25 June 2019
By Maynard Paton
Results verdict on System1 (SYS1):
- An unspectacular performance with gross profit unchanged and profit rebounding due only to cost cuts.
- The new AdRatings service suffered a woeful start after generating revenue of just £3k.
- The lack of all-round progress prompts awkward questions as to whether the group’s advert-analysis services are actually of much interest to the marketing industry.
- The accounts remain cash rich and would exhibit respectable ratios were it not for the chunky AdRatings start-up costs.
- The P/E could be somewhere between 10 and 15 assuming AdRatings one day breaks even (or is scrapped). I continue to hold.
- Event links and share data
- Why I own SYS1
- Results summary
- Revenue, profit and dividend
- A wider doubt
- Balance sheet and cash flow
Event links and share data
Shares in issue: 12,576,619
Market capitalisation: £28.9m
Why I own SYS1
- Market-research agency that predicts the long-term effectiveness of client adverts, with success built upon a “difficult-to-replicate” history of advert assessments created over 20 years.
- Boasts founder/entrepreneurial/owner-friendly chief exec who has overseen an acquisition-free growth record, retains a 23%/£7m shareholding and has declared five special dividends.
- Offers cash-rich accounts, decent underlying margins and a potentially modest valuation — assuming the new AdRatings division can one day break even.
Revenue, profit and dividend
- A trading statement issued during April had already indicated these results would not be spectacular.
- Gross profit — SYS1’s main top-line performance measure — was indeed the £22m cited in April.
- Reported profit was affected by AdRatings start-up costs of £2,214k, a one-off gain of £251k and a share-based payment credit of £196k.
- Pre-tax profit before the AdRatings start-up costs, the one-off gain and the share-based payment credit was indeed the £3.7m cited in April.
- Progress was made only by reducing expenses following the “miserable” preceding year. Gross profit fell 1% while operating profit (before AdRatings start-up costs, the one-off gain and share-based payments) rebounded by 80%.
|Year to 31st||Dec 2014||Dec 2015||Dec 2016||Mar 2016||Mar 2017||Mar 2018||Mar 2019|
|Gross profit (£k)||19,410||20,250||25,643||20,989||26,984||22,231||22,050|
|Operating profit (£k)||4,301||4,546||6,229||5,052||6,308||1,985||1,932|
|Other items (£k)||-||-||-||-||-||-||-|
|Finance income (£k)||(15)||(45)||(29)||(21)||(29)||7||2|
|Pre-tax profit (£k)||4,286||4,501||6,200||5,031||6,279||1,992||1,934|
|Earnings per share (p)||23.0||24.0||31.9||26.7||32.7||9.9||10.0|
|Dividend per share (p)||4.3||4.5||1.1||4.5||7.5||7.5||7.5|
|Special dividend per share (p)||12.0||-||12.0||-||38.1||-||-|
- A notable development was the maintained dividend.
- SYS1’s interim statement had said: “Final dividend may be reduced, depending principally on the scale of further investment in AdRatings and on opportunities to repurchase shares at an attractive valuation.”
- These results then stated:
“Given the investment opportunities with AdRatings, and a share price which some consider depressed, the decision to maintain the dividend was considered carefully.
This level of dividend will not impair the Company’s plans for AdRatings, as we have sufficient liquidity to cover planned investment including that relating to AdRatings.”
- However, the door was seemingly left ajar for a future dividend cut:
“Whilst the Board is prepared to consider reducing the dividend (as flagged in our Interim Statement), it views maintenance of the dividend as a useful discipline which it seeks to adhere to unless there is sufficiently clear-cut reason otherwise (which, in the Board’s view, is not the case at this time).
- The charts below from the results presentation show the gross-profit performance and the divisional gross-profit performances for the last twelve quarters:
- SYS1 claims its “main competitive strength” lies within its Communications division.
- The group says the Communications division has “developed market research techniques which we believe are better able to predict the long-term effectiveness of advertising than anyone else’s.”
- The Communications division offers “the most potential”, too:
- Meanwhile, the Brand division is said to be the most stable, and the Innovation division to be the most unpredictable.
- SYS1’s half-year split showed second-half gross profit up 3-4% versus the preceding first half and versus the comparable second half of 2018:
|H1 2018||H2 2018||FY 2018||H1 2019||H2 2019||FY 2019|
|Gross profit (£k)||11,394||10,837||22,231||10,802||11,248||22,050|
|Admin costs* (£k)||(10,554)||(9,692)||(20,246)||(9,133)||(9,022)||(18,155)|
|Operating profit (£k)||840||1,145||1,985||1,669||2,226||3,895|
(*excludes AdRatings costs and £251k one-off gain for 2019)
- Last year’s introduction of a ‘Creative Guidance System’ — a plan to split certain work to provide cheaper, automated services and eventually win larger contracts — has yet to bear fruit.
- SYS1 says its pricing competitiveness has been restored, but admits the large-scale programmes are a “work-in-progress”.
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- The new AdRatings service has suffered a woeful start.
- SYS1 recapped what this product offers:
“AdRatings is a large database showing ‘ratings’ or ‘scores’, of adverts in the market as a whole. It allows clients to assess the effectiveness of their historical advertising and benchmark it against peer companies, competitor categories and the industry as a whole.”
- This time last year, SYS1 said AdRatings would be “dramatically better, cheaper and faster than any existing provider.”
- The service launched during November and generated revenue of only £3k during the subsequent four or so months.
- If the service was indeed “dramatically better, cheaper and faster than any existing provider”, then surely many clients would have signed up straight away and paid SYS1 a lot more than £3k.
- A now-deleted tweet from @System1Research claimed AdRatings had gained 50 “subscribers” soon after launch.
- My enquiries revealed those 50 subscribers included free trials:
- Free trials for AdRatings are (supposedly) limited to 14 days (clause 3).
- At launch, AdRatings asked customers to pay £1k/$2k a month. The AdRatings website now shows the price has doubled to £2k/$4k a month.
- Revenue of £3k during four months suggests the service has captured only one paying customer.
- SYS1 said in this results statement: “We are piloting ways both to enhance and commercialise this [AdRatings] database with a small number of clients, prior to an expected further roll out later in the current financial year.”
- SYS1 said in the accompanying results presentation: “AdRatings is still in the Beta testing and development phases, with a limited number of clients. We are developing the functionality and commercial offering and expect sales to accelerate once it begins to catch on, but cannot predict when.”
- AdRatings was seemingly never ‘launched’ at all. Instead, the service remains as a pilot project in beta testing.
- The distinct lack of AdRatings progress prompts some awkward questions.
- In particular, exactly what extra functionality does AdRatings require? The service already contains data for 34,000-plus adverts and offers the fundamental advert-comparison feature.
- Why have SYS1’s existing clients not subscribed?
- SYS1 serviced 251 clients during 2019, and earned an average £88k gross profit from each one. The client base includes multinationals that could easily afford the initial £12k (or the current £24k) a year subscription.
- Indeed, price cannot be a dissuasive factor — because SYS1 said AdRatings would be “dramatically… cheaper” than the alternatives. Management comments at the 2018 AGM suggested “ultra-low pricing ought to encourage subscribers”.
- I can only conclude the lack of uptake must be due to clients just not being interested in what AdRatings has to offer.
- When I studied the AdRatings website back in November, two thoughts struck me:
- Thought 1) Numerous categories cover only a handful of advertisers. Potential subscribers may therefore already have a good idea of who is performing well in their sector — and not require SYS1’s data.
- Thought 2) Certain categories — such as finance and medical — are hamstrung by various advertising regulations. Such adverts are generally deemed by SYS1 to be 1-star money-wasters, which begs the question why anyone would pay to discover how much money everybody else serving the category is (apparently) wasting.
- SYS1 remains optimistic about the start-up service:
“We view the risk/reward profile of AdRatings as attractive. The investment has limited downside risk and high upside potential, both in terms of helping propel our existing Communications business and in creating a new scalable revenue stream.”
- £3m was spent on AdRatings last year and £2.5m is budgeted for the current year. I suppose the “limited downside risk” is the service being culled and at least £5.5m (43p per share) being wasted.
- Some 105 AdRatings subscribers paying £2k a month are required to cover costs of £2.5m a year.
A wider doubt
- The lack of AdRatings revenue raises a wider doubt about the whole business — are SYS1’s services actually of any interest to the majority of marketing departments?
- The “miserable” results for the preceding year were blamed on cutbacks at multinationals following a mooted bid for Unilever.
- However, client cutbacks can only be blamed for so long.
- SYS1 admits its gross profit has grown at 5% per annum since 2012 — a modest performance that suggests the group’s marketplace may not offer wonderful potential.
- That 5% growth history even comes with the effective backing of industry gurus Les Binet and Peter Field — high-profile experts that praise the long-term, brand-building adverts that SYS1 champions.
- Perhaps the brutal reality is that most marketing departments neither care about SYS1’s services, nor care about the style of advertising that SYS1 claims should lead to “profitable growth”.
- SYS1 appears frustrated by the industry’s general direction. The group asks: “Who Killed Effective Advertising?” Clive Clickthrough? Ingid Investor? Brandon Blockchain?
- Further frustration: SYS1 points to a 46-year-old advert that resonates more with today’s viewers than 99% of modern adverts:
- The irony of course is that SYS1 informs companies whether their marketing is effective — but appears to be not so effective when marketing its own services.
Balance sheet and cash flow
- SYS1’s books remain reasonably straightforward. The results RNS was commendably published with the full accounts.
- The AdRatings expenditure continues to leave SYS1’s accounting ratios less attractive than before.
|Year to 31st||Dec 2014||Dec 2015||Mar 2017*||Mar 2018||Mar 2019|
|Operating margin (%)**||22.2||22.4||22.6||8.9||8.8|
|Return on average equity (%)||36.6||35.8||47.9||14.9||14.4|
(*15 months **operating profit as a proportion of gross profit)
- Exclude the AdRatings expense, one-off gain and share-based payment credit, and operating profit as a proportion of gross profit would have been a worthy 17% for 2019.
- Cash conversion was not great:
|Year to 31st||Dec 2014||Dec 2015||Mar 2017*||Mar 2018||Mar 2019|
|Operating profit (£k)||4,301||4,546||7,260||1,985||1,932|
|Depreciation and amortisation (£k)||425||459||556||374||287|
|Net capital expenditure (£k)||(273)||(322)||(290)||(113)||(1,030)|
|Working-capital movement (£k)||(89)||(1,053)||767||832||(858)|
|Net cash (£k)||5,347||6,365||8,266||5,784||4,315|
- The increase to net capital expenditure was due to £923k spent on AdRatings that was capitalised on to the balance sheet and mostly avoided the income statement. (This expenditure will be amortised fully through the income statement during the next three years.)
- Prior to 2019, net capex had been prudently covered by the depreciation and amortisation charged against earnings.
- The adverse working-capital movement was due to higher trade receivables, which perhaps reversed the favourable movement of the prior year.
- SYS1 has tended to manage its working capital well — the multinational client base could easily be very slow payers to such a small supplier.
- Free cash flow for the year was a negative £463k, which after £940k paid as dividends left the bank balance £1.4m lighter at £4.3m (34p per share).
- SYS1’s books remain free of debt and free of pension obligations.
- Assessing SYS1’s valuation requires a view on the prospects of AdRatings.
- Assume the net present value of AdRatings is zero, and SYS1’s £29m market cap is simply 11 times my £2.7m (or 21p per share) earnings estimate for the other parts of the group (before the one-off gain and share-based payment credit).
- Assume the £4.3m cash position is surplus to requirements, too, and the rating is less than 10 times.
- Assume instead that SYS1 will plough on with AdRatings losing £2m a year forever, and 2019’s reported earnings of £1.3m support a multiple of 22x.
- A potential outcome for AdRatings is significant losses occurring for the next year or two, followed by minimal profit contributions thereafter.
- Let’s say a further £5m is pumped into AdRatings before the division breaks even. A £29m market cap plus £5m gives £34m, which divided by my £2.7m earnings estimate leads to a 13x rating.
- Assume £10m is pumped into AdRatings before the division breaks even, and the multiple becomes 15x.
- My sums suggest the share price is expecting AdRatings to absorb a substantial amount of money before the new service eventually covers its costs.
- My estimated multiples of between 10x and 15x look about right for a business that has expanded at a 5% per annum average since 2012.
- SYS1 claimed its “[i]nvestment in AdRatings, while significant, will not strain the balance sheet, is discretionary, and is being managed dynamically as we learn from initial client feedback.”
- During 2019, the main parts of the group delivered an underlying £3.7m operating profit — which would just about cover the £2.5m projected current-year spend on AdRatings and another £940k as dividends.
- SYS1’s outlook comments did not hint at imminent growth fireworks:
“Although we have limited short-term revenue visibility, we believe that the core business can return to steady long-term growth, and that in addition the Company has upside potential with AdRatings.”
- A repeat of the 7.5p per share dividend supplies a 3.3% income at 230p.
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Disclosure: Maynard owns shares in System1.