A Day out at the Zoo (Digital)

On my way to visit Zoo Digital (LON:ZOO), a leading supplier of efficient workflow software for the creative media industry, I was reminded of a long ago National Express journey I endured as a penniless student travelling from Nottingham to Leeds via Sheffield, home to the head office of ZOO; as you left Sheffield and headed for the M1, you were taken on a meandering tour of post-industrial Britain, along the Meadowhall Road which now leads to the Mecca of the shopping aficionado in Yorkshire – Meadowhall – or Meadow ‘Hell’, if you are not of the shopping persuasion.   Sheffield, as most of us know, was the ‘home’ of Stainless Steel in Britain.

By the early 1990’s, which is when I took those depressing trips back, there was very little left of the manufacturing sites; essentially, they were now empty brick shells, bordered by elevated mortar piles preventing  illegal squatting by the local ‘traveller’ community.

Beginnings

This is where the ZOO Digital story really starts, with a predecessor company founding and morphing itself in Sheffield; there were strong financial incentives available at the time from the Department of Trade and Industry (DTI) through a variety of grants to re-energise the city with new forms of employment.  Dr Stuart Green, current Chief Executive of ZOO Digital, an AIM listed company, takes up the story:

“ZOO has its origins in a small software company that I co-founded in Sheffield in 1989 with three others; I had completed my doctoral research at the University of Bristol and we had discussed a number of suitable locations to site our new software business, having agreed that we wanted to be based outside London in a location that provided good value services, high quality of life and easily available software skills, whilst having a ‘centralish’ location within the UK.  Sheffield won out and we are still here today”.

ZOO Digital now has two main geographic locations in El Segundo, California and Sheffield.

The business

ZOO Digital provides software and related services that support the authoring, re-purposing and distribution of creative media.  ZOO claims that its products form an integrated suite of web-based and desktop applications for audio / visual content and printed materials, adapting these media for different languages, formats and delivery mechanisms.

There are currently six core software products available:

1)     Translation management system (TMS) – which helps clients manage global projects with complex media workflows and thousands of translations.  This eradicates the need for duplication, improved brand consistency and control.

2)     Templated authoring system (TAS) – which ZOO claims is the only professional DVD authoring solution that “de-skills” the creation of a DVD file, so creating titles quicker and cheaper.  This leads to DVD titles produced correctly, first time, reducing the labour required and the amount of quality control to check the titles.

3)     Media Adaptation Tool (MAT) – it is claimed that this is the only automated tool which creates single and multi-lingual variants of printed and digital materials in multiple language and sizes.

4)     Blu-ray Authoring system (BDX) – this product is claimed to be the only Blu-ray authoring system that simplifies the production of Blu-ray discs with a “template approach” thus reducing the time spent on authoring / quality control and removing the need for highly skilled (and  expensive) staff.

5)     ZOO eBook Builder (ZEB) – is an eBook editing tool which combines full support for fixed-layout electronic book files with the ability to regionalise a title for many different countries.  Graphically rich books can be converted into eBooks from the files originally used to create traditional “print version” books.

6)     Interactive Content editor (ICE) – allows film and music studios to produce content for consumers interested in enhanced features and additional content with their digital media downloads.  The product is designed to create enhanced iTunes movies and albums in the form of iTunes Extras and iTunes LP.

The business model

ZOO Digital’s business model is quite straight forward.  It charges fees per month based on the functionality selected by the client; the traditional software model of initial licence fee, annual maintenance fee and implementation costs are all ‘rolled’ into a monthly rental.  This rental increases with the number of titles generated / produced by the ZOO software.

This has a large advantage for prospective and existing clients as it is a much simpler ‘sell’ to an organisation (and especially to a large corporate procurement department) when the software is purchased on a monthly rental basis, which impacts on an operating / maintenance budget rather than requiring a large ‘upfront’ capital budget which could add significant complications to gain the necessary approvals.

Clients are typically contracted for a period of at least one year.  If there is any bespoke development required outside of the standard software solution(s), for example to integrate with the client’s internal IT systems, then the client must then pay for this.  Stuart was very keen to stress the following point:

“Whenever we are asked to develop new functionality for a client, it must have a fit to other existing / prospective clients too; we are very protective of the long-term strategic plan for our software solutions and if we felt that a development being proposed did not match our long-term roadmap, we would be reluctant to proceed”.

Stable management

Stuart has been Chief Executive Officer since 2006, having originally been Chief Technology Officer since ZOO was founded.  Helen Gilder, Group Finance Director, has been with the group for 12 years and a number of key senior management have been with the Group for a similar period. Also, the highly rated Commercial Director, Gordon Doran, has been with ZOO since 2005.  So, this is a closely knit team that appears to work well together.

Clients

ZOO supplies a significant number of ‘blue chip’ entertainment organisations, including Disney, Warner Brothers, Sony Pictures and ABC with a number of their software solutions.  Of late, ZOO has been concentrating on diversifying the client base by exploring new opportunities in other sectors, such as healthcare and cosmetics, and this is mentioned in more detail through their tie-up with Multi Packaging Solutions as outlined later in the article.

Falling DVD sales

On the issue of ZOO’s interim results on 6 December 2011 for the period ending 30 September 2011, the company made a significant profits downgrade. This had quite an effect on an already drifting share price, pushing the company to a low of 9p, equating to a market capitalisation of approximately £3.0million.

The key to this announcement was that ZOO, along with the rest of the global entertainment industry, had encountered a ‘fall off’ of DVD revenues.  Stuart explains further.

“Currently, a number of our revenue streams are derived from the DVD authoring market.  As an example, the entertainment industry released around 17,000 titles to the US retail trade industry based on the DVD format in 2010.  A large proportion of these releases relate to ‘Episodic TV features’.  By this, I mean series such as Mad Men or Desperate Housewives.  Due to the continual move to digital download, and to rental rather than purchase, a smaller proportion of new ‘Episodic features’ were produced for the DVD format”.

“At this point, it is important to state that these particular revenue streams are not directly generated off the back of how many DVD units are sold but rather how many titles are converted to DVD formats.  This has been reducing and at a much faster pace than we had anticipated”.

Stuart believes that it has seen a 40% fall-off in DVD revenues versus an anticipated estimate of 15% earlier in 2011. This has had an impact on group forecasted revenues, where the company was anticipating $13.8million revenue for FY 2012.  This has now reduced to $11.7million (a 15% reduction on previous broker estimates).

Multi Packaging Solutions (MPS)

During 2010, ZOO Digital announced a corporate deal whereby Multi Packaging Solutions (http://www.multipkg.com), an unlisted New York based packaging organisation with over $500million in revenues, took an equity stake in ZOO Digital.  Initially, a consideration of £859k was paid, equating to 9.1% of the outstanding equity of ZOO at a price of 40p per share.  Furthermore, MPS were allocated performance-related warrants to subscribe for an additional 2.148million shares at 50p, which lapses on 31 July 2013. 

The MPS ‘stake’ has now been diluted to around 6.6%, following the conversion of 50% of an outstanding Convertible Unsecured Loan Stock currently in issuance. 

“The Multi Packaging Solutions relationship is very important to us as this is one further string to our bow as it were in terms of diversifying our client base from a predominantly entertainment focus, to new industry areas which we feel have attractive growth profiles, including healthcare and cosmetics.  Indeed, MPS has already introduced us to a new client and an agreement has been signed with a leading international videogame publisher back in June last year.  This client will be utilising our Translation Management System (TMS) and Media Adaption Tool (MAT)” states Stuart.

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New Revenue streams

Stuart and his senior management team have been working extremely hard on developing new revenue streams for the ZOO business and have identified three core areas – Electronic Sell Through (EST), Blu-ray and eBook production as offering very attractive market opportunities in the medium term.  To deal with each in turn:

EST

EST will mean very little to the non-IT literate private investor but EST really relates to products such as iTunes Extra and iTunes LP, enabling content owners of film, music and TV to provide CD or ‘DVD-like’ packages delivered as online content.

Blu-ray

Blu-ray has certainly seen an increase in ‘take-up’ by many of ZOO Digital’s entertainment clients, Stuart was a little guarded as to whether Blu-ray could compensate for the long term decline of DVD revenue streams but it would certainly add “a more than useful return for the group”.

eBooks

The eBooks opportunity for ZOO Digital is potentially very large and centres around eReader devices such as the iPad, Kindle and Nook (Barnes and Noble) which each employ different digital formats.  From Stuart’s perspective:

“ZOO’s applications are agnostic to the varying eBook formats.  We can support all three of the current formats.  The publishing industry’s challenge is being able to support rich graphic imagery, such as high definition photographs, in addition to text in order to create an engaging ‘reading’ experience.  I stand by my belief that eBooks could represent a significant opportunity for us, especially when you consider that some US publishers report year on year growth of 20% in this market.  We are currently trialing our software solutions (ZOO eBook Builder) with a number of large bluechip publishing houses”.

Finances

Revenues for the 6 months to 30 September 2011 were $5.9million (2010: $8.1million) which led to an operating loss of $1.087million (2010: Profit of $0.880million) and loss before tax of $1.295million. 

The company was keen to point out that they have very quickly looked to reduce their fixed cost overheads following the tail off in DVD revenues by reducing US headcount and although this has slightly increased their operating expenses, these changes should result in a reduction of $1.2million in fixed costs per year.

In addition, the company also stated that following a part conversion and restructuring of a convertible unsecured loan note ($5.6million) which was due to be repaid in October 2011, the company had cash at the period end of $1.5million.

Gross margins were a very healthy 85% during the period.

Financial Forecasts and the Future

‘House broker‘ finnCap, in a recent research note, is estimating revenues of $11.7million for the year ending March 2012 and $14.0million for the year ending March 2013.  This will lead to an adjusted Loss before tax of $1.1m (2012) and adjusted profit before tax of $1.0million (2013).

On a forecasted EPS of 2.5 cents, ZOO Digital is trading on a prospective P/E of 8.27 times based off a mid price of 13.25p (as at 25 January 2012).

“We’ve tried to be very conservative on our revenue numbers and especially in light of the decline of the DVD market.  If anything, the decline should not be as aggressive as we are currently forecasting but we won’t have a clearer picture until next month; I’m a great believer in under-promising and over-delivering and that is what we hope to achieve moving forward” stated Stuart.

As already mentioned, Stuart has been canny enough to diversify the ZOO business into a number of growth areas.

“We have been working for some time on new revenue areas for the business, especially in the E-Publishing and EST (Electronic Sell Through) areas for which our software works well”.

Strong shareholder base and Modest Director share purchases

What is extremely heartening with ZOO Digital is its shareholder base.  Despite only having a £4m market cap, they have a number of well known blue chip shareholders, one of which is Herald Investment Trust, which is led by the inimitable Katie Potts.

“Herald has a very strong investment franchise in small cap technology listed businesses and we’re delighted that they have been long term shareholders in ZOO. Katie and her team are very supportive of the business and have been a valuable sounding board for me” commented Stuart.

Currently, Herald has 20.1% of the issued shareholder capital followed by private equity investor Foresight Group, which has 19.7% and is represented on the ZOO Board by non-executive director James Livingston.

Reassuringly, Stuart has 14.9% of the business.  Thus, between just these three parties, over 50% of the shares are held by ‘stable and friendly’ shareholders.  In other words, it would be quite challenging for a third party to make an audacious (and no doubt cheap) swoop for the business without the agreement of these core shareholders.

It has also been interesting to note that a number of modest Director share purchases have been made over the past three weeks or so, including 216,300 shares for the benefit of Foresight Group and James Livingston for a total consideration of just over £32,000, as well as an investment by the non-Executive Chairman, Roger Jeynes, of 100,000 shares for a total consideration of £9,500, increasing his holding from just 20,000 to a current 120,000 shares held.

In addition, the ZOO Employee Share Trust (“ZEST”) has acquired, in aggregate, a further 173,000 shares at prices around 9p – 11.7p.  All these purchases lend a strong indication that senior management believes that the share price may have ‘bottomed out’ at these levels.

Conclusion

The AIM market is throwing up a whole host of ‘bargain basement’ companies at the moment.  ZOO Digital appears to be in this category with potential in E-books, EST and Blu-ray markets.  Despite an unfortunate profit warning late last year due to misreading the dramatic tail off of episodic DVD titles, the company is competently managed with an excellent shareholder base.  ZOO is a potentially attractive business at these levels (12p) for an investor who wishes to add a little ‘small cap spice’ to their portfolios.

Simon Murphy does not currently have a beneficial holding in Zoo Digital Group plc.