PNI DIGITAL MEDIA INC PN.TO
March 11, 2014 - 12:18pm EST by
bentley883
2014 2015
Price: 1.24 EPS $0.00 $0.00
Shares Out. (in M): 41 P/E 0.0x 0.0x
Market Cap (in $M): 52 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 42 TEV/EBIT 0.0x 0.0x

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  • Micro Cap
  • Turnaround
  • Asset light

Description

Investment Thesis: I believe the shares of PNI offer small/micro cap investors, or members PA accounts, an opportunity to invest in a company in the early stages of a major turnaround, with a healthy 15%-20% growth runway, an attractive valuation on EBITDA & FCF and a free call option on an possible event that could roughly double the intrinsic value of the Company. After an extended period of earnings shortfalls, various disappointments and being basically written off for dead by most investors, PNI has transformed its financial model by renegotiating the contract terms with its customers, leapfrogged the competition with technology improvements to its platform and signed a number of new customer agreements and relationships which should position the Company for a period of healthy growth and improving profitability. The recently reported December quarter marked a significant milestone in PNI’s turnaround with a number of positive factors combining to driving the first real upside in revenue growth in a number of years and illustrating the financial leverage inherent in the Company’s business model. While the benefit of some of PNI’s newly announced customer signings and growth opportunities will evolve during the next 12-18 months, the potential exists for some additional opportunities (especially winning a major customer) that are not factored into my forecasts. With EBITDA potential of ~$5.0m-$5.5m from PNI’s existing customer base possible in calendar 2015 (which is 25%-40% below pre-transition levels), the shares are currently trading at a EV/EBITDA multiple of ~8x, or a low-to-mid teens FCF/EV yield. Comparing PNI to other similar SaaS vendors, yields a price at or above $2.00 per share.

Overview: PNI Digital Media (PNI) is a software company that offers a “white label” platform-as-a-service (PaaS) solution that enables large retailers the ability have their customers create consumer generated digital content (including photos, files, presentations, business & greeting cards and invitations) from various platforms (including in-store kiosks, on-line and mobile devices), to their production facilities. PNI generates revenues primarily based on a percent or fixed fee of the transaction value that it process from its retail partners (78% of revenues in FY 2013), with the remainder of its revenues from fees associated with installations, membership, professional and archive services. The Company’s customer base includes such large pharmacy chains as CVS and Rite Aid, discount store chains as Wal-Mart (Canada & Argentina), warehouse clubs as Costco (US, Canada & Australia), and Sam’s Club, grocers as Tesco (UK) and business printing companies as Office Depot and Alpha Graphics. For a more details on the Company’s history, various problems/challenges it has faced and turnover in its management ranks over the last few years, all of which contributed to the significant decline in the share price during this transition period, I would point you to read Googie’s 1/6/13 prior report. Instead, I will focus my comments on why I believe the shares are an opportunistic investment at this point.

Key Investment Points:

Successful renegotiation of customer agreements significantly improves PNI’s financial model: While the Company has faced a number of both internal (technology refresh of its platform, roll-out of stationary and business printing) as well as external issues (currency) over the last few years, the most significant/challenge has been the decline of traditional 4x6 proto processing, which began at the end of 2010 and accelerated into FY 2011. PNI, consistent with the industry standard at the time, structured its legacy contracts based on the number of pictures uploaded as opposed to the value of the transactions that it processed for its customers. In the last few years the market dynamics have shifted significantly as consumers have moved away from printing photos to either viewing them on-line (and now on mobile devices) or purchasing photo related merchandise. This shift penalized PNI in that while the amount of transactions utilizing the Company’s platform continued to grow, its business model was not able to benefit from the shift to higher value transactions. For example, under the old contract terms, despite its large average sales price its retail partners were seeing, PNI’s revenues from a entire photo book were equal to a single photo upload.

An important point to understand was that despite the decline in revenues and serious financial challenges PNI faced in the 2011/12 time period associated with the shift in the market leading to the decline in the number of traditional photo prints customers were processing: 1) the number and value of transactions that the Company was handling for its customers on its platform actually continued to increase during this period and 2) PNI not only maintained all of its key customer relationships, but signed on new retailers. This is a clear testimonial of the value that PNI’s retail customers placed on the value proposition of its platform. These trends also differ from most other companies reporting revenue declines and underscore that this was not a situation were the Company’s product, or value proposition to its customers, was flawed, broken or facing competitive pressures. Thus, given the solid value proposition PNI’s platform offered its customers, the Company was able to convince its retail customers to move away from the old industry standard model tied to photo uploads to a new model based on the value of their transactions.

PNI Digital

Annual Revenue & Transaction   Trends

 

 

 

Year

Revenue ($M)

Transactions (M)

FY 2009

24.5

14.6

FY 2010

25.5

17.1

FY 2011

23.7

18.4

FY 2012

22.7

19.1

FY 2013

20.9

20.1

 

During FY 2012/13 management began making progress in changing the contract terms of most of its major customers. In November 2013, with the renegotiation of the contract terms with Costco, the Company’s largest customer (~45% of revenues), management announced that all of its major contracts have been renegotiated to a model based on PNI receiving a percentage of a retailers transaction revenues. The recently reported December quarter saw the first impact of this change. As these new contract terms take hold during FY 2014, this should provide an bump-up in revenues (even assuming transaction volumes were to remain the same) without any associated costs; leading to margin expansion. Management estimates that the change in terms with Costco will bump-up annual revenues by ~10%, or close to $1 million.

Another positive factor going forward, is that a renegotiated contract with Tesco (PNI’s largest UK-based retailer) at less favorable (but consistent with industry standard) terms recently crossed the one year anniversary period. This issue negatively impacted FY 2013 revenues and is now in the past from a revenue growth comparison standpoint.

Diversification efforts outside of photo prints, offers more favorable growth opportunities: Two of the major diversification initiatives that PNI has been undertaking over the last few years has been to offer customers though its platform a diversified mix of photo merchandising products (photo books, calendars, cards, etc.) and business printing (presentations, reports, etc.). Independent industry research forecasts expect the number of photo prints processed to continue to decline over the next few years. However, the amount and value of photo related merchandise is expected to grow. Noteworthy, these higher value products are often created with customer content pulled from cloud and social networks such as Dropbox, Facebook, Instagram, Google+ Photos, Flickr and SkyDrive all of which are now integrated to the PNI Platform through the Company’s API. Some of the independent market forecasts I have seen suggest the photo merchandise market sector will growth ~5%-10%, with photo book growth in the 15%-20% range over the next few years. PNI’s new platform capabilities should now enable the company a fair amount of tailwind to participate in this more favorable growth.

Critical to PNI’s diversification strategy has been its efforts to address the needs of the business printing market, including such products as business cards, brochures, presentations, multi-page documents, posters and postcards. Independent market research shows that the broad global web-to-print (a subset of which PNI is targeting) will experience significant growth in the next few years. Complementing the Company’s in-house development efforts in this area, was the April 2013 acquisition of Quarterhouse Software, a leading developer of web based print on demand software for commercial printers and distributors. On the heals of this acquisition, PNI signed an agreement with AlphaGraphics, a leading provider of on-line business printing services. AlphaGraphics customers will be able to create, edit and up-load the products they create to their in-house printing capabilities. PNI’s expansion into the business printing market could open the door for the Company to sign agreements with other mid-sized printers looking for an on-line solution.

In August 2013 in a major milestone announcement, PNI signed a three year agreement with Office Depot to offer their “Copy & Print” customers the ability to print the business products/documents they create in either in-store off offsite print locations.  PNI will connect its platform to the ~1,100 Office Depot “Copy & Print” locations beginning in calendar 2014. Underscoring the significance of this deal, Office Depot’s annual printing related revenues approximate $150 million compares with PNI’s existing photo related customers’ transaction revenues of ~$250 million. When full implemented, management expects Office Depot could contribute ~$5-6 million in annual revenue to PNI (compared with the Company’s current revenue run rate of ~$22 million) and represent one of the Company’s top five customers. While the impact of the Office Depot relationship will begin to impact PNI’s revenues during FY 2014, the more significant impact will be felt in FY 2015. Additionally, the growth in business printing should offset some of the Company’s weak seasonality during the first half of the calendar year.

Noteworthy, the diversification away from the photo processing market is already favorably impacting the Company’s financial results. Underscoring the progress PNI has already had transitioning its business model to photo related merchandise, in the seasonally strong December quarter, about 2/3rds of revenues were derived from non-photo processing. Thus, legacy photo processing has currently become a significantly smaller source of PNI’s revenues and with the roll-out of stationary, business printing and other diversification initiatives, will likely continue to decline even further.  

Improvements to the Company’s platform provide technology leadership relative to on-line/mobile and new growth opportunities: A major reason behind some of the Company’s problems during the 2011/12 period was the result of software and technology deficiencies. These problems resulted in numerous delays in rolling out the Company’s stationary and business printing initiatives, required costly increases to R&D spending and resulted in management turmoil.

One of the three major tenants of PNI’s turnaround strategy was to improve its platform and bring new leading edge technology to the market. The software code was improved to more easily expand the capabilities of the platform to new retailers and roll-out new features. In addition, management made a decision to transition the platform off Adobe Flash to HTML5. As a result of transitioning the PNI platform to HTML5, most of our the Company’s builders will work on any device. Noteworthy, this includes all Android and Apple iOS devices, which make up a growing part of the mobile and tablet market. The launch of HTML5 builder technology has enabled a number of applications to be developed that allow access to PNI’s platform from various cloud and social media sources such as such as Dropbox, SkyDrive, Google, Instagram and Facebook. With hundreds of millions of photos uploaded every year, this gives consumers the ability to access this data and more easily process photo merchandise and PNI’s retail partners the ability to monetize these photos.

In the spring of 2013, the Company has released a mobile application programming interface (API), which allows software developers to write apps that access the PNI network. This allows PNI to extend its capabilities to the rapidly growing tablet and mobile markets as well as accessing various social media sources. In April 2013 PNI’s new platform including a new user interface and content management began rolling out to its customers and is now pervasive throughout the entire network.

Highlighting the success of these technology initiatives was the October 2013 announcement of a partnership with Samsung, allowing its smart phone customers direct access to the PNI network. As a result, Samsung users will be able to electronically transfer any photos taken with their phones or tablets to any retailer on the PNI network for processing. PNI will receive a percent of the transaction value of the total order. It is likely that management is trying to expand this offering to other phone/tablet manufacturers. Additionally, in January 2014 PNI launched its first app for Google Glass. This announcement, which showcases the Company’s technology leadership, extends PNI ecosystem and access to its platform from Apple iOS and Android devices to this product.

One issue that these relationships helps address is that despite the growth of photo images captured on mobile devices, there has not been a corresponding growth in print volumes due to the difficulty of transferring these images to a photo processing lab. Currently, only prints are available for ordering from mobile devices. However, management expects that before the 2014 holiday quarter, the Company will have expanded this to include other products, including cards, canvas and collages. Given the combination of the continued growth in the installed base of mobile phones and the fact that taking photos is now the number one use of smart phones today, this capability should open up a new a potentially large revenue stream for the Company.

The technology improvements to make the Company’s platform have resulted in a significant increase in orders originating from mobile devices. As a result, the percentage of orders originating from mobile devices grow from de minimis in late 2012 to over 7% of orders in 2013. I suspect this number will grow rapidly over the next 12-18 months.

Unlike many companies looking for strategies to try to not get left behind and capture the growing trend to use mobile devices (phones and tablets) and social media, PNI today offers its retail customers a solution to capture and monetize these trends. Most of the improvements that PNI has made to its platform are unique compared with the Company’s competitors and give the platform a competitive advantage. These technology improvements give PNI’s retail customers the ability to address a potential discontinuity shift in the industry; the move to on-line/mobile ordering. PNI’s new platform (HTML5 based, embracing Android and Apple iOS devices) combined with its features (builders and mobile apps) and partnerships (i.e. Samsung) gives its retail partners the tools and capabilities to address this challenge and the capability to gain market share from on-line competitors. The combination of PNI’s technology leadership and unique features coupled with the threat from the shift to on-line/mobile, also affords the Company the ability to potentially grow the ranks of its retail customer base (from those using a competitive or in-house offering) while opening up new first mover growth opportunities by partnering with other companies who can leverage its platform.

PNI’s growth catalysts have yet to fully play out: One of the most exciting parts of the investment thesis on PNI is that the company’s financials have yet to reflect all the positive catalysts, which have already been announced. Thus, I would submit that as a result of this fact, there a greater degree of predictability to PNI’s future revenue expansion. The following factors are only not beginning to contribute or have yet to contribute to PNI’s revenues, including:

  • the ~10% step-up in revenues from renegotiating the Company’s Costco contract to a model based on PNI receiving a percentage of a retailers transaction revenues.
  • a continued shift the Company’s retail customer transactions to faster growing and higher average transaction photo merchandise products,
  • the roll-out of the Company’s business printing initiative, spearheaded by Office Depot ($5-$6 million when fully rolled-out), beginning in the first half of calendar Q1 2014,
  • success in further penetrating the mobile phone/tablet market (aided by the Company’s Samsung agreement), and the upcoming capability for mobile ordering from just prints to photo related merchandise (expected before the holiday 2014 season) and,
  • benefit from the Company’s photo services API and the growing number of photo apps in the market.

In the recently reported FY Q1 (December) quarter, where revenues grew 24% y/y, investors began to see the benefit of some of these factors impact results. As these benefits continue to roll-out, I believe PNI could experience revenue expansion of about 15%-20% per year over the next 24 months.

A highly scalable asset-light business model should translate into healthy earnings leverage in the future: As is the case with many software vendors, PNI’s platform is highly scalable with very little incremental costs necessary to support a significant increase in revenues. Thus, a meaningful pick up in revenues will likely see most of these dollars fall to the gross profit line. Thus, a meaningful increase in transaction revenues within its network, will likely have an oversized impact on profitability. Noteworthy, during the FY 2009/10 period when annual revenues were in the $24-25 million range gross margins were in the mid-to-high 70% range. Management believes there are no real changes in its business model to suggest that these margins are not achievable in the future with some growth. With gross margins currently in the low 60% in the last quarter, this illustrates the potential upside leverage in one aspect of PNI’s model.

In addition, PNI has been investing a significant amount of money in upgrading its technology platform. Noteworthy, since PNI’s revenues peaked during the 2010/2011 period (and subsequently declined through early 2013) R&D spending is up ~20%. This spending was centered on improving the Company’s software code, converting to a HTLM5 backbone, rolling out stationary and business printing, new mobile offerings and new partnerships. Given that the upgrade to PNI’s platform has been completed and many of the Company’s new initiatives have now rolled out (i.e. phase one of its turnaround plan has been completed), a number of outsourced R&D teams have been scaled back. Noteworthy, in the last two quarters during the re-acceleration in PNI’s revenue growth, R&D spending declined ~10% in dollar terms. In future periods, it is likely that additional R&D spending can be scaled back. I suspect that R&D spending trends during the next 12-18 months will show little growth from a dollar perspective spending.

With expectations for revenue growth in the 15%-20% range over the next 24 months, the inherent leverage in PNI’s financial model and the likelihood of a further wind-down in R&D spending, I believe the profitability levels should show significant expansion during this period. Looking out to the calendar 2015 year, I believe that PNI’s EBITDA could be ~$5.0-$5.5million. While working capital tends to swing with the seasonality of the business, FCF should approximate these levels as well. Obviously, should PNI win another major retailer, these estimates could prove conservative.

Looking back at historical financials illustrates the leverage in PNI’s business model with scale. Prior to the downtrend in photo processing in the FY 20010 time period, the Company’s was able to generate EBITDA of ~$7 million on a revenue base of ~$25 million. Management believes that the business model offers the same scale benefits as in the past. As the revenue benefits from the renegotiated contracts as well as from a number of agreements/partnerships that have already been announced begin to be realized, the scale benefits should materialize.

In December, PNI raised $7.5 million in capital to sure up its balance sheet and repay its credit line. With a solid balance sheet now in place, the Company’s will have the financial resources to fund its growth initiatives. As was the case in the recently reported seasonally strong, and holiday shortened, Q1 (December), working capital needs could be an issue. Thus, while PNI should be solidly cash flow positive this year, the Company’s balance sheet is now strengthened to support both growth initiatives (including the possibility of new major customer wins) and any potential modest bolt-on acquisitions.

FY Q1 marked a significant milestone in PNI’s recovery: Recently reported results for the December 2013 quarter (Q1 FY 2014) marked a milestone in the Company’s turnaround efforts on a number of fronts. PNI’s 24% increase in revenues established a new record and showed an acceleration in growth from a number of the Company’s initiatives which also drove transactions to record levels. Helping fuel the Q1 expansion was an increase in cards & stationary (33% of revenues vs. 26% y/y) and a 161% growth in orders from mobile devices. In the quarter, PNI saw a double-digit year-over-year growth in all of the Company’s major product categories including prints, cards and invitations, canvas and photo books. Another important sign of progress in Q1 was that that for the first time in a number of years PNI’s revenue (ttm) per transaction increased. The increase in this measurement is a clear sign that the changes to the contract agreements with the Company’s retailers and the non-photo products and stationary diversification initiatives to increase the average transaction of its customers are taking hold.

The quarter shows that PNI has made significant progress in executing on its turnaround plan. A year ago management outlined a three part turnaround plan, with phase one being in new technology, phase two being new customers and phase three being improved revenues. The Q1 results signify that PNI has begun to transition into phase three of its recovery plan. As previously noted, the financial leverage associated with a revenue acceleration should result in translate into significant gains in profitability. This was apparent in the period, as revenues grew 24%, total expenses were down slightly in dollar terms. As a result gross, operating and EBITDA margins all recorded significant increases on a year-over-year basis. Noteworthy, in the seasonally strong quarter EBITDA approximated $2 million (23.8% margin) versus about $0.2 million (3.2% margin) a year earlier. While FCF was negative in the period, that was the result of temporary changes in working capital.

Potential big new customer wins possible, representing a windfall revenue opportunity and a free call option with the stock:  The value proposition that PNI provides its retailers is the capability, in a low cost manor, to offer their customer base a competitive offering of a broad range of digital photo merchandise (accessible in-store, on-line or mobile) that drives incremental revenue, in-store traffic and market share versus on-line competitors. The improvements to the Company’s platform, the increased breath of products and services offered as well as the diversity to connect with customers through mobile devices, and access data in the cloud and social networks, which other competitors can’t match, has given PNI a competitive advantage to try to exploit.

While PNI has compiled a impressive list of retail customers who use the Company’s platform, there are some significant retailers that either use competitive (Wal-Mart U.S.and Walgreen’s) or in-house developed (Target, FedEx/Kinkos and Staples) solutions. I suspect that none of these other retailers would like to be in a position of losing customers/market share due to an inferior product offering. With its technology improvements and partnerships (with software vendors and Samsung) PNI has raised the competitive bar and the stakes to remain competitive. PNI’s large customer base affords the Company the ability to leverage its development costs across its entire customer base. Those retailers with in-house developed solutions may begin to question the economics to continue to remain competitive versus outsourcing the solution to a provider such as PNI.

From a competitive perspective, PNI’s major competitor is Snapfish, a division of Hewlett-Packard. Snapfish has two major customers, Wal-Mart US and Walgreens, but has not been successful in growing beyond these customers. PNI has been targeting winning either of these customers from Snapfish. With gross photo processing revenues of ~$150 million and ~$300 million respectively, either Wal-Mart U.S. or Walgreens would represent a huge win relative to PNI’s gross photo processing revenues of ~$250 million. Winning either of these retailers, in my opinion would double the intrinsic value of the Company overnight!

Thus, how realistic of a possibility is it that PNI could win one of these customers from Snapfish? I would note the following points to consider when accessing this possibility. Previously, PNI was successful in winning the Costco business from Snapfish during 2008 and signed up Walgreen’s for social stationary products. Currently Snapfish’s technology platform lacks HTML5 builders and mobile apps. Noteworthy, as part of PNI’s Samsung deal, the Company also partnered with Walgreens andWal-MartU.S.to make their locations available for printing from the Samsung devices. This opens the door a little for PNI to showcase its technology. PNI has an existing relationship withWal-MartCanada&Argentinaand Sam’s Club. Unlike PNI, Snapfish’s direct-to-consumer business, where it directly interacts with and owns the customer account, is a direct competitor to both Wal-Mart and Walgreen’s. The importance of Snapfish to Hewlett-Packard today remains unclear. Snapfish represents a legacy acquisition (acquired in March 2005), under a former management team, that appeared to most observers at the time to be focused on driving home-based photo printing and ink sales. Some of the research I have done suggests a significant drop in headcount and a fair amount of turnover at Snapfish, including the senior management running this HP division. Along these lines, the Snapfish employee reviews on Glassdoor.com paint a less than flattering picture of the company, technology, leadership and morale:

http://www.glassdoor.com/Reviews/Snapfish-Reviews-E37621.htm

While I have no insights suggesting certainty that wining either retailer will occur, I would note that given the scenario outlined, it is not an unrealistic possibility. I would suspect that each of these two retailers will be accessing their competitive positions during the all important year end holiday season in 2014 using the Snapfish technology platform. If Snapfish does not update its platform to offer more competitive technology, this may open the door for PNI. If I had to handicap which retailer would be more likely to switch to PNI, I would say Wal-Mart, based on the pre-existing relationships some of the international divisions have with the Company. Noteworthy, I have not included in my modeling PNI winning either of these two retailers, nor is the stock discounting this possibility. Thus, how many times do you see an investment opportunity with a free call option on a possible event that could double the intrinsic value of the company overnight?

Conservative forecasts; upside is possible if PNI can return to prior margin levels : For modeling purposes I have assumed the following:

  • Revenue growth averaging ~15%-20% thru calendar 2015 to ~$25/$29 million in FY 2014/15. Considering PNI’s current revenue run rate of ~$21 million as well as the ~$1m bump-up from the renegotiated Costco contract, the      potential $5-$6 million annual potential from the Office Depot agreement and the growth potential from mobile apps, this assumption could prove conservative.
  • Gross margins rising to only ~57% and ~59% in FY 2013/14. Given PNI’s highly scalable revenue model with minimal growth-related costs incremental costs and that in the FY2009/10 period gross margins were in the mid-to-high 70% range (more consistent with typical software companies) on a annual revenue base of only $24-$25 million, this could also prove conservative.
  • Operating expenses are modeled to grow at ~5% during this period, given the big software and re-development efforts are now behind the Company, contracted R&D teams are being scaled back and overhead will scale more slowly than sales.
  • I have assumed the f/x impact will be a wash over this period, but in the past, this has pressured profitability.
  • Relative to other items, financing costs are minimal, with NOL’s of ~$10 million in both Canada and the UK, PNI should not need to pay taxes until FY 2017, D&A should approximate ~$2 million while cap-ex runs ~$1.5-2.0 million per year.
  • No new major retailer wins to add to the Company’s existing customer base. While I have discussed the possibility of winning Wal-Mart & Walgreen’s as potential wild card opportunities, there is also a possibility that PNI signs a few mid-sized business printing partnerships.
  • Given these set of assumptions, EBITDA should approximate $5.0-$5.5 million in calendar 2015.                   

It is noteworthy to point out that in my forecasts, I have not assumed the same margin leverage with scale that the Company has achieved in the past, before the current transition and contract adjustments. Prior to the downtrend in photo processing in the FY 20010 time period, the Company’s was able to show gross margins in the mid-to-upper 70% range and generate EBITDA of ~$7 million on a revenue base of ~$25 million. Management believes that the business model offers the same scale benefits as in the past. Thus, my forecasts, which are illustrated below, could prove conservative.

PNI Digital Media Inc. -    Income Statement
                 
  FY2008 FY 2009 FY 2010 FY2011 FY2012 FY 2013 FY 2014E FY2015E
Total Revenue 17.050        24.447        25.357        23.686        22.713        20.899        24.801 29.200
Cost Of Goods Sold 7.410 6.660 5.377          9.399          9.838          9.807        10.718        11.868
Gross Profit 9.640 17.787 19.980        14.287        12.875        11.092        14.083        17.332
GM% 56.5% 72.8% 78.8% 60.3% 56.7% 53.1% 56.8% 59.4%
                 
Operating Expenses        17.794        19.427        17.991        14.356        14.317        14.867        14.354        15.072
% 104.4% 79.5% 71.0% 60.6% 63.0% 71.1% 57.9% 51.6%
Operating Income      (8.154)           (1.64)             1.989      (0.069)         (1.442)         (3.775)         (0.271)    2.260
                 
D&A          5.264          6.016          4.217          2.895          2.025 1.660          1.907          1.907
EBITDA        (2.89)             4.376          6.206          2.826          0.583      (2.115)             1.636          4.167
% -16.9% 17.9% 24.5% 11.9% 2.6% -10.1% 6.6% 14.3%
                 
Interest Exp. (Net)          0.012      (0.211)         (0.077)         (0.006)             0.005      (0.014)         (0.091)                    0
Currency   Exchange           0.461          0.551          0.185      (0.125)         (0.083)         (0.484)         (0.564)                    0
EBT Excl. Unusual Items      (7.681)         (1.301)             2.097      (0.199)           (1.52)         (4.272)         (0.926)    2.260
                 
Non-Operating Items      (1.037)         (0.318)         (0.055)                 0      (0.788)         (0.572)                    0                 0
                 
Pretax Income      (8.717)         (1.619)             2.042      (0.199)         (2.308)         (4.845)         (0.926)    2.260
Income Tax Expense            0.151        (4.81)         (1.299)             1.814          2.823                 0                 0
Net Income      (8.717)           (1.77)             6.852 1.100      (4.123)         (7.667)         (0.926)    2.260
                 
Shares Out. (FD)        33.384        33.611        33.908        33.985        34.178        34.299 41.400 41.500
Diluted EPS ($0.26) ($0.05) $0.20 $0.03 ($0.12) ($0.22) ($0.02) $0.05

Attractive valuation on an absolute and relative basis: So why does this opportunity exist? Part of the reason is that in the past the investors have been disappointed and frustrated by the downturn in PNI’s financials and the delays in managements efforts to re-position the Company, roll-out new initiatives and transition the business model. So some degree some of the criticism of management for not foreseeing the transition in the industry away form photo processing and the delays are not without merit. Thus, after being frustrated by the performance of the stock, many past holders gave the company up for dead, looked to get out at any price, and are understandably reluctant to re-visit the idea. Given the  company’s low capitalization and lack of any major sell-side coverage in theUS, PNI may not be a name that is on the radar of most investors. Also with the healthy bounce in the shares off the bottom the shares don’t screen well on a trailing-twelve-month (ttm) basis and investors may feel they already missed the stock. Finally, the shares have backed away about 15%-20% from the pre-December quarter announcement run-up in the stock price.

Based on the current share price and 41.4 million shares outstanding, PNI has a market cap of  ~$52 million. When adjusting for the cash on the balance sheet and the expected reversal of working capital used in the December quarter, the enterprise value approximates $42 million. Thus, given my forecast for EBITDA of ~$5.0-$5.5 million in calendar 2015, the multiple is only about 7.6x-8.4x. With FCF approximating this level, the FCF/EV yield is in the low-to-mid teens. The shares are also valued at ~1.4x my 2015 sales forecast. Given the Company’s 15%-20% growth opportunity and the free call option associated with the possibility of winning a huge piece of business away from a weak competitor, I would submit this is an attractive valuation.

While the initial temptation would be to compare PNI to some of the other on-line printing companies, like Shutterfly (SFLY) and Vistaprint (VPRT) due to the focus on the photo/printing industry, I would argue that these vendors have a different consumer focused marketing/manufacturing business model. PNI’s has a more classic asset-light enterprise software model, with greater leverage and higher potential returns. Thus, I believe it would be more appropriate to compare PNI to similar Canadian SaaS software vendors with more scalable transaction oriented business models. Looking at these companies shows that on average they sell at EV multiple of 13x-15x forward EBITDA and 2.5x-3.5x sales. Applying the mid-range of these comparisons would translate into a price at or above $2.00 per share.

Risks:

  • Customer concentration: PNI generates the majority of its revenues from a handful of the major retailers. In FY 2013 (September), Costco, the Company’s largest customer accounted  for 41% of revenues and the top four customers contributed 91% of  revenues. Thus the loss of any retailer would have a significant impact on the business. Noteworthy, all of the Company’s customer relationships are longstanding (PNI has not lost a major customer). In addition, I would submit these relationships are very sticky given the depth of the IT integration between PNI and its reseller partners and the increased costs associated with keeping up with some of the major technological      challenges/shifts taking place in the industry. Finally, I would point out that currently the Company’s major competitor appears to be in somewhat of a weakened state.
  • Competition from on-line players:  There is a shift in the industry to a number of social media companies (i.e. Google, Facebook, Twitter, Instagram, etc.) for storing/sharing information, including pictures. Photo finishing is not a primary service they offer. However, this could change to include avenues outside of the Company’s service or its customers. In addition, on-line printers (i.e. Shutterfly and Vistaprint) are attempting to gain market share from      retailers. Should these companies implore a more aggressive pricing policy to gain market share, PNI’s retailers may be negatively impacted.
  • Foreign currency: PNI’s reports its results in Canadian dollars. About 75% of revenues are from the U.S. and another 8% from the U.K., with most of its costs in Canada. The Company does not employ a hedging strategy. As a result, its past results have shown some impact on revenues and profits and could do so in the future.

 

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • Growth in revenues and profitability from both new retail relationships (especially Office Depot) and organic growth in the market.
  • Success in driving a greater mix of revenues from photo merchandising, stationary and business printing.
  • An increased mix of orders coming from mobile devices and a greater number of mobile apps from developers.
  • Signing new contracts with additional retail partners.

 

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    Description

    Investment Thesis: I believe the shares of PNI offer small/micro cap investors, or members PA accounts, an opportunity to invest in a company in the early stages of a major turnaround, with a healthy 15%-20% growth runway, an attractive valuation on EBITDA & FCF and a free call option on an possible event that could roughly double the intrinsic value of the Company. After an extended period of earnings shortfalls, various disappointments and being basically written off for dead by most investors, PNI has transformed its financial model by renegotiating the contract terms with its customers, leapfrogged the competition with technology improvements to its platform and signed a number of new customer agreements and relationships which should position the Company for a period of healthy growth and improving profitability. The recently reported December quarter marked a significant milestone in PNI’s turnaround with a number of positive factors combining to driving the first real upside in revenue growth in a number of years and illustrating the financial leverage inherent in the Company’s business model. While the benefit of some of PNI’s newly announced customer signings and growth opportunities will evolve during the next 12-18 months, the potential exists for some additional opportunities (especially winning a major customer) that are not factored into my forecasts. With EBITDA potential of ~$5.0m-$5.5m from PNI’s existing customer base possible in calendar 2015 (which is 25%-40% below pre-transition levels), the shares are currently trading at a EV/EBITDA multiple of ~8x, or a low-to-mid teens FCF/EV yield. Comparing PNI to other similar SaaS vendors, yields a price at or above $2.00 per share.

    Overview: PNI Digital Media (PNI) is a software company that offers a “white label” platform-as-a-service (PaaS) solution that enables large retailers the ability have their customers create consumer generated digital content (including photos, files, presentations, business & greeting cards and invitations) from various platforms (including in-store kiosks, on-line and mobile devices), to their production facilities. PNI generates revenues primarily based on a percent or fixed fee of the transaction value that it process from its retail partners (78% of revenues in FY 2013), with the remainder of its revenues from fees associated with installations, membership, professional and archive services. The Company’s customer base includes such large pharmacy chains as CVS and Rite Aid, discount store chains as Wal-Mart (Canada & Argentina), warehouse clubs as Costco (US, Canada & Australia), and Sam’s Club, grocers as Tesco (UK) and business printing companies as Office Depot and Alpha Graphics. For a more details on the Company’s history, various problems/challenges it has faced and turnover in its management ranks over the last few years, all of which contributed to the significant decline in the share price during this transition period, I would point you to read Googie’s 1/6/13 prior report. Instead, I will focus my comments on why I believe the shares are an opportunistic investment at this point.

    Key Investment Points:

    Successful renegotiation of customer agreements significantly improves PNI’s financial model: While the Company has faced a number of both internal (technology refresh of its platform, roll-out of stationary and business printing) as well as external issues (currency) over the last few years, the most significant/challenge has been the decline of traditional 4x6 proto processing, which began at the end of 2010 and accelerated into FY 2011. PNI, consistent with the industry standard at the time, structured its legacy contracts based on the number of pictures uploaded as opposed to the value of the transactions that it processed for its customers. In the last few years the market dynamics have shifted significantly as consumers have moved away from printing photos to either viewing them on-line (and now on mobile devices) or purchasing photo related merchandise. This shift penalized PNI in that while the amount of transactions utilizing the Company’s platform continued to grow, its business model was not able to benefit from the shift to higher value transactions. For example, under the old contract terms, despite its large average sales price its retail partners were seeing, PNI’s revenues from a entire photo book were equal to a single photo upload.

    An important point to understand was that despite the decline in revenues and serious financial challenges PNI faced in the 2011/12 time period associated with the shift in the market leading to the decline in the number of traditional photo prints customers were processing: 1) the number and value of transactions that the Company was handling for its customers on its platform actually continued to increase during this period and 2) PNI not only maintained all of its key customer relationships, but signed on new retailers. This is a clear testimonial of the value that PNI’s retail customers placed on the value proposition of its platform. These trends also differ from most other companies reporting revenue declines and underscore that this was not a situation were the Company’s product, or value proposition to its customers, was flawed, broken or facing competitive pressures. Thus, given the solid value proposition PNI’s platform offered its customers, the Company was able to convince its retail customers to move away from the old industry standard model tied to photo uploads to a new model based on the value of their transactions.

    PNI Digital

    Annual Revenue & Transaction   Trends

     

     

     

    Year

    Revenue ($M)

    Transactions (M)

    FY 2009

    24.5

    14.6

    FY 2010

    25.5

    17.1

    FY 2011

    23.7

    18.4

    FY 2012

    22.7

    19.1

    FY 2013

    20.9

    20.1

     

    During FY 2012/13 management began making progress in changing the contract terms of most of its major customers. In November 2013, with the renegotiation of the contract terms with Costco, the Company’s largest customer (~45% of revenues), management announced that all of its major contracts have been renegotiated to a model based on PNI receiving a percentage of a retailers transaction revenues. The recently reported December quarter saw the first impact of this change. As these new contract terms take hold during FY 2014, this should provide an bump-up in revenues (even assuming transaction volumes were to remain the same) without any associated costs; leading to margin expansion. Management estimates that the change in terms with Costco will bump-up annual revenues by ~10%, or close to $1 million.

    Another positive factor going forward, is that a renegotiated contract with Tesco (PNI’s largest UK-based retailer) at less favorable (but consistent with industry standard) terms recently crossed the one year anniversary period. This issue negatively impacted FY 2013 revenues and is now in the past from a revenue growth comparison standpoint.

    Diversification efforts outside of photo prints, offers more favorable growth opportunities: Two of the major diversification initiatives that PNI has been undertaking over the last few years has been to offer customers though its platform a diversified mix of photo merchandising products (photo books, calendars, cards, etc.) and business printing (presentations, reports, etc.). Independent industry research forecasts expect the number of photo prints processed to continue to decline over the next few years. However, the amount and value of photo related merchandise is expected to grow. Noteworthy, these higher value products are often created with customer content pulled from cloud and social networks such as Dropbox, Facebook, Instagram, Google+ Photos, Flickr and SkyDrive all of which are now integrated to the PNI Platform through the Company’s API. Some of the independent market forecasts I have seen suggest the photo merchandise market sector will growth ~5%-10%, with photo book growth in the 15%-20% range over the next few years. PNI’s new platform capabilities should now enable the company a fair amount of tailwind to participate in this more favorable growth.

    Critical to PNI’s diversification strategy has been its efforts to address the needs of the business printing market, including such products as business cards, brochures, presentations, multi-page documents, posters and postcards. Independent market research shows that the broad global web-to-print (a subset of which PNI is targeting) will experience significant growth in the next few years. Complementing the Company’s in-house development efforts in this area, was the April 2013 acquisition of Quarterhouse Software, a leading developer of web based print on demand software for commercial printers and distributors. On the heals of this acquisition, PNI signed an agreement with AlphaGraphics, a leading provider of on-line business printing services. AlphaGraphics customers will be able to create, edit and up-load the products they create to their in-house printing capabilities. PNI’s expansion into the business printing market could open the door for the Company to sign agreements with other mid-sized printers looking for an on-line solution.

    In August 2013 in a major milestone announcement, PNI signed a three year agreement with Office Depot to offer their “Copy & Print” customers the ability to print the business products/documents they create in either in-store off offsite print locations.  PNI will connect its platform to the ~1,100 Office Depot “Copy & Print” locations beginning in calendar 2014. Underscoring the significance of this deal, Office Depot’s annual printing related revenues approximate $150 million compares with PNI’s existing photo related customers’ transaction revenues of ~$250 million. When full implemented, management expects Office Depot could contribute ~$5-6 million in annual revenue to PNI (compared with the Company’s current revenue run rate of ~$22 million) and represent one of the Company’s top five customers. While the impact of the Office Depot relationship will begin to impact PNI’s revenues during FY 2014, the more significant impact will be felt in FY 2015. Additionally, the growth in business printing should offset some of the Company’s weak seasonality during the first half of the calendar year.

    Noteworthy, the diversification away from the photo processing market is already favorably impacting the Company’s financial results. Underscoring the progress PNI has already had transitioning its business model to photo related merchandise, in the seasonally strong December quarter, about 2/3rds of revenues were derived from non-photo processing. Thus, legacy photo processing has currently become a significantly smaller source of PNI’s revenues and with the roll-out of stationary, business printing and other diversification initiatives, will likely continue to decline even further.  

    Improvements to the Company’s platform provide technology leadership relative to on-line/mobile and new growth opportunities: A major reason behind some of the Company’s problems during the 2011/12 period was the result of software and technology deficiencies. These problems resulted in numerous delays in rolling out the Company’s stationary and business printing initiatives, required costly increases to R&D spending and resulted in management turmoil.

    One of the three major tenants of PNI’s turnaround strategy was to improve its platform and bring new leading edge technology to the market. The software code was improved to more easily expand the capabilities of the platform to new retailers and roll-out new features. In addition, management made a decision to transition the platform off Adobe Flash to HTML5. As a result of transitioning the PNI platform to HTML5, most of our the Company’s builders will work on any device. Noteworthy, this includes all Android and Apple iOS devices, which make up a growing part of the mobile and tablet market. The launch of HTML5 builder technology has enabled a number of applications to be developed that allow access to PNI’s platform from various cloud and social media sources such as such as Dropbox, SkyDrive, Google, Instagram and Facebook. With hundreds of millions of photos uploaded every year, this gives consumers the ability to access this data and more easily process photo merchandise and PNI’s retail partners the ability to monetize these photos.

    In the spring of 2013, the Company has released a mobile application programming interface (API), which allows software developers to write apps that access the PNI network. This allows PNI to extend its capabilities to the rapidly growing tablet and mobile markets as well as accessing various social media sources. In April 2013 PNI’s new platform including a new user interface and content management began rolling out to its customers and is now pervasive throughout the entire network.

    Highlighting the success of these technology initiatives was the October 2013 announcement of a partnership with Samsung, allowing its smart phone customers direct access to the PNI network. As a result, Samsung users will be able to electronically transfer any photos taken with their phones or tablets to any retailer on the PNI network for processing. PNI will receive a percent of the transaction value of the total order. It is likely that management is trying to expand this offering to other phone/tablet manufacturers. Additionally, in January 2014 PNI launched its first app for Google Glass. This announcement, which showcases the Company’s technology leadership, extends PNI ecosystem and access to its platform from Apple iOS and Android devices to this product.

    One issue that these relationships helps address is that despite the growth of photo images captured on mobile devices, there has not been a corresponding growth in print volumes due to the difficulty of transferring these images to a photo processing lab. Currently, only prints are available for ordering from mobile devices. However, management expects that before the 2014 holiday quarter, the Company will have expanded this to include other products, including cards, canvas and collages. Given the combination of the continued growth in the installed base of mobile phones and the fact that taking photos is now the number one use of smart phones today, this capability should open up a new a potentially large revenue stream for the Company.

    The technology improvements to make the Company’s platform have resulted in a significant increase in orders originating from mobile devices. As a result, the percentage of orders originating from mobile devices grow from de minimis in late 2012 to over 7% of orders in 2013. I suspect this number will grow rapidly over the next 12-18 months.

    Unlike many companies looking for strategies to try to not get left behind and capture the growing trend to use mobile devices (phones and tablets) and social media, PNI today offers its retail customers a solution to capture and monetize these trends. Most of the improvements that PNI has made to its platform are unique compared with the Company’s competitors and give the platform a competitive advantage. These technology improvements give PNI’s retail customers the ability to address a potential discontinuity shift in the industry; the move to on-line/mobile ordering. PNI’s new platform (HTML5 based, embracing Android and Apple iOS devices) combined with its features (builders and mobile apps) and partnerships (i.e. Samsung) gives its retail partners the tools and capabilities to address this challenge and the capability to gain market share from on-line competitors. The combination of PNI’s technology leadership and unique features coupled with the threat from the shift to on-line/mobile, also affords the Company the ability to potentially grow the ranks of its retail customer base (from those using a competitive or in-house offering) while opening up new first mover growth opportunities by partnering with other companies who can leverage its platform.

    PNI’s growth catalysts have yet to fully play out: One of the most exciting parts of the investment thesis on PNI is that the company’s financials have yet to reflect all the positive catalysts, which have already been announced. Thus, I would submit that as a result of this fact, there a greater degree of predictability to PNI’s future revenue expansion. The following factors are only not beginning to contribute or have yet to contribute to PNI’s revenues, including:

    In the recently reported FY Q1 (December) quarter, where revenues grew 24% y/y, investors began to see the benefit of some of these factors impact results. As these benefits continue to roll-out, I believe PNI could experience revenue expansion of about 15%-20% per year over the next 24 months.

    A highly scalable asset-light business model should translate into healthy earnings leverage in the future: As is the case with many software vendors, PNI’s platform is highly scalable with very little incremental costs necessary to support a significant increase in revenues. Thus, a meaningful pick up in revenues will likely see most of these dollars fall to the gross profit line. Thus, a meaningful increase in transaction revenues within its network, will likely have an oversized impact on profitability. Noteworthy, during the FY 2009/10 period when annual revenues were in the $24-25 million range gross margins were in the mid-to-high 70% range. Management believes there are no real changes in its business model to suggest that these margins are not achievable in the future with some growth. With gross margins currently in the low 60% in the last quarter, this illustrates the potential upside leverage in one aspect of PNI’s model.

    In addition, PNI has been investing a significant amount of money in upgrading its technology platform. Noteworthy, since PNI’s revenues peaked during the 2010/2011 period (and subsequently declined through early 2013) R&D spending is up ~20%. This spending was centered on improving the Company’s software code, converting to a HTLM5 backbone, rolling out stationary and business printing, new mobile offerings and new partnerships. Given that the upgrade to PNI’s platform has been completed and many of the Company’s new initiatives have now rolled out (i.e. phase one of its turnaround plan has been completed), a number of outsourced R&D teams have been scaled back. Noteworthy, in the last two quarters during the re-acceleration in PNI’s revenue growth, R&D spending declined ~10% in dollar terms. In future periods, it is likely that additional R&D spending can be scaled back. I suspect that R&D spending trends during the next 12-18 months will show little growth from a dollar perspective spending.

    With expectations for revenue growth in the 15%-20% range over the next 24 months, the inherent leverage in PNI’s financial model and the likelihood of a further wind-down in R&D spending, I believe the profitability levels should show significant expansion during this period. Looking out to the calendar 2015 year, I believe that PNI’s EBITDA could be ~$5.0-$5.5million. While working capital tends to swing with the seasonality of the business, FCF should approximate these levels as well. Obviously, should PNI win another major retailer, these estimates could prove conservative.

    Looking back at historical financials illustrates the leverage in PNI’s business model with scale. Prior to the downtrend in photo processing in the FY 20010 time period, the Company’s was able to generate EBITDA of ~$7 million on a revenue base of ~$25 million. Management believes that the business model offers the same scale benefits as in the past. As the revenue benefits from the renegotiated contracts as well as from a number of agreements/partnerships that have already been announced begin to be realized, the scale benefits should materialize.

    In December, PNI raised $7.5 million in capital to sure up its balance sheet and repay its credit line. With a solid balance sheet now in place, the Company’s will have the financial resources to fund its growth initiatives. As was the case in the recently reported seasonally strong, and holiday shortened, Q1 (December), working capital needs could be an issue. Thus, while PNI should be solidly cash flow positive this year, the Company’s balance sheet is now strengthened to support both growth initiatives (including the possibility of new major customer wins) and any potential modest bolt-on acquisitions.

    FY Q1 marked a significant milestone in PNI’s recovery: Recently reported results for the December 2013 quarter (Q1 FY 2014) marked a milestone in the Company’s turnaround efforts on a number of fronts. PNI’s 24% increase in revenues established a new record and showed an acceleration in growth from a number of the Company’s initiatives which also drove transactions to record levels. Helping fuel the Q1 expansion was an increase in cards & stationary (33% of revenues vs. 26% y/y) and a 161% growth in orders from mobile devices. In the quarter, PNI saw a double-digit year-over-year growth in all of the Company’s major product categories including prints, cards and invitations, canvas and photo books. Another important sign of progress in Q1 was that that for the first time in a number of years PNI’s revenue (ttm) per transaction increased. The increase in this measurement is a clear sign that the changes to the contract agreements with the Company’s retailers and the non-photo products and stationary diversification initiatives to increase the average transaction of its customers are taking hold.

    The quarter shows that PNI has made significant progress in executing on its turnaround plan. A year ago management outlined a three part turnaround plan, with phase one being in new technology, phase two being new customers and phase three being improved revenues. The Q1 results signify that PNI has begun to transition into phase three of its recovery plan. As previously noted, the financial leverage associated with a revenue acceleration should result in translate into significant gains in profitability. This was apparent in the period, as revenues grew 24%, total expenses were down slightly in dollar terms. As a result gross, operating and EBITDA margins all recorded significant increases on a year-over-year basis. Noteworthy, in the seasonally strong quarter EBITDA approximated $2 million (23.8% margin) versus about $0.2 million (3.2% margin) a year earlier. While FCF was negative in the period, that was the result of temporary changes in working capital.

    Potential big new customer wins possible, representing a windfall revenue opportunity and a free call option with the stock:  The value proposition that PNI provides its retailers is the capability, in a low cost manor, to offer their customer base a competitive offering of a broad range of digital photo merchandise (accessible in-store, on-line or mobile) that drives incremental revenue, in-store traffic and market share versus on-line competitors. The improvements to the Company’s platform, the increased breath of products and services offered as well as the diversity to connect with customers through mobile devices, and access data in the cloud and social networks, which other competitors can’t match, has given PNI a competitive advantage to try to exploit.

    While PNI has compiled a impressive list of retail customers who use the Company’s platform, there are some significant retailers that either use competitive (Wal-Mart U.S.and Walgreen’s) or in-house developed (Target, FedEx/Kinkos and Staples) solutions. I suspect that none of these other retailers would like to be in a position of losing customers/market share due to an inferior product offering. With its technology improvements and partnerships (with software vendors and Samsung) PNI has raised the competitive bar and the stakes to remain competitive. PNI’s large customer base affords the Company the ability to leverage its development costs across its entire customer base. Those retailers with in-house developed solutions may begin to question the economics to continue to remain competitive versus outsourcing the solution to a provider such as PNI.

    From a competitive perspective, PNI’s major competitor is Snapfish, a division of Hewlett-Packard. Snapfish has two major customers, Wal-Mart US and Walgreens, but has not been successful in growing beyond these customers. PNI has been targeting winning either of these customers from Snapfish. With gross photo processing revenues of ~$150 million and ~$300 million respectively, either Wal-Mart U.S. or Walgreens would represent a huge win relative to PNI’s gross photo processing revenues of ~$250 million. Winning either of these retailers, in my opinion would double the intrinsic value of the Company overnight!

    Thus, how realistic of a possibility is it that PNI could win one of these customers from Snapfish? I would note the following points to consider when accessing this possibility. Previously, PNI was successful in winning the Costco business from Snapfish during 2008 and signed up Walgreen’s for social stationary products. Currently Snapfish’s technology platform lacks HTML5 builders and mobile apps. Noteworthy, as part of PNI’s Samsung deal, the Company also partnered with Walgreens andWal-MartU.S.to make their locations available for printing from the Samsung devices. This opens the door a little for PNI to showcase its technology. PNI has an existing relationship withWal-MartCanada&Argentinaand Sam’s Club. Unlike PNI, Snapfish’s direct-to-consumer business, where it directly interacts with and owns the customer account, is a direct competitor to both Wal-Mart and Walgreen’s. The importance of Snapfish to Hewlett-Packard today remains unclear. Snapfish represents a legacy acquisition (acquired in March 2005), under a former management team, that appeared to most observers at the time to be focused on driving home-based photo printing and ink sales. Some of the research I have done suggests a significant drop in headcount and a fair amount of turnover at Snapfish, including the senior management running this HP division. Along these lines, the Snapfish employee reviews on Glassdoor.com paint a less than flattering picture of the company, technology, leadership and morale:

    http://www.glassdoor.com/Reviews/Snapfish-Reviews-E37621.htm

    While I have no insights suggesting certainty that wining either retailer will occur, I would note that given the scenario outlined, it is not an unrealistic possibility. I would suspect that each of these two retailers will be accessing their competitive positions during the all important year end holiday season in 2014 using the Snapfish technology platform. If Snapfish does not update its platform to offer more competitive technology, this may open the door for PNI. If I had to handicap which retailer would be more likely to switch to PNI, I would say Wal-Mart, based on the pre-existing relationships some of the international divisions have with the Company. Noteworthy, I have not included in my modeling PNI winning either of these two retailers, nor is the stock discounting this possibility. Thus, how many times do you see an investment opportunity with a free call option on a possible event that could double the intrinsic value of the company overnight?

    Conservative forecasts; upside is possible if PNI can return to prior margin levels : For modeling purposes I have assumed the following:

    It is noteworthy to point out that in my forecasts, I have not assumed the same margin leverage with scale that the Company has achieved in the past, before the current transition and contract adjustments. Prior to the downtrend in photo processing in the FY 20010 time period, the Company’s was able to show gross margins in the mid-to-upper 70% range and generate EBITDA of ~$7 million on a revenue base of ~$25 million. Management believes that the business model offers the same scale benefits as in the past. Thus, my forecasts, which are illustrated below, could prove conservative.

    PNI Digital Media Inc. -    Income Statement
                     
      FY2008 FY 2009 FY 2010 FY2011 FY2012 FY 2013 FY 2014E FY2015E
    Total Revenue 17.050        24.447        25.357        23.686        22.713        20.899        24.801 29.200
    Cost Of Goods Sold 7.410 6.660 5.377          9.399          9.838          9.807        10.718        11.868
    Gross Profit 9.640 17.787 19.980        14.287        12.875        11.092        14.083        17.332
    GM% 56.5% 72.8% 78.8% 60.3% 56.7% 53.1% 56.8% 59.4%
                     
    Operating Expenses        17.794        19.427        17.991        14.356        14.317        14.867        14.354        15.072
    % 104.4% 79.5% 71.0% 60.6% 63.0% 71.1% 57.9% 51.6%
    Operating Income      (8.154)           (1.64)             1.989      (0.069)         (1.442)         (3.775)         (0.271)    2.260
                     
    D&A          5.264          6.016          4.217          2.895          2.025 1.660          1.907          1.907
    EBITDA        (2.89)             4.376          6.206          2.826          0.583      (2.115)             1.636          4.167
    % -16.9% 17.9% 24.5% 11.9% 2.6% -10.1% 6.6% 14.3%
                     
    Interest Exp. (Net)          0.012      (0.211)         (0.077)         (0.006)             0.005      (0.014)         (0.091)                    0
    Currency   Exchange           0.461          0.551          0.185      (0.125)         (0.083)         (0.484)         (0.564)                    0
    EBT Excl. Unusual Items      (7.681)         (1.301)             2.097      (0.199)           (1.52)         (4.272)         (0.926)    2.260
                     
    Non-Operating Items      (1.037)         (0.318)         (0.055)                 0      (0.788)         (0.572)                    0                 0
                     
    Pretax Income      (8.717)         (1.619)             2.042      (0.199)         (2.308)         (4.845)         (0.926)    2.260
    Income Tax Expense            0.151        (4.81)         (1.299)             1.814          2.823                 0                 0
    Net Income      (8.717)           (1.77)             6.852 1.100      (4.123)         (7.667)         (0.926)    2.260
                     
    Shares Out. (FD)        33.384        33.611        33.908        33.985        34.178        34.299 41.400 41.500
    Diluted EPS ($0.26) ($0.05) $0.20 $0.03 ($0.12) ($0.22) ($0.02) $0.05

    Attractive valuation on an absolute and relative basis: So why does this opportunity exist? Part of the reason is that in the past the investors have been disappointed and frustrated by the downturn in PNI’s financials and the delays in managements efforts to re-position the Company, roll-out new initiatives and transition the business model. So some degree some of the criticism of management for not foreseeing the transition in the industry away form photo processing and the delays are not without merit. Thus, after being frustrated by the performance of the stock, many past holders gave the company up for dead, looked to get out at any price, and are understandably reluctant to re-visit the idea. Given the  company’s low capitalization and lack of any major sell-side coverage in theUS, PNI may not be a name that is on the radar of most investors. Also with the healthy bounce in the shares off the bottom the shares don’t screen well on a trailing-twelve-month (ttm) basis and investors may feel they already missed the stock. Finally, the shares have backed away about 15%-20% from the pre-December quarter announcement run-up in the stock price.

    Based on the current share price and 41.4 million shares outstanding, PNI has a market cap of  ~$52 million. When adjusting for the cash on the balance sheet and the expected reversal of working capital used in the December quarter, the enterprise value approximates $42 million. Thus, given my forecast for EBITDA of ~$5.0-$5.5 million in calendar 2015, the multiple is only about 7.6x-8.4x. With FCF approximating this level, the FCF/EV yield is in the low-to-mid teens. The shares are also valued at ~1.4x my 2015 sales forecast. Given the Company’s 15%-20% growth opportunity and the free call option associated with the possibility of winning a huge piece of business away from a weak competitor, I would submit this is an attractive valuation.

    While the initial temptation would be to compare PNI to some of the other on-line printing companies, like Shutterfly (SFLY) and Vistaprint (VPRT) due to the focus on the photo/printing industry, I would argue that these vendors have a different consumer focused marketing/manufacturing business model. PNI’s has a more classic asset-light enterprise software model, with greater leverage and higher potential returns. Thus, I believe it would be more appropriate to compare PNI to similar Canadian SaaS software vendors with more scalable transaction oriented business models. Looking at these companies shows that on average they sell at EV multiple of 13x-15x forward EBITDA and 2.5x-3.5x sales. Applying the mid-range of these comparisons would translate into a price at or above $2.00 per share.

    Risks:

     

     

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

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