September 20, 2010 - 3:29pm EST by
2010 2011
Price: 1.44 EPS $0.07 $0.18
Shares Out. (in M): 34 P/E 21.0x 8.0x
Market Cap (in $M): 49 P/FCF 10.0x 8.0x
Net Debt (in $M): -4 EBIT 2 6
TEV ($): 45 TEV/EBIT 20.0x 8.0x

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This idea was last written up by issambres839 under the name Photochannel in early 2008.  Basically, issambres' thesis has played out exactly as expected, with respect to everything but the share price.  I refer you back to his original writeup, and discussion thread, for a more fulsome discussion of the business' history.  I think that now is a good time to revisit the name, as some very significant recent headwinds (forex) are starting to abate, and the Company's underlying growth should become much more clear in coming quarters.

It's relatively rare to be able to buy a business at a 10% trailing free cash flow yield.  Generally, when this opportunity presents itself, the candidate falls into one of two categories:

1) A business in terminal decline, which by definition is subject to declining free cash generation and a declining free cash yield, or

2) A business with a substantial amount of financial leverage, which also raises the risk that the level of free cash generation is unsustainable

What is truly exceptional is the ability to buy a business at a 10% trailing free cash flow yield, where the company in question is in a net cash position, is growing its free cash flow rapidly, and has the drivers in place to grow its top line at a 10-20% rate for the foreseeable future.

PNI Digital Media ("PNI" or the "Company") is such a company.

PNI's is a Canadian-based provider of transaction processing and routing services for digital media to bricks and mortar retailers.  In layman's terms, they provide the technology and network that processes and routes a consumer's uploaded digital photos to a local store, where those photos can be either made into prints, or used to create various photo gifts (mugs, etc.).  PNI's customers include some of the largest retailers in the world, including Costco, SAM's Club, CVS, Tesco, ASDA, and Wal-Mart Canada.

PNI's business is highly scalable: new customers (and their associated transactions) generate little additional cost, so margins on incremental revenues are extremely high.  The beneficial results of this operating model can be seen in the historical financials.  The Company's trailing twelve months (TTM) free cash flow was consistently negative through the end of calendar 2008 as customer ramp was insufficient to offset the heavy upfront capital expenditures necessary to build out the network infrastructure.  However, since then, as transaction growth has continued apace and run-rate capital expenditures have dropped considerably, TTM free cash flow has grown from US$1.4mm to US$4.6mm as of the Jun 2010 quarter.  This US$4.6mm in free cash flow on the current US$48mm market cap yields the aforementioned 10% free cash flow yield.  PNI has used this cash flow to completely pay off its debt, and today the Company has a net cash balance of roughly US$0.14/shr, representing about 10% of the market cap.  Recently, management put a modest share buyback plan in place and began executing on it in the most recent quarter.

Meanwhile, ongoing growth prospects for the business appear strong.  Transaction growth across the network, after dipping slightly to 16% year-to-year in the Dec 2009 quarter, reaccelerated to 18% in the Mar 2010 quarter, and 20% in the most recent Jun 2010 quarter.  Management is guiding towards a long-term growth rate of 15-20% in transactions, the primary driver of revenue.  In addition, the Company is moving into two adjacent, related areas: social stationery (wedding invitations, etc.) and business printing.  The roll-out of these verticals is expected in early calendar 2011, and if successful could provide PNI with access to new markets with at least as much revenue potential as their existing market, if not substantially more.

So why is this opportunity available, i.e. a cash-rich company with 15% top line growth potential at a 10% free cash flow yield?  There are a couple of reasons: one secondary and, I believe, one primary.

The secondary driver of the valuation disconnect is liquidity.  With a market cap of roughly $50mm US, the Company doesn't meet the minimum mandates of many large institutional investors.  Bid-offer spreads can be high, and building a position requires patience.  The Company trades OTC in the US, another hurdle for many institutions.  Shares can also be purchased on the TSX Venture exchange in Canada, but there too liquidity can be sparse.

The primary driver of the valuation disconnect, though, is the massive headwinds the Company has faced in recent quarters from the strength of the Canadian dollar.  PNI reports its financial results in Canadian dollars, however, roughly 2/3 of the Company's revenue is denominated in US dollars.  So, as the Canadian dollars strengthens an equivalent amount of US$ revenue translates into a smaller amount of reported Canadian dollar revenue.  Following the abrupt appreciation of the US$ as a result of flight-to-safety in late 2008 and early 2009 during the height of the financial crisis, the Canadian dollars has appreciated consistently.  So, since the 4th calendar quarter of 2009 PNI has faced successive quarterly headwinds of 13%, 16%, and 12% in its US$-denominated revenue.  Not coincidentally, reported revenue growth over that time frame has dropped from >25% year-to-year, to under 5% in the most recent quarter.  On the surface, then, based purely on a cursory review of the reported results, it appears as if PNI's aggressive growth days are behind it, despite the fact that transaction growth has actually improved in recent quarters.

Fortunately, there is a light at the end of the tunnel.  Year-over-year US$/C$ comparison should get considerably easier in the current quarter.  Quarter-to-date the Company is facing only a 5% forex headwind, and the comparisons should continue to ease in coming quarters.  As they do, the Company's growth should once again become apparent to investors, roughly matching transaction growth, and the current valuation disconnect is unlikely to last.  A combination of consistently growing free cash flow, and a declining free cash yield as investors once again warm to the growth story, should provide substantial upside to PNI shares.


C$ strength abates, underlying growth becomes clear.  More aggressive share repurchase activity.  Roll-out of social stationery and business printing verticals.
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