SYSTEM1: Remarkable Q2 May Lead To 8x P/E And Potential Recovery Helped By ITV Progress, New Clients And Net Cash

11 December 2020
By Maynard Paton

Results summary for System1 (SYS1):

• A pandemic-disrupted first half, albeit with headline numbers that disguised a remarkable return to profitability during Q2.

• Revenue improvements within the Communications and UK segments suggest the tie-up with ITV is working.

• A bold pricing structure, greater ambition clarity and even improved film-making may explain why adidas has become a client.

• The accounts are in reasonable shape, with significant net cash, positive cash generation and perhaps a decent profit margin following various cost savings.

• Extrapolating the Q2 profit leads to a lowly 8x multiple and intriguing recovery/upside possibilities. I have bought more shares.

Contents

• Event links, share data and disclosure
• Why I own SYS1
• Results summary
• Coping with Covid-19
• Revenue and profit
• Divisions and geographies
• Test Your Ad
• Achtung!
• Financials
• Valuation
• Portfolio trade

Event links, share data and disclosure

Event: Interim results and presentation for the six months to 30 September 2020 published 17 November 2020

Price: 185p
Shares in issue: 12,659,784
Market capitalisation: £23.4m

Disclosure: Maynard owns shares in System1. This blog post contains SharePad affiliate links.

Why I own SYS1

• Market-research agency that predicts the effectiveness of television adverts, with progress resting upon “the most accurate tool available for predicting long-term, brand-building, profitable growth.”

• Boasts founder/entrepreneurial/owner-friendly chief exec who has overseen acquisition-free growth, retains a 23%/£5m shareholding and has declared five special dividends.

• Conversion from consultancy work to supplying data alongside a deal with ITV plus a remarkable return to profit leads to tantalising recovery possibilities.

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

Results summary

Coping with Covid-19

• Annual results published during June had already warned this H1 performance would be disrupted by the pandemic.

• SYS1 admitted at the time:

“In the two months to end May, Revenue and Gross Profit were 36% and 38% respectively below the same period of last year. Over these months the business as a whole incurred a Pre-Tax loss of some £0.7m as we pursued our short-term objectives of continuing to develop our new automated product set, while conserving cash by shrinking the cost base to offset lower sales.”

• The losses arising during April and May led to the axing of the dividend, the furloughing of staff and the deferral of 20% of board salaries.  

• A trading statement during October then implied a remarkable profit recovery had occurred.

• October’s update signalled a £0.6m pre-tax, pre-impairment profit for this H1, which suggested June, July, August and September had registered an astonishing £1.3m pre-tax, pre-impairment profit versus the £0.7m loss for April and May. 

• Sure enough, the results presentation confirmed the return to profitability for Q2:

• These results actually declared a £0.4m adjusted pre-tax profit for the half — £0.2m less than was signalled within October’s update due to additional adjustments (see Revenue and profit below). 

• SYS1 said trading had indeed picked up after May: 

“From June, as sales began to recover, arrangements put in place to reduce employees’ hours were progressively reversed, and the partial deferral of some senior employees’ salaries ended in August. In summary, the business emerged from H1 stronger than it started, with Q2 Revenue, adjusted Profit Before Tax and Net Cash well up on the preceding quarter.”  

• But the general outlook was cagey:

“[C]ontinued uncertainty over the medium- and longer-term impact of Covid-19 on the major economies in which System1 operates, heightened by recent “lock-down” measures, leads us to continue to suspend  financial guidance.”

• The dividend remains suspended, too.

• SYS1 said the “widespread adoption of new ways of working” during the pandemic had prompted the closure of certain overseas offices, with the associated staff now working from home.

• SYS1 reckoned reduced office requirements should lead to annual savings of £0.4m.

• This H1 also witnessed a 12% reduction to the workforce.

• The cost reductions and remarkable Q2 profit rebound may be related to the appointment of a new finance director during April…

• …although few would have said at the time recruiting an FD once fined by the FCA and FRC was very promising. 

• During the half SYS1 received government benefits of £0.6m, mostly from the United States.

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Revenue and profit

• SYS1 used the word “disappointing” to describe this H1 financial performance.

• Revenue fell 26% and led to a reported loss:

• The results were complicated by a number of adjustments:

• The £1m impairment related to the aforementioned office closures and is arguably a one-off charge.

• The £0.6m government support is I trust a one-off benefit.

• Severance costs of £0.6m could be deemed one-off, but SYS1 has recorded severance costs every year since 2012 that have totalled £2m.

• Reversing the bonus and provision gains seems a sensible adjustment.

• Taking the adjustments at face value, adjusted operating profit dived 79% to £0.4m.

• SYS1’s start-up Test Your Ad service (formerly ‘AdRatings’) hampered the interpretation of the performance.

• During FY 2019 and FY 2020, £5m was spent developing Test Your Ad in exchange for revenue of only £56k. 

• SYS1 had previously reported progress including and excluding Test Your Ad expenditure, but these results were the first not to disclose Test Your Ad’s financials.

• However, the commentary on Test Your Ad did appear relatively positive (see Test Your Ad below).

• Trying to guess the contribution from Test Your Ad during this H1 versus the comparable H1 is thankfully not that necessary given the aforementioned level of adjusted Q2 profitability and the group’s market cap (see Valuation below).

• Note, too, that these results did not disclose various KPIs that were previously regular results fixtures:

Divisions and geographies

• SYS1 operates three market-research divisions.

• The most attractive division is Communications, which evaluates television adverts and which SYS1 has previously claimed has:

“developed market-research techniques [that]…  are better able to predict the long-term effectiveness of advertising than anyone else.”

• The Brand division tracks ongoing client-brand popularity, while the Innovation division tests new marketing concepts.

• The Communications division offers the widest potential ‘moat’ to shareholders. 

• The fledgling Test Your Ad service — on which SYS1 is pinning its longer-term hopes — is part of Communications.

• Brand has in the past been the more reliable of the three income sources, while Innovation caters for ad-hoc work and is the most unpredictable.

• The table below summarises the revenue contributions from each department:

• Communications was the only division to have delivered revenue higher during this H1 than the H1 of two years ago. 

• Revenue from Communications represented 40% of total revenue during this H1, versus 27% two years ago.

• Innovation revenue during this H1 dropped 33% as new marketing concepts were put on hold during the lockdown.

• The presentation hinted that the divisions may soon consolidate into just Data and Consultancy:

• Somewhat astonishingly, UK and Asia-Pacific (APAC) revenue both managed to improve during this H1:

• Americas revenue almost halved, due in part to the region’s three largest clients reducing their budgets. 

• Wishful thinking perhaps, but the out-performance of Communications and the UK may be linked to ITV’s involvement with the Test Your Ad service (see Test Your Ad below).

• This presentation bullet-point was encouraging:

Test Your Ad

• The revamped Test Your Ad website describes the service as “the most accurate tool available for predicting long-term, brand-building, profitable growth”.

• Test Your Ad captures the second-by-second responses to television adverts from 150 members of SYS1’s online panel: 

• According to SYS1, the greater the panel’s ‘feel-good’ response, the more likely the advert will generate long-term additional sales:

• At least two years of Test Your Ad development had resulted in scant extra revenue and significant losses. 

• But a tie-up with ITV at the start of 2020 appeared to validate the Test Your Ad philosophy, data and conclusions.

• Finally… a large organisation (ITV) had determined Test Your Ad was actually useful!

• The pandemic unfortunately led to the axing of a SYS1-ITV summer advert competition.

• But client interest in Test Your Ad — albeit from a small base — appears to have grown.

• The following remark from this H1 statement was very encouraging:

“…the high new business win-rate of our Test Your Ad predictive products…”

• The win-rate actually jumped 64% on three times as many “big pitches”:

• New clients apparently include adidas:

• I am convinced ITV’s involvement has sparked this much-needed attention towards Test Your Ad.

• After all, ITV has links with many more deep-pocketed advertisers than SYS1…

• …and the broadcaster’s new desire to show more effective ads must have some bearing within the industry.  

• ITV’s Q3 update encouragingly showed advertising spend returning to almost 2019 levels…  

“We saw advertising trends improve in Q3 with total advertising spend down 7% year on year. July was down 23%, August up 3%, September down 2% and October down 1% compared to the same periods in 2019. September and October were against the Rugby World Cup in 2019. A number of categories spent more year on year in Q3 including FMCG, Supermarkets, Publishing and Broadcasting, Telecommunications, Food, Government, Charities and Other, and Household Stores.“

• …which seems to tie in with SYS1’s much better Q2 (July August and September).

• A very promising development is SYS1’s Test Your Ad pricing:

• SYS1 is going all out to disrupt the ad-testing market with low, simple and transparent pricing.

• I am all for this ‘challenger’ proposition — assuming of course Test Your Ad really is better, faster and cheaper than the established alternatives.

• SYS1 even published its Test Your Ad rate card:

• The Test Your Ad pricing reminded me of the 2019 SYS1 AGM, when management was quizzed about the lack of Test Your Ad progress:

• My AGM notes included:

“Potential clients were apparently not interested in the [Test Your Ad] service as the price was ‘too cheap‘ — with the implication that the service would be poor.”

“The low cost of AdRatings [now Test Your Ad] meant the service did not reach the attention of chief marketing officers (CMOs) — who could not justify their time evaluating a £12k/year service. ‘Needs to be £50k/year to be credible‘.”

• The rate-card publication suggests the pricing issue has now been resolved — or at least accepted by SYS1 that clients will still have reservations.

• Revisiting those AGM notes also reminded me of SYS1’s ambition for Test Your Ad — “to become the ‘YouGov of advertising data’.”

• This H1 statement said SYS1 continued to invest in “a new generation of highly predictive, lower cost, automated products” — which I hope will help the company’s YouGov ambition.

• YouGov’s share price implies the approach is a fine one to adopt:

• SYS1’s ‘roadmap’ below suggests the Brand and Innovation divisions could soon have their own Test Your Ad equivalents — which will further underpin the conversion to automated/lower-cost services:

Achtung!

• I wrote in my annual-results review that “SYS1 is ironically very poor at marketing its own product.”

• I cited “Where the Lemons Bloom”,  a short film written and presented by Orlando Wood, SYS1’s chief innovation officer:

• The film opens with the line “Kennst du das Land, wo die Zitronen blühn?” and then recounts the early life of German writer Johann Wolfgang von Goethe and his trip to Italy in 1786.

• I wrote: 

“Experience the full 21m22s recording, and you too may think you have inadvertently tuned into a BBC4 history documentary.“

“Just how this somewhat indulgent and rather dull film that talks of “brain lateralisation” is meant to resonate with modern-day marketing folk is not clear to me.”

• The problem stemmed from the film’s System 2-type production.

• To recap:
  • System 1 thinking is automatic, intuitive, emotional and reactive, while;
  • System 2 thinking is conscious, effortful, logical and deliberate.

• In my view, Mr Wood wanted his audience to engage their System 2 brains, concentrate on what he said and think rationally about how they should enhance their marketing creativity.

• Trouble is, his audience were likely to have their System 1 brains engaged and become quickly fed up with 18th century German poetry.

• Mr Wood implemented some improvements to his latest film.

• The title “Achtung! How to attract and sustain attention” is certainly a much more System 1-type headline. 

• Then the first line of the film — “What is it that attracts and holds our attention?” — followed by a minute of a Bugs Bunny cartoon should keep most viewers watching.

• See for yourself:

• True, Achtung! looks at famous paintings before diving into all the research data. But at least the film includes a few more obvious references to modern adverts than Where the Lemons Bloom.  

• The improvements to the second film accompany enhancements to the clarity of SYS1’s overall message (which is ironic given SYS1 judges the messages conveyed by adverts).

• For instance, last year’s H1 results presentation offered the following ‘vision’ and ‘goal’ ambitions:

• The ambitions have since been reworded in a more succinct manner:

• That earlier Test Your Ad rate-card slide is another example of a clear and bold message. 

• I guess half the battle to winning new ad clients is just getting through the door — and a clear and bold proposition for Test Your Ad ought to at least provide SYS1 more attention.  

• Another earlier slide showed greater clarity and consistency emerging within SYS1’s product offering:

• Applying a consistent ‘Test Your’ naming convention to products could even be viewed as a System 1 fluent device.

Financials

• SYS1’s accounts finished the half in reasonable shape — bearing in mind the pandemic disruption.

• Cash ended the half-year at £8.0m and debt at £2.9m, leaving net cash of £5.1m

• A loan of £0.5m related to the US government’s furlough scheme, which post-half-year was “fully forgiven”. 

• The underlying net cash position was therefore £5.6m.

• A £0.5m R&D tax credit bolstered net cash flow to £1.0m. Another £0.5m credit may occur during the second half. 

• The FY 2020 results from June said: 

“Cash net of debt facilities ended May at £3.9m compared with £4.1m at 31 March”

• Net cash flow during April and May was therefore a negative £0.2m, and net cash flow during June to September was therefore a positive £0.7m excluding the tax credit.

• The important operating cash movements — working capital and capital expenditure — seemed under control during the half:

• Development on the Test Your Ad service is now expensed as incurred rather than capitalised onto the balance sheet.

• Revenue during Q2 may have been £5.5m assuming equal gross margins during Q1 and Q2:

• An adjusted Q2 pre-tax profit of £0.9m would therefore support an adjusted Q2 pre-tax margin of 16% — which is not bad for a business thumped by the pandemic during Q1.

• That 16% Q2 margin shows the office savings, staff layoffs and board-pay deferrals clearly having an impact.

• Property lease obligations on the balance sheet came to £3.2m versus an associated right-of-use asset of £1.7m. 

• The £1.5m difference arguably reflects the rent SYS1 will pay in excess of the cost of commencing the same leases today. 

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Valuation

• Although SYS1 continues to suspend its financial guidance and dividend, the results commentary included a few promising snippets:

“Client and market feedback give us confidence that our new products and infrastructure will provide a platform for accelerated growth over the years to come.”

“Our sales pipeline remains strong in the UK and is improving in the USA.  These trends provide grounds for optimism.”

• The presentation suggested Q3 gross profit would be greater than £4.4m — i.e. close to the £4.7m reported for Q2:

• Extrapolating the Q2 adjusted pre-tax profit of £0.9m supports an intriguing valuation.

• £0.9m * 4 = £3.6m pre-tax, which after standard 19% UK tax would give earnings of £2.9m.  

• The £23.4m market cap could therefore equate to a multiple of 8 based on that extrapolation.

• Whether that extrapolation is justified is of course up for debate.

• But an 8x multiple provides good room for error should the extrapolation prove too optimistic.

• Within my FY 2020 write-up, I said SYS1’s cash position should not really be used for valuation purposes due to the company’s then loss-making predicament.

• But Q2 witnessed SYS1 return to profitability and cash generation, and the £5m-plus net cash position is presently hard to ignore with a £23.4m market cap. 

• The potential single-digit multiple and up to 20% of the market cap backed by cash makes this share far from expensive.

• The possible lowly valuation also means many finer parts of this H1 performance may not be that relevant to the longer-term share-price direction.

• Of greater relevance to investors are the progress of Test Your Ad and the general shift towards becoming a ‘data business’ with automated processes, cut-price products and more dependable revenue.  

• And despite the pandemic, the transformation may now be succeeding given:
  • The Test Your Ad win rate;
  • The resilience of UK/Communications revenue, and;
  • The 16% Q2 adjusted pre-tax margin.

Portfolio trade

• The ITV product validation, remarkable Q2, apparent lowly rating and opportunity for recovery prompted me to buy more SYS1 following these results.

• I increased my holding by more than three times at 173p per share including all costs.

Maynard Paton

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