Photochannel PNWIF W
April 14, 2008 - 3:04pm EST by
2008 2009
Price: 3.55 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 142 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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How many companies trade at 8 times cash flow but are growing sales organically at 60%? With two major new customers, Sam’s Club and Costco U.S., and existing clients growing at 60%, Photochannel’s sales, cash flow and earnings are about to explode. I expect by the end of this month, when Costco gets “turned on” as a customer, Photochannel will be on an annual run rate of cash flow of $0.25 per share. With 80% plus gross margins, 40% EBITDA margins expected in 2009 and at least $0.45 a share in cash flow, Photochannel will be rolling in cash. Yet it only trades at 8 times my estimate for 2009 cash flow.
Private label online photo processing
Photochannel manages the front and back end of a retailer’s photo processing website(s). They are basically a private label version of Shutterfly (NASDAQ: SFLY). Using the example of CVS (NYSE: CVS), a consumer will go to and choose “photo,” then “Get started.” Photochannel takes over from there and handles all of the uploading and storage of pictures, then electronically delivers those pictures in the right format to that customer’s CVS location and in one hour those digital pictures are ready to be picked up by the customer. It is important to make the specific distinction of what Photochannel does. They do not own the photo development/printing equipment in the retailer such as CVS. They only help process, store and digitally send the photos as consumers upload the photos to the retailer’s website. They also handle email lists and email marketing functions for their customers for a fee.
Their customer list is pretty impressive for a Canadian microcap company:
1) Wal-mart Canada
2) Costco Canada
3) CVS (U.S.)
4) Black’s (Canada)
5) Costco (U.S.)
6) Sam’s Club (U.S.)
7) Tesco (U.K.)
8) ASDA (Wal-Mart UK)
9) Shoppers Drug Mart (Canada)
10) Loblaw (Canada)
Other retailers include Kmart (US), Eckerd’s (US), etc.
Photochannel provides the same web/photoprocessing service for all of these clients.
Customers uploading pictures online is small but growing fast
Photochannel gets paid a transaction fee every time a customer orders a print(s) and/or gifting product(s) online from one of its client retailers. If a person walks into a store and prints it off of a kiosk or deals with a person from the desk, then Photochannel doesn’t get paid. And this is a very important point, because right now only around 12% of digital prints are uploaded from a computer and printed at a retailer. This means that 88% of digital printing customers are walking into a store and working with a kiosk or a person behind the counter when they could have just uploaded them online and saved themselves the hassle. Why is that?
Well, one reason is that uploading online is relatively new. A mere 18 months ago, CVS, one of the five or six largest photo processing retailers in the US didn’t even have an online component to their photo processing.
Even though the amount of prints uploaded online is only 12% now, this is almost 40% higher than it was in 2006, as growth is soaring for online printing to retail according to the Photo Marketing Association ( Photochannel is currently experiencing a 60-70% growth rate of its customer base in transaction revenue. This growth rate is higher than the retail industry, because its customer base such as CVS are larger retailers who are more successful at marketing to customers than the retail industry as a whole.
As retailers ramp up their marketing and technology and start actively educating consumers, the percentage should continue to soar. Sometime in the next 3-5 years over 50% of customers printing at retail will have uploaded their pictures online, from currently around 12%. The question is when and how fast will this happen.
Acquisition of Pixology should lead to an integrated online/kiosk product
Last fall, Photochannel acquired a poorly run kiosk software company called Pixology. Pixology is based in England and had some key customer accounts including Tesco and ASDA (Wal-Mart UK) as well as Costco (US). Pixology also had an interesting kiosk software technology that Photochannel desired.
Photochannel has worked the past six months at getting Pixology to breakeven and is now working on integrating Pixology’s kiosk software to work with Photochannel’s online solution.
Through Pixology, Photochannel will now be involved in a retailer’s kiosk. Photochannel has developed a new integrated product and by this summer, retailers will be able to offer customers the ability to upload and save pictures online from the retail kiosk. This new product will also allow customers to grab photos already saved online and print them out from the retail store. For the first time, it will allow retailers to offer gifting items like photobooks, greeting cards, coffee mugs, etc. – all in real time live over the internet instead of working manually with counter personnel to mail an order to the retailer’s gifting manucaturer.
I think that retailers will love this solution and the success of this software integrated solution could provide substantial upside to my numbers. (I currently include nothing in my estimates from this product.)
New customer wins of Costco and Sam’s Club
Photochannel won the Costco US contract in November of 2007 and won Sam’s Club in February of 2008. Both of these contracts were won from Snapfish, a division of Hewlett Packard, and Photochannel’s main competitor.
The enormity of these wins will soon be evident to the bottom line, making an immediate impact in the June quarter. I estimate that Sam’s Club (which is already up and running) is already Photochannel’s second largest customer on a run rate. And that once Costco comes online (by the end of April), Costco should be at least twice the size of Photochannel’s largest customer, Wal-Mart Canada.
Wal-Mart should come up for bid by year’s end or early next year
Snapfish, Photochannel’s primary competitor, is living a double life, and that double life is upsetting its customers. Snapfish is trying to have a branded website in which they print for the customer and mail it to the person’s home in addition to being a private label technology provider to retailers. This must have become a point of contention, when in December Snapfish’s branded website cut picture prices to $0.09 a print, well below what its own customers of Wal-Mart and Walgreens were charging. How much do you think Wal-Mart likes it when its suppliers compete with them?
Six months ago, Snapfish had Wal-Mart US, Walgreens, Sam’s Club and Costco as clients. Clearly Snapfish is losing customers to Photochannel, as they now just have Wal-Mart and Walgreens.
More importantly, with the exception of Wal-Mart US, Photochannel now has every Wal-Mart entity offering online photo solutions under contract including Wal-Mart Canada (which just happily renewed its contract), ASDA (Wal-Mart UK), Wal-Marts in Puerto Rico and Argentina as well as Sam’s Club in Canada and the US (which is owned Wal-Mart).
I believe that the Wal-Mart US contract expires in late 2009 (the site launched in September of 2006) and a RFP (request for proposal) will come up by year end or early next year. I think that Photochannel has an excellent shot at winning this contract.
Wal-Mart US is the largest photo processor by far and this win could easily bring in $0.50 or more a share in earnings to Photochannel in 2010 and beyond.
Costs and capex will flatline as revenue soars, as fixed cost investments are done
I believe that Photochannel has had to spend a lot of money to add capacity through technology and data centers to handle the growth in existing and new customers and has recently spent a lot of money to restructure Pixology after its acquisition. This has caused expenses and capex to soar in the recent short term. But this is all over going forward.
Consider that capex may be as much as $5 million this year, due to a new data center and other growth capex requirements, but that ongoing capex should only be $1 to $1.5 million a year. This shows how much of a cash cow business Photochannel will be going forward.
Further, the company has taken on more people than they need going forward to design and launch Sam’s Club US and Costco US in a timely manner. So I believe head count should actually go down this year as sales ramp. Depending on new opportunities, headcount could actually fall from 93-95 people to 88-90.
The point of talking about capex and expenses flat lining and falling is to explain how past expenses seen in previous quarters will not be rising with sales and to understand how much cash flow Photochannel will be generating.
Operating model is fantastic
Photochannel doesn’t have much in the way of selling or marketing expense, because it doesn’t market directly to the consumer. The retailers do the marketing and promotion. Further, once Photochannel makes its investment in technology, it can scale the amount of data it processes quite easily and only has to make minimal capex investments going forward. It is primarily for these two reasons that Photochannel makes a fantastic investment.
Once volume gets going in May, gross margins will reach close to 80% and eventually, gross margins could get as high as 90%. I expect an EBITDA margin next year of 40% (this is before stock compensation expense).
Revenue for the June quarter is poised to explode due to Costco and Sam’s Club
The key to the attractiveness of investing in Photochannel now is the near term catalyst of a revenue explosion.
The addition of Costco US and Sam’s Club US should cause transactional revenue to more than double in their first full quarters of operation, from $2.3 million to $5 million. I calculated this number based upon transaction revenue from both Sam’s Club and Costco to be at least $2 million a quarter in transaction revenue. Add that to my estimate of the March quarter’s revenue (estimated) of $3.5 million and you should get to around $6 million. (This assumes both of these new contracts having had a full quarter of operation.)
Very importantly expenses should be flat at around $2.5 million excluding amortization and stock compensation expense, so the entire amount of new revenue will flow to the bottom line. I am expecting EBITDA should be around $2.0 million for the first full quarter of these new customers being live or $0.05 per share on a fully diluted share count of 40 million shares (including all warrants and options).
There is a good chance that revenue for the fiscal 4th quarter (ending September) could be close to or even exceed all of fiscal 2007’s revenue. Costco and Sam’s Club are simply that big.
Equally exciting is that Sam’s Club had been operating on a five year old system and with Photochannel’s up to date system, Sam’s Club expects to show above average growth (possibly triple digit growth) from past volume as customers learn about the new system.
Seasonally the strongest quarter is the December quarter (fiscal 1st quarter), and the company should earn around $8.0 million in revenue and at least $0.09 a share in EBITDA.
The run rate of revenue by the beginning of the September ending 4th quarter should be $28 million at a 75% gross margin and $11 million of expenses. That gives me an annual cash flow per share of about $0.25 per share.
In 2009, with a full year of Costco and Sam’s Club, gross margin should increase to 80% and the EBITDA margin should be 40% and the company should do about $0.45 per share in cash flow.
And this is important; none of these figures include any new customer wins. Any new customer wins would be upside on these numbers.
I expect that by the time Photochannel reports the June quarter in August, that the company will probably hold their first earnings conference call.
The main competitor and comparable public company is Shutterfly (NASDAQ: SFLY). Shutterfly trades at 33 times 2008 earnings estimates that have been falling. The advantage that Photochannel has is that it doesn’t have to market to customers, nor does it have to have the expensive machines to print. Shutterfly has to spend tons of money on marketing. This compares poorly to retailers that already have a connection to consumers who are already shopping at the stores. It is my opinion that once Photochannel starts to perform and show substantial cash flows and earnings, investors who are infatuated with Shutterfly will flock to Photochannel.
The other comparison is Snapfish, which was bought by Hewlett Packard in 2005 for $180 million. Consider that Photochannel is taking all of Snapfish’s customers and that the market is so much bigger than it was in 2005, and Photochannel’s market cap (fully diluted with 40 million shares) of under $150 million looks paltry in comparison.
Both comparisons make Photochannel look very inexpensive.
This is my second report
I decided to write a second report (first one was January 2007) because Photochannel is a much better investment now than it was in 2007 and its risk profile is so much lower than when I first recommended it. Photochannel did not have Costco or Sam’s Club as customers and had not acquired Pixology when I first wrote it up. And yet, investors today are paying little more than they did in early 2007.
Further, I have taken a lot more care to make sure that my cash flow and earnings figures are spot on. It’s very easy to get carried away when you see how much photo processing retailers do and how little of it is done online. If the migration online accelerates, Photochannel will make a lot more money than I have estimated here.
Photochannel is finally on the cusp of a substantial increase in revenue on an expense base that will stay flat. This will result in a waterfall of cash flow and earnings. The stock sells for a substantial discount to its growth rate and its comparables. I believe this discount is due to its trading on the bulletin board and in Canada. Also, only one analyst covers Photochannel, and I believe this is bound to change.
Once Photochannel is on the NASDAQ (stock needs to be over $4) and a few more analysts cover the company, its earnings reports should drive the company to at least $7 to $8 per share. I believe that with new customer wins the stock could easily trade into double digits by next year.


-Costco comes online
-announcement of June and September quarters
-future guidance for 2009
-NASDAQ listing
-WalMart win
-Other customer wins
-Revenue and cash flow surge
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