|Shares Out. (in M):||10||P/E||0||0|
|Market Cap (in $M):||22||P/FCF||0||0|
|Net Debt (in $M):||2||EBIT||0||0|
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First, Creative Realities participates in the secularly growing digital marketing industry with a comprehensive offering of technologies and services that no competitor can match.
Second, the “challenged” industry is very fragmented with generally poor profitability. Creative Realities potentially can grow quickly with a planned roll-up strategy to achieve the scale needed for strong profitability in a competitive market.
Third, the company has gross margins superior to their competitors due to a cost advantage. Importantly, it appears they can transfer much of this cost advantage to acquired operations.
Fourth, the company is led by a dynamic ceo, a “serial entrepreneur”, who previously founded and organically grew a startup before successfully pursuing a roll-up strategy in the IT industry remarkably similar to the plans for Creative Realities. Much of the experience from this roll-up strategy is directly applicable to the current situation. The development of the company’s custom-designed employee resource planning (ERP) system, too expensive for the company’s current size, but a significant cost advantage as the company scales, is likely motivated by this experience and IT expertise. A high quality ceo running a really small company can make for terrific investment returns.
Fifth, this business has characteristics that can produce a sustainable high return on equity. It’s an asset-light business requiring primarily offices staffed by talented people with computers and a few warehouses for distributing hardware. Little capital is required to grow rapidly. While participants in the industry are all selling substantially the same products and services, healthy margins are still possible as customers face high switching costs. Regular upgrades, improvements and expansions as flat screen costs continue to fall will be necessary. The customer’s existing supplier has a big advantage getting this business. Ceo Rick Mills targets 20% ebitda margins.
Sixth, the IPO and Nasdaq listing has generated some small measure of liquidity that should permit the company to use their stock as a “currency” for the acquisition strategy. Mills has ambitions to increase revenues to $150 million, six times higher than 2018 revenues, in the next three years.
Seventh, since Rick Mills became ceo of Creative Realities in an October 2015 merger, he has roughly doubled revenues organically. With the just closed acquisition of Allure Global in November, he should have the added scale to achieve consistent profitability.
Finally, the valuation on the stock at well less than 1 times revenue does not reflect the company’s superior gross margins near 50%, the recent 30%+ organic revenue growth, or the leverage to the bottom line that will come with scale.
CUSTOMER SWITCHING COSTS
Digital marketing has no high-value or proprietary technology. The reason there are currently hundreds of little digital marketing firms is because it’s not difficult to start a digital marketing business. You can buy your flat screens from a number of manufacturers and there’s not a lot of difference among them. There’s a number of content management software (CMS) systems you can license. Screen installation services are available from contractors like the Conexus World company that Creative Realities ceo Rick Mills started in 2010. You can contract with Amazon Cloud for servers. Lease some office space and hire sales people, software engineers, networking engineers, some advertising content creators, and a book keeper and you’re in business. Not a lot of capital is required.
The competitive nature of the business is evident in the financials of publicly traded digital marketing firms. As discussed later, Creative Realities is a compilation of start-up companies two of which, Wireless Ronin and Broadcast International, were independent and publicly traded. These two companies burned through more than $100 million in investor money before joining with Conexus World and a New-York based interactive digital marketing firm to form Creative Realities. After raising $10 million in the recent IPO, the market values the whole lot today at just $30 million. Publicly-traded digital signage company RMG Networks, after repeated reverse splits totaling 1 for 30, finally went private in 2018 at $1.30. It came public as a SPAC at a reverse split adjusted $300, so after 10 years of waiting investors lost 99% of their money. Buying a stock in this industry takes guts (or stupidity) in view of the history.
This is a service business. People create content, write software, install screens, and keep your network running. Creative Realities gross margins, however, have run 62% in the latest quarter, 48% in 2018, 42% in 2017, and 50% in 2016. Those are healthy margins for a services business that requires little capital. Mills notes in the 4Q, 2016 conference call that they’re higher than their competitors because Creative Realities has a cost advantage. The reasons are important to the investment thesis and will be discussed later. But why do digital marketing businesses whose services are essentially commodities earn high gross margins?
Before I even asked, CFO Will Logan volunteered in a phone call that their products and services and everyone else’s in the industry are essentially the same. But he noted that switching costs matter. Once you have a customer established with their screens installed, their network running, and their employees trained on the software, it costs them a lot to switch to a competitor and do it all over again. When an upgrade or expansion comes, the incumbent provider has a big advantage in bidding for the business. Even a new customer realizes they’re going to be stuck with the provider they choose for years. A myriad of other things like network uptime, comprehensive offerings, geographic reach, and financial stability may be more important than cost. The reason the industries’ gross margins are high and can remain high is that customers face high switching costs. Couple that characteristic with an asset-light business model and there’s potential for a sustained high return on equity business.
Finally, consider that screen prices remain a significant cost of digital marketing campaigns, but screen prices continue to fall rapidly. Digital marketing should become more attractive and the industry should grow. The out of home digital marketing industry is projected to continue to grow at an annual rate around 11% through 2023. Captive customers are likely going to need more high-margin software and services over time. A Creative Realities investor could hope for a sustained high return on equity business that organically grows at a moderate rate too.
Creative Realities CEO and significant shareholder Rick Mills believes the industry needs to consolidate. As screens became increasingly cost-effective, little digital signage firms popped up in every major population area with an estimated 300 to 600 of them in the United States today. They’re typically owned by a sole proprietor/founder that managed to get a project with one or two major anchor customers and then built up a number of smaller clients over time. Revenues are typically $3 million to $10 million but Rick notes they don’t have any good means to expand. Gross margins are healthy but profitability is “challenged” as the business lacks sufficient scale to cover all the network support and fixed costs. He wants to roll some of these little operations up and become one of the “three, four, or five” enterprise grade companies that achieve sufficient scale to be profitable and flourish. CFO Will Logan emphasized in a phone conversation that in their thinking it’s all about scale. There’s nothing fundamentally wrong with these businesses today; they’re just too small to cover all the operating costs and leave a healthy profit. Mills does think falling screen prices are going to increase customer screen rollout sizes up to 20,000 or 30,000 (from 5000 or so) screens for that large anchor customer. That customer may begin to question if that little $5 million revenue sole proprietor has the resources to support that larger rollout. It might be time to pay the switching costs and contract with a larger organization with the scale, national reach, comprehensive services offering, and financial strength to handle big rollouts. All the more reason for the industry to consolidate, and Mills plans to be the publicly-traded consolidator. If his thesis and strategy is right, a Creative Realities investor could hope for a sustained high return on equity business that grows rapidly, with organic growth juiced up by acquisitions.
I’m buying the story, but I’ll note that if you read the filings of Creative Realities predecessor Wireless Ronin, you’ll see they had the same roll-up strategy in mind in 2014. They rolled up a lot of red ink. Mills opines in the 2017 interview linked below that there was nothing fundamentally wrong with their roll-up strategy. The company just needed better execution at integrating merged companies together. So why can Mills succeed where others have failed? You’ll see his strategy to integrate efficiently later, a strategy that reflects both his technical background and his prior experience rolling up a remarkably similar fragmented industry. So on to this background first.
UNIQUELY EXPERIENCED AND AMBITIOUS LEADERSHIP
CEO Rick Mills tells his story in this interview (https://www.sixteen-nine.net/2017/06/07/sixteennine-podcasts-rick-mills-creative-realities-cri/) but I’ll try to summarize briefly. He founded an IT company called "The Computer Store of Kentucky" in the Louisville area in the 1980’s. He grew it organically before merging it with publicly-traded Pomeroy Computer Services where he became the COO. Little IT companies had popped up in every major city in the 80’s as computers and the internet became ubiquitous. As Pomeroy COO, Mills executed 18 acquisitions of these little IT companies between joining the company in January, 1993 and his exit from the company on March 31,1999. SEC filings still available reveal that revenues grew from $61.3 million in the year prior to his arrival to $627 million in his final full year with earnings per share rising from $0.35 to $1.72. This is great experience for his current roll-up strategy as selling, installing, and supporting computers is similar to selling, installing, and supporting the flat screens needed for the digital marketing space. Numerous little IT companies popping up and then being consolidated in the 1990’s is similar to digital marketing companies popping up in the 2000’s and 2010’s decades and needing to be consolidated today. No wonder Mills sees the opportunity and has ideas about how to do it right.
Sixty-three year old Rick Mills' successful experience at Pomeroy Computer Services is at least a good sign that he might be a capable executive. CFO Will Logan notes that he’s a “serial entrepreneur” that has started a number of companies. At 63 he doesn’t need to be working but is at the office every day excited to be building another company in an industry that he “believes in” and plans to continue for at least several years. His current employees at Creative Realities give him unusually good reviews on Glassdoor and Indeed. His ambitions for the company are evident in their comments.
This is the company you want to work for now, so you can be a part of where it's going to be in ten years. This is a company and a team on the rise, and big things are coming. There are big demands, they want hard work and they want skill. But if you come to the table and give it your all, you'll get back more than you put it. It's a tough place, but fair. Best job I've ever had.
Creative Realities has many of the challenges of any start-up mode company, but they will succeed because of their fantastic CEO; a true business leader in every sense.
New CEO, Rick Mills, doesn't need any advice; he "gets" it.
Tremendous atmosphere that continues to get better each day. Highly focused team that continues to bring in top talent. Leadership is top notch and really looks out for the needs of our employees. Some of the recent hires have made an immediate impact on the organization
There is a lot of investment in new platforms and technology underway. The offices and work environment are very inviting and comfortable. A lot of big name clients always keeps work interesting when you can actually show people you know what you are supporting and doing for a living.
The last comment about “a lot of investment in new platforms and technology underway” hints at the preparation to efficiently integrate and also transfer the high gross margins Creative Realities currently earns to the acquisitions to come. While Mills has been preparing for efficient acquisitions, he's grown Creative Realities revenues organically in 2016, 2017, and 2018 from $13.7 million to $17.7 million to about $25 million. I'd note that this revenue growth has been repeatedly lower than the enthusiastic guidance given to investors, and the stock is less than half its pre-IPO pink sheet trading price, but it’s still impressive growth. The CFO, Will Logan, notes in a phone conversation that the missed guidance is due mostly to delays and not lost business.
Mills started Conexus World around 2008 as a company that installs and services flat screens for businesses. Mills still had contacts with installation people all over the country that he had used to install computers and IT phone systems for businesses in his prior Pomeroy life. With his network of service organizations, he could support the nationwide installation needs of companies like current Creative Realities customers Chrysler and Mazerati dealerships, Circle K convenience stores, Ryder Truck, Chanel stores, Coca-Cola, and fast food restaurant chains. Conexus World just installed and serviced, however. The cloud-based content management software, the local hardware and software support, and the assistance creating the customized content for customers was provided by other companies. Mills wanted a comprehensive digital marketing company with national reach and starting Conexus World was just the first step.
To make it happen, he merged in October 2015 his $4.5 million revenue Conexus World installation company with a relatively large but struggling publicly traded digital media company, Creative Realities, and retained the Creative Realities name. Creative Realities consisted of a New York based interactive marketing organization that had merged in 2014 with publicly-traded Wireless Ronin. Another publicly traded company, Broadcast International, had merged with Wireless Ronin a year or so prior. Those two publicly traded companies had burned through more than $100 million in investor money. What they had left of value was their own content management systems with capabilities to centrally manage all of a global enterprise’s digital media assets and some mostly unhappy customers. Mills took stock in the newly merged company as compensation for his contribution of Conexus and assumed the CEO role. Creative Realities could now offer a comprehensive solution, content creation in their owned software including interactive marketing campaigns, installation and service of screens nationwide, and network operations and IT-like support that has since been relocated from New Jersey to Louisville. Mills intent was made clear in the merger press release
Rick Mills, the incoming Chief Executive Officer and Director of the Company added, “We are pleased to be joining forces with the Creative Realities team. This is about creating scale and a platform optimized for organic growth and acquisitions. As the growth of digital marketing continues to accelerate, we are well positioned to be the provider of the total solution.”
But Creative Realities was a financially distressed company requiring Mills to borrow $4 million or so (bonds eventually bought by Pegasus who owned 60% of the common) to keep the company afloat while he cut SG&A in half and met with customers to reassure and retain them. Since then revenues that had been flat for years have doubled and the company is back on sound footing. Most of the debt and all of the preferred stock was eliminated in the November, 2018 IPO by converting them to common while also raising $10 million to pay for the $8.5 million Allure Global acquisition that closed a few weeks later.
Mills has done an IT industry roll-up before and the digital marketing roll-up is very similar. Mills is trying to execute the roll-up strategy right. This requires efficient integration of acquisitions taking full advantage of the resulting scale to operate at a lower cost. CFO Will Logan explained some of the cost advantages the company has enjoyed and I’ll use COO John Walpuck’s comments to explain another that they’ve spent a couple years creating.
First, Mills moved all the network operations from New Jersey to Louisville. The major expense for the company is salaries for skilled engineers. CFO, Will Logan, notes that salaries in Louisville are 10% to 20% lower than in many other areas. He humorously noted his salary was public information and suggested looking at it as evidence. Kentucky housing costs run 74% of the national average and the city of Louisville runs at 86%. University of Louisville and Bellarmine University (where Will Logan attended) are in the city to provide talent.
Second, Will Logan noted that they already have more scale than many of the acquisition targets they’re considering. The flat screen prices they pay are about 10% lower than the smaller firms because of the higher volume.
The third cost advantage is the most interesting and probably stems from Mills expertise in IT and specifically expertise in integrating IT companies. Creative Realities has been investing in an efficient custom-developed operating platform designed to integrate acquisitions efficiently but also to operate with the efficiency of large corporations. Logan noted that these were investments too expensive for a company their current size but they’ve made them in preparation to be bigger. There’s five or so different content management software systems in common use and customers of acquired companies generally will not want to switch. Mills has developed the software to run all five and created the computer science infrastructure in Louisville to very efficiently transfer the “back office” needs of acquired operations to the servers in Louisville. Project management and IT support for the acquired software will also be provided from Louisville. The idea is to acquire and quickly reduce network operation and IT-like support costs by merging them onto their efficient Louisville platform operated with less expensive labor.
COO John Walpuck describes their efforts on the 2nd quarter 2018 conference call as follows:
I'm going to talk just briefly about our systems infrastructure and tool sets as a part of our broader platform here at CRI. In short, we know of no one else in the industry who has these capabilities, this complete suite of capabilities and offerings today. We believe our system infrastructure, tool sets and, importantly, how we leverage these is a competitive advantage today and we have a roadmap to further distance ourselves from the competition in the future.
In sum, it's currently comprised of three core systems. It includes third party integrations via APIs and integration layers with partners and certain very high volume transactional services clients.
It's all cloud based. Each serves as a true origin system with full integration across all systems, highly, highly scalable. This infrastructure and tool set is designed to scale and support hundreds of millions of dollars of transactions with minor additional investment and personnel.
The functionality at a higher level includes field service with the ability again to support very high volume transactional service processing, project management, inventory management, order processing, client portal capabilities, automations, alerts, escalations et cetera.
The systems themselves are critical, but we believe it is also extremely important to know how we holistically incorporate these into our operations. It's literally an ERP solution that actively involves the people, how we communicate internally and with our clients and partners, processes and ongoing process improvements, the raw data itself that's going into the system, how we train our employees, the reporting operational and financial and then again the feedback loops are super important here with the actions that we're taking based on each of the foregoing.
Going forward we're actively working on specific additional third party partner integrations and actively adding additional functionality. Again, we believe this is a competitive advantage today and will further distance ourselves from the competition in the months and years to come.
Rick, back to you.
I like the management, and I like the “challenged businesses” roll-up opportunity, and I like the valuation, but this is the reason that convinced me to own the stock. Creative Realities can buy companies and quickly reduce their server, program management, IT support, and other production system costs by moving these functions to their efficient Louisville operations. This is going to jack the gross margins of acquisitions closer to the higher levels that Creative Realities has been earning. The Allure Global acquisition was purchased for 0.9 times revenue, but after integration will likely contribute more than the 20% ebitda margins that Mills is targeting for the entire company. That makes the purchase price effectively less than 4.5 times ebitda, very cheap for an asset-light company with captive customers. There’s more similar acquisition targets in this “challenged” industry.
Will Logan provided some information from their recent Allure Global acquisition. Salaries at Allure in Atlanta were indeed 10-20% higher than Louisville so there should be some back office and network cost savings. He expected the acquisition to be integrated in just “30 to 60 days”. When I was incredulous, he noted some things will probably go wrong but that’s what they were planning. Mills averaged 3 acquisitions a year at Pomeroy so apparently he’s prepared to integrate these IT-like businesses quickly. Benchmark analyst Bill Sutherland reports that Mills targets $150 million in revenue with 20% ebitda margins in three years. That’s a lot of acquisitions but if integration can be done in 60 days maybe it’s possible. Logan also offered that Allure Global used Quickbooks to do their accounting. When moved to Louisville, their ERP system is going to handle orders efficiently, simultaneously managing accounting and inventory and project management tasks in the same system (similar to SAP I think but customized for their business). In short, Allure Global is a tiny company with tiny company systems that should show cost savings when integrated into Creative Realities big company systems in Louisville.
I think this could be a compelling roll-up situation for reasons that I’ll summarize.
1. These are a lot of small mom and pop businesses that have no ability to grow outside of their limited geographies to get the scale that will be important as this industry matures. Mills notes that a lot of owners are near retirement age and the systems in Louisville are designed to handle "hundreds of millions of dollars in transactions" with few additional people or equipment. CFO Will Logan expects SG&A to remain relatively fixed as revenues grow.
2. A rolled up company can support nationwide retailers that all these small local businesses cannot. National reach will be required for many customers and scale is going to become important to be cost competitive for all customers.
3. The screens just keep getting cheaper so digital media advertising is likely to continue to grow. Last year the industry grew 12% and projections are for that to continue for a long time.
4. Creative Realities is now Nasdaq listed with about $10 million of shares in the float. That gives them stock to pay for acquisitions allowing them to roll up quickly.
5. You’ve got a ceo who has successfully done a similar roll-up in a very similar business in the past. He’s already turned around Creative Realities to some extent with organic growth. He still owns a significant chunk of the company (around 6% I think).
6. The company has spent a couple of years creating a unique ability to acquire, integrate quickly, and take out back-office costs. One might expect the gross margins of acquisitions to be boosted to the superior 50% range that Creative Realities has been posting. This could create a lot of value for shareholders.
7. The stock trades at a market cap of about $22 million (roughly 9.8 million shares outstanding) with pro-forma 2018 revenues of $35 million. That seems cheap in view of their capital-light operations, near 50% gross margins, and revenues that have nearly doubled organically in the last couple of years. They did the IPO in November when the market was spooked. Trying to sell a $10 million offering of a nanocap was tough. CFO Will Logan confirmed that they had difficulty getting the IPO done but offered that they felt they could not delay as the Allure Global acquisition could be lost. He noted the IPO cleaned up the preferred stock and debt as well and would allow them to be more aggressive with further acquisitions. Scale is paramount in their thinking. I noted that Rick Mills’ ownership was diluted in the IPO, and Will related that Rick’s thinking was that they had to do what was best for the company (achieve scale). If they did that, the shareholders would eventually benefit despite the dilution. The IPO at a bad time may have created an attractive entry price.
The rational for the dilutive IPO and Nasdaq listing was to create a currency for acquisitions. Acquiring a 0.9 times sales company using a 0.9 times sales stock doesn’t create so much value. Creative Realities needs to realize a higher stock price to finance a roll-up. I don’t believe a 0.9 times revenue valuation on an asset-light business with near 50% gross margins makes sense unless the business can’t scale. The market doesn’t agree with me currently, however.
Be aware that Mills has a history of over-optimism on guidance. Just this summer they expected $33 million in revenue for 2018 that has already been dialed back to $23.2 to $27 million. Year 2017 had projections of $26 million in revenue initially that ultimately resulted in $17.5 million. I don’t fault Mills for what is actually healthy growth, but I do fault him for giving guidance that the company doesn’t even come close to meeting.
Much of Creative Realities work is capital spending prone to be dialed back in bad times. Just five customers account for a majority of revenue and work from these customers can be lumpy. In particular, large installations in Fiat-Chrysler dealerships, Circle K convenience stores, and large non-recurring software development projects in recent years may not be replaced in 2019.
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