System1: As H1 Figures Show Just 4% Top-Line Growth And AdRatings Burning £2m A Year, Could ITV’s Euro 2020 Competition Validate A Potential Recovery?

20 December 2019
By Maynard Paton

Results summary for System1 (SYS1):

  • Another unremarkable performance, with underlying gross profit up 4% and profit (without AdRatings) rebounding 24% due mostly to improved cost control.  
  • The start-up AdRatings service continues to lose £2m a year and is increasingly dictating the company’s progress, potential and valuation.
  • An ITV competition to determine the most “emotionally engaging” advert during Euro 2020 could create extra recognition for System1-type marketing and SYS1’s services. 
  • The accounts remain cash rich and the business (without AdRatings) exhibited a healthy 21% margin.
  • The P/E could be anywhere between 8 and 26 depending on how AdRatings, share-based payments and the cash position are viewed. I continue to hold.

Contents

Event: Interim results and presentation for the six months to 30 September 2019 published 07 November 2019

Price:
210p
Shares in issue: 12,576,619
Market capitalisation: £26.4m

Why I own SYS1

sys1 system1 hy 2020 results john lewis ad
  • Market-research agency that predicts the long-term effectiveness of client adverts, with success built upon a “difficult-to-replicate” database 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%/£6m shareholding and has declared five special dividends.
  • Offers cash-rich accounts, high underlying margins and a potentially low valuation — assuming the new AdRatings service can one day break even.

Further reading: My SYS1 Buy report | All my SYS1 posts | SYS1 website

Results summary

sys1 system1 hy 2020 results summary

Revenue, profit and dividend

  • Gross profit — SYS1’s main top-line performance indicator— was indeed up 7% (to £11.6m) while pre-tax profit (before share-based payments and AdRatings losses) was indeed £2.4m (up 24%).
  • Three factors complicated SYS1’s profit progress:
    • A £251k exceptional gain recorded during the comparable H1 and accounted for within operating profit;
    • The introduction of IFRS 16, whereby operating lease costs are now partly recognised as a finance expense, and;
    • Share-based payments, which were credits during this H1 and the preceding H2.
H1 2018H2 2018H1 2019H2 2019H1 2020
Revenue (£k)13,82213,11713,18213,71413,704
Gross profit (£k)11,39410,83710,80211,24511,568
Admin costs* (£k)(10,325)(9,698)(8,794)(9,422)(9,109)
Operating profit (£k)1,0691,1392,0081,8232,459
IFRS 16 finance cost (£k)--(72)(65)(60)
Operating profit less finance cost (£k)1,0691,1391,9361,7582,399
Share-based payments (£k)(229)6(41)17386
Exceptional item (£k)--251--

(*excludes exceptional item and share-based payments)

  • Adjusting for the £251k exceptional gain and the share-based payments, but including the IFRS 16 finance cost, ‘underlying’ profit before tax increased 24% from £1.9m to £2.4m.
  • The 24% improvement simply reflects gross profit growing by 7% and costs increasing by 4%.
  • Bear in mind that the comparable H1 2019 was somewhat lacklustre, with competitive pricing and re-designed products causing a sub-par performance twelve months ago.
  • SYS1 admitted gross profit growth for this H1 at constant currency rates was only 4%. 
  • Indeed, gross profit was only 2% higher than the gross profit reported for H1 2018.
  • The 2019 annual results reminded shareholders that gross profit has compounded at only c5% per annum since 2012. 
  • SYS1 confessed that growth during this H1 was “not yet on the trajectory we are aspiring to”.
  • A notable development was the maintained 1.1p per share dividend.
  • This time last year SYS1 said: “[The] 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.”
  • The subsequent annual results revealed an unchanged final 6.4p per share payout:

Given the investment opportunities with AdRatings, and a share price which some consider depressed, the decision to maintain the dividend was considered carefully.

  • 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 [2018] 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).

  • A dividend cut could still be forthcoming. This results RNS said: “We are keeping this [dividend] policy under review
  • Perhaps sustaining the dividend rather than ploughing even more money into AdRatings (see AdRatings below) and/or repurchasing shares tells us something about the prospects for both AdRatings and the share price.
sys1 system1 hy 2020 results aa ad

Divisions 

  • SYS1 operates three market-research divisions.
  • SYS1 has claimed its “main competitive strength” lies within its Communications division, which assesses televisions adverts and has “developed market research techniques which we believe are better able to predict the long-term effectiveness of advertising than anyone else’s.”
  • The Brand division tracks ongoing client-brand popularity, while the Innovation division tests new marketing concepts.
  • The Communications division should offer the best growth prospects and the widest ‘moat’ to shareholders. Brand is apparently the more reliable of the three income sources, while Innovation is apparently the most unpredictable.
  • The table below summaries the gross-profit contributions from each department:
H1 2018H2 2018H1 2019H2 2019H1 2020
Comms (£k)3,5823,4123,0594,3133,608
Brand (£k)2,1022,4091,7261,9731,628
Innovation (£k)4,3814,0234,9294,0575,135
Other (£k)1,1687819785891,068
Agency (£k)161212110316129
AdRatings (£k)----21
Total (£k)11,39410,83710,80211,24811,589
  • Communications gross profit gained 18% on the comparable H1 2019 — but this 18% leap appears to be an anomaly.
  • Communications gross profit for this H1 was actually equal to that achieved for H1 2018.
  • Full-year Communications gross profit improved by 5% during 2019, and was only 3% higher than the level recorded during 2016.
  • The numbers do not suggest the more attractive Communications division is growing at a particularly impressive rate.
  • Communications gross profit as a proportion of group gross profit has increased from 28% to 33% since 2016. 
  • SYS1 therefore remains somewhat dependent on progress within the less trail-blazing Brand and Innovation operations.

AdRatings

  • The new AdRatings service continues to earn a pitiful income — just £21k during the last six months.
  • To recap what AdRatings 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.

sys1 system1 hy 2020 results adratings dashboard
  • This results RNS described AdRatings as “the world’s largest, and most predictive and validated database of short and long-term advertising effectiveness”
  • AdRatings is based on the ad-testing performed by the Communications division and — according to SYS1 — no other source of advert ratings “correlates with long-term profitability” the way AdRatings does.
  • The AdRatings database now contains more than 42,000 analysed adverts for subscribers to study.
  • The AdRatings analysis appears to be accurate:
sys1 system1 hy 2020 results adratings outcomes
  • And yet paying AdRatings subscribers can be counted on one hand (or even one finger).
  • Why are SYS1’s current 246 clients not interested? 
  • Management comments at the AGM during August revealed:
    • Interested clients require “validation” — they want to see market-share changes in their particular advertising category correlate to changes to SYS1’s star ratings for the relevant adverts. SYS1 has correlation evidence for only certain advertising categories. Work is underway to ensure all categories have such validation.
    • The low (£2k/month) subscription cost of AdRatings has meant the service has still to reach the attention of chief marketing officers (CMOs) — who can’t justify their time evaluating a £24k a year product.
  • Attracting the attention of CMOs is important to SYS1. 
  • Management comments at the AGM claimed CMOs generally accept the benefits of System1-type advertising and are open to experiment. 
  • Trouble is, a CMO’s team is often risk-averse and wishes to keep using existing suppliers/methods/data rather than throw away years of work and restart using other suppliers/methods/data.
  • This results RNS said AdRatings had been “a factor… in our gaining much greater access to marketing leaders in large multinationals”.
  • I am hopeful this “greater access” can lead to extra revenue in time.
  • SYS1 claimed AdRatings offers “in the longer term… high upside potential”.
  • £1.2m was spent on AdRatings during the last six months, and the total cost to date has been £4.2m.
  • Total AdRatings revenue to date has been £24k.
  • The 2019 results had revealed a £2.5m AdRatings budget for the current year. 
  • These H1 results implied the full-year cost could be less than £2.4m (before tax).   
  • Management comments at the AGM indicated AdRatings was becoming an integral part of the business —rather than a standalone operation that could (in theory) be scrapped.
  • The AdRatings costs should therefore not be ignored for valuation purposes.
  • The 2019 results disclosed AdRatings expenditure consisted of £1.08m for data collection, £1.55m for IT development work and £0.4m for running/other expenses.
  • AdRatings costs would therefore reduce to £1.5m per annum were the IT development work to cease completely.
  • The AdRatings costs could of course be offset by additional subscribers and/or extra revenue from SYS1’s other services.

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Industry developments

  • These H1 results referred to a new SYS1 book called Lemon:
sys1 system1 hy 2020 results lemon book
  • SYS1 said: “Lemon sets out why advertising effectiveness has been in decline over the last few decades and what it will take to reverse the decline at a profound level — and it has received wide industry endorsement.”
  • I suppose the “wide industry endorsement” for Lemon could help sales of the book exceed the £24k income from AdRatings.
  • Whether Lemon will lead to major changes to multinational advertising campaigns remains to be seen. 

Emotional campaigns, and in particular those that are highly creative and generate powerful fame/buzz effects, produce considerably more powerful long-term business effects than rational persuasion campaigns.”

  • Judging by SYS1’s recent progress, few in the industry appear to have read either book.
  • Perhaps television advertising is shrinking and adverts work differently online.
  • Funnily enough, online businesses remain the largest spenders on UK television adverts.
  • For instance, Amazon spent £60m (up 21%) to broadcast UK television adverts during 2018. 
  • Meanwhile, websites such as Monzo and Sosander have enjoyed bumper demand following their initial television ventures.
  • Advert consultancy Thinkbox claims television remains the most profitable medium for advertisers:
sys1 system1 hy 2020 results thinkbox tv profit
  • Marketing expert Mark Ritson reckons “TV’s death dive continues to be overstated and misinformed”.
  • Mr Ritson writes: “I have nothing really to say in my column this week other than a) look at the bar chart and b) no, really LOOK at it…
sys1 system1 hy 2020 results mark ritson tv viewing

ITV Euro 2020 competition

A potentially significant industry development comes from ITV:

ITV is the latest media owner to launch a Channel 4-style competition to win free ad space, this time for a prime slot during the Euro 2020 final to the advertiser with the “most emotionally engaging campaign”.

“The broadcaster hopes a competition for free ad space will also improve the quality of the campaigns that run during the major football tournament. Commercial director Simon Daglish said it will work with an “independent research company” to judge the most “emotionally engaging” campaigns from a brand or agency.”

  • ITV encouraging multinationals to develop “emotionally engaging” adverts ought to be of enormous assistance to SYS1.
  • SYS1 may even be the mystery “independent research company” that performs the judging.
sys1 system1 hy 2020 results world cup adverts
  • The biggest night for commercial TV ever” was apparently fairly typical for adverts. 

Humble 20-second ads [including Alpecin Shampoo’s bizarre “Fight For Your Hair!”] shared space with expensive-looking marquee campaigns from BT Plus and Samsung.

A third of the ads tested… ended up with 1-Star, suggesting that — from a brand-building perspective — the money was largely wasted.

  • I am hopeful this ITV competition — and the influence the competing adverts will have on their respective product sales — will prompt more companies to consider SYS1’s services.

Financials

  • SYS1’s accounts remain reasonably straightforward. 
  • Cost cuts and product changes during recent years allowed pre-tax profit — before AdRatings and share-based payments — to represent a healthy 21% of gross profit for this H1 (versus 17% for full-year 2019).
  • Cash conversion was not great during the six months.
  • Total earnings of £860k had to fund additional working capital of £616k and dividends of £804k. A very low tax payment kept the cash outflow to £306k.
  • Cash ended the half at £4.1m.
  • Total AdRatings expenditure was £1,274k, of which £232k was capitalised on to the balance sheet and avoided the income statement. 
  • This capitalised expenditure will be amortised through the income statement during the next three years.
  • The carrying value of the capitalised AdRatings costs is now £885k.
  • SYS1’s books remain free of bank debt and free of pension obligations.

Valuation

  • Assessing SYS1’s valuation requires a view on share-based payments and the prospects for AdRatings.
  • The vagaries of IFRS 2 have meant SYS1 has recorded share-based payment credits for the last twelve months.
  • The credits reverse earlier share-based payment charges, after the likelihood of options becoming exercisable reduced considerably.
  • The 2019 annual report indicates 355,823 options have vested, which if exercised would increase the share count by 3% to 12,932k (and raise £61k for SYS1).
  • Calculating earnings per share using this enlarged share count seems a better way of accounting for options than the fluctuating IFRS 2 charge.
  • SYS1’s other options all require the share price to reach 500p (or more) before potential vesting.
  • I will be delighted to revisit my option sums when the share price reaches 500p.
  • Pre-tax profit excluding share-based payments were almost £4.2m for the twelve months to September 2019. 
  • Earnings come to £3.0m, or 23.1p per share, after applying the 29% tax used in these results and the 12,932k option-adjusted share count.
  • Assume the net present value of AdRatings is zero, SYS1’s 210p share price is 9 times the 22.9p per share earned by the rest of the group.
  • Assume SYS1 will soldier on with AdRatings losing £2.0m a year after tax for ever, and ongoing earnings could be 7.9p per share to support a 26x rating.
  • Assume the cash position of £4.1m, or 31.7p per share, is surplus to requirements, and the cash-adjusted multiples range from 8x to 23x.
  • The likely earnings outcome — at least for the next few years — could be mid-way between 22.9p and 7.9p per share, which points to a 15x cash-adjusted multiple.
  • SYS1’s outlook comments did not hint at an immediate return to superior growth:

We continue to have limited short-term revenue visibility, so, as always, it is difficult to predict how the year will unfold.  Nevertheless, we continue to believe that the business is making progress and in the longer term has high upside potential driven by its AdRatings asset and the more general digitisation of the business.

  • The trailing 7.5p per share dividend supplies a 3.6% income at 210p, and is just about covered by the above 7.9p per share earnings estimate.

Maynard Paton

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Disclosure: Maynard owns shares in System1.

2 thoughts on “System1: As H1 Figures Show Just 4% Top-Line Growth And AdRatings Burning £2m A Year, Could ITV’s Euro 2020 Competition Validate A Potential Recovery?

  1. Maynard Paton Post author

    System1 (SYS1)

    New Employees

    Forgot to mention this from the results statement:

    “Across the business as a whole, we are investing ever more in Talent. During H1 we recruited 2 new members to our management team: Karen Wolfe (formerly Vice President Customer Success at Nielsen), as Chief Commercial Officer, and Jon Evans, (formerly UK Marketing Director at Lucozade Ribena Suntory) as Chief Marketing Officer. They follow Stefan Barden (Board Adviser – previously CEO of Wiggle) and Mark Beard (Chief Information Officer – formerly Group Head of IT at Wiggle) who joined during the course of last year.”

    The appoints of the former Vice President Customer Success at Nielsen and the former UK Marketing Director at Lucozade Ribena Suntory appear encouraging.

    Nielsen is one of SYS1’s major rivals and its services are apparently entrenched within many marketing departments — something SYS1 has to combat.

    SYS1’s appointment of a chief marketing officer is overdue. I am sure Mr Evans was already known to SYS1’s chief exec prior to the appointment as his name has come up in casual conversation at AGMs.

    Fascinating interview with Mr Evans here:
    “Rather than spending hundreds of thousands of pounds on a new ad, we decided as a team to repeat the same campaign for the second year because our market share went up, we know it works. But we could spend more money on media because we weren’t spending it on agency fees and production,” Evans explains.

    “For me that’s a no-brainer but you’d be amazed at how hard it is to get people to do that because everybody wants to make their own thing, they want to learn, to prove themselves. Some people would rather make a worse ad but say they’ve made an ad and it be new than repeat something someone else has done very effectively.”

    Maynard

    Reply
  2. Maynard Paton Post author

    System1 (SYS1)


    Trading Update and Planned Share Buyback

    Oh dear — a profit warning. Bad news for me as I had bought more SYS1 shares before this statement. More on that purchase in a minute. I have interspersed the text with my comments.

    —————————————————————————————————————————–
    System1 Group PLC (AIM: SYS1) (the international online market research agency), announces today the following trading update for its financial year to the end of March 2020.

    After H1 single-digit growth, followed by modest further progress in Q3, trading in Q4 to date has been disappointing, due in the main to the ongoing transition of sales talent, and subsequent disruption and decline in adhoc revenue from smaller clients. Given the limited visibility in some areas, it is difficult to predict the full year outturn, but the Board believes Gross Profit will be slightly down compared to the prior year.

    The Company continues to invest heavily in its AdRatings database, sales talent, digitisation and automation, in support of its increasing emphasis on Advertising Effectiveness. Underlying Overhead Costs (excluding Share Based Payments and AdRatings) are expected to increase 4-6% over the 2019/20 financial year.

    The lower than expected Gross Profit and increased costs are expected to result in a normalised 2019/20 Profit Before Tax (i.e. excluding Share Based Payments and AdRatings) materially below the current market expectation.
    —————————————————————————————————————————–

    The phrase “ongoing transition of sales talent” suggests key employees have been leaving, and continue to leave. Fellow blogger Paul Scott made a good point about Glassdoor reviews.

    The latest review says: “ I should have listened to the reviews prior to joining and ruining my career. The company is being run into the ground by a consultant and has perpetual global turnover.” That sounds ominous.

    I wonder if the ‘consultant’ is Stefan Barden (point 4), a ‘board adviser’ who is leading SYS1’s tech strategy and ‘digitising’ the business. His way of working may not quite fit in with marketing ‘creative’ types.

    I suspect the investment in AdRatings (see below) and the shift to becoming an advert ‘data’ business has meant management’s focus has changed and employees within the ‘legacy’ brand-tracking and innovation-testing departments have perhaps felt neglected.

    Anyway, the RNS said gross profit would be “slightly down” on 2019 while underlying overhead costs would increase between 4% and 6%.

    Assuming gross profit is unchanged and underlying overheads increase 5%, then 2020 operating profit (excluding AdRatings) might be £22.05m less (£18.35m*1.05) = £2.78m. The first half reported a c£2.5m operating profit, so profitability during the second half has collapsed to just c£0.3m.

    Costs up with stagnant (at best) sales is not great. Rising costs will in part be due to appointing new senior employees.

    —————————————————————————————————————————–
    At the same time AdRatings, now rebranded “Test Your Ad”, is starting to show its commercial promise. As part of ITV Media’s objective to ‘Get people to fall back in love with advertising’, they have chosen System1 as their partner in rating the ‘Nation’s favourite Ads’ and helping advertisers to create more of them – starting with a UEFA Euro 2020 Competition to select the best sporting Ad, with the winner awarded a free advertising slot in the half-time break of the final match.
    —————————————————————————————————————————–

    So my hunch in the blog post above — “SYS1 may even be the mystery “independent research company” that performs the judging” — proved correct.

    Anyone on SYS1’s mailing list could have known about the ITV partnership in advance of this RNS. The formal announcement was made on 29th January and the (free) tickets to the event had already heralded the deal:

    I attended the event, hosted in a cinema in central London.

    Perhaps the most disappointing — but not surprising — part of the event was the audience’s response to being asked who had read Peter Field’s “Crisis in Creative Effectiveness”. Very few hands were raised, which probably explains why SYS1 has struggled to sell its services of late — marketers just don’t want to know about their adverts becoming less effective.

    During the presentation, SYS1 gave lots of tips to creating an advert winner. Here are the best ads of 2019, at least according to SYS1.

    Kate Waters, ITV’s director of client strategy and planning, revealed the SYS1 deal had been prompted by surveys showing the public’s increasingly unfavourable attitude towards adverts.

    Since the early 90s, the number of people that look favourably towards television adverts has halved, while those who look unfavourably has doubled.

    Ms Waters admitted ITV had in the past been like the motel owner below, and effectively turned a blind eye to what its customers were up to:

    Now ITV wants to “get people to fall back in love with advertising” — presumably so advertisers can make more effective adverts, sell more stuff, and then have more money to spend on more adverts (on ITV).

    ITV spoke to about 20 industry experts, including Orlando Wood, the chief innovation officer at SYS1.

    From what I could tell from the presentation and post-presentation chit-chat, SYS1 was the only firm able to offer what ITV was looking for. Could that mean SYS1 really does have unique data that might possess a ‘moat’? Partnership talks with SYS1 began about three to fours months ago.

    I think ITV actually expected the data and effectiveness testing would have to be created in-house.

    All told, the ITV deal appears to validate the value of SYS1’s data and the AdRatings project. Perhaps other commercial broadcasters may one day feel SYS1’s data is useful. ITV has further details of the advert competition here.

    —————————————————————————————————————————–
    The Company has £4.2m cash, and no debt, and in line with the Company’s approach to capital allocation, the Board intends to conduct a share buyback program of up to £1.5m of the Company’s shares, following its normal post year-end Trading Update in April, subject to the Company’s share price and cash balance at the time. This would be by way of market purchases. The Company will provide a further update nearer the time. Any share buybacks will be made under the existing authority the Company has in place to make market purchases, and also in accordance with the Market Abuse Regulation (EU) No. 596/2014 and Commission Delegated Regulation (EU) No. 2016/1052 where practicable.
    —————————————————————————————————————————–

    I am not quite sure why SYS1 wants to wait until after April’s statement before undertaking a buyback. Perhaps the company wants to know exactly how bad Q4 has been before buying — well, that is how I feel at the moment. Obscure stock-market regulations may be preventing the buyback of course.

    Cash was £4.1m at the half year, so has increased by £0.1m during Q3.

    Assuming AdRatings costs a further £1.2m during H2, then the H2 operating cash loss could be £0.9m (including capitalised AdRatings costs).

    I’m not so sure instigating a buyback and sustaining the dividend (£0.9m/year) is wise when the overall business is losing money. As SYS1 has hinted, I think the dividend will have to go to leave room for error with any buyback.

    I increased my shareholding by 75% by buying SYS1 shares both before and after the 29th January event. The average price I paid was 251p including all costs, and those purchases will teach me about trying to be too clever with industry announcements.

    Using my sums in the blog post above, I reckon a 251p share price had valued the business (excluding AdRatings) at 10x my earnings guess adjusted for the £4m cash position. I had felt the ITV deal would give AdRatings a net present value of at least zero.

    I still think ITV’s involvement is positive for SYS1 and AdRatings, and the NPV of the latter is now much more likely to be greater than zero post-ITV.

    However, SYS1 appears to be going ‘all in’ with its Advertising Effectiveness and AdRatings departments, which perhaps has led to the other departments losing employees and momentum.

    SYS1 will become a higher quality business if it succeeds in transforming into a full ‘data’ operation with ongoing subscription revenues etc, but the path will not be straightforward and the group’s financial performance will be unpredictable in the meantime.

    Maynard

    






PS Thanks to Emma for recommending my blog :-)

    Reply

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