for the company.
A loss of a key client appears to be the main risk here. The balance sheet is not in a great position, considering intangible assets there is a small negative tangible asset position. Prepayments and accrued income have jumped sharply over the past year.
The main bugbear most will have with this is the valuation. At a market cap of £100m+, the valuations even on an adjusted EBITDA were incredibly high. Today, the valuation of the company has come down to £46m, which is a more realistic target for investors to consider. Stockopedia estimates were giving net profits as $1.8m for 2019 and $2.3m for 2020, although this might be set back due to the profit warning today.
It has to be considered whether the cause of the warning is due to a one-off or something more structural. The company assures us that it is not. Although the decline in legacy DVD titles does seem to be market-based, this is not where the bulk of money is made.
Some worries for me are if value is really added: people are where the talent lies and not the company itself. There may be a risk that someone else finds a way to recruit and organise them, although it has not looked that way thus far with many big media companies happy with Zoo.
Another worry is dilution. The convertible loan and options add more potential shares to the pot, and the expensive borrowings thus far indicate perhaps a reticence of the banks to fund the company, perhaps due to the lack of tangible assets. Therefore more equity raises could happen in future, especially if acquisitions come into play. On the flipside, the CEO accounts for a large number of shares.
I still believe the shares are still quite expensive, but could become good value on a better update next time around if customer concentration risk is reduced. 3/5.