|Shares Out. (in M):||85||P/E||19||16|
|Market Cap (in $M):||205||P/FCF||22||11|
|Net Debt (in $M):||-90||EBIT||7||15|
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CyberLink is an investment opportunity with an attractive asymmetrical risk/reward potential thanks to strong downside protection, potential upside driven by overdue improvements to its core business and a free option on its market-leading Augmented Reality (AR) solution spin-off for the beauty industry.
The company was founded in 1996 by a husband-and-wife team, Alice and Jau Chang. Its lead product, PowerDirector, has been ranked the number one video-editing product by PC Magazine, ahead of Adobe’s Premier Pro, for 15 years running. Jau earned his PhD in electronics at UCLA under one of the “fathers of the Internet” (Prof. Leonard Kleinrock, not Al Gore…). He also met his wife there, Alice, who was attending the MBA program at the time. Alice was an Executive Vice President of Trend Micro before joining Cyberlink as CEO in 1997.
Based in Taipei, CyberLink’s corporate culture of innovation and engineering expertise would be typical of startups found in Silicon Valley with the addition of a laser focus on profitability.
Jau and Alice have assembled a top-notch team of 150 R&D engineers, most of which have been with the company for years. Their core expertise in high-performance and low-footprint video and photo editing software is a natural breeding ground for developments in AR, Face Recognition and Artificial Intelligence (AI).
Some of that expertise has been put to spectacular effect in a spin-off called Perfect Corp which has become the global leader in AR solutions for the beauty industry in four short years. Their mobile app has been downloaded over 700 million times, and it has become the market-leading software solution supplier to the beauty industry and their distribution partners. Perfect Corp’s competitive positioning was strengthened by L’Oréal’s captive acquisition of ModiFace, in 2017, sending most of the rest of the beauty industry to the only remaining independent supplier.
Additional initiatives such as an AI-enabled face-recognition application have been recognized with a top-15 ranking in the MegaFace University of Washington test, and a top-20 ranking from the National Institute of Standards and Technology, both of which are the gold standard for the industry. The first commercial application, called FaceMe, will be deployed in products and services embedded in the rich Taiwanese electronics eco-system from next year. The fact that they are one of the only non-Mainland Chinese suppliers could well be a strategic advantage in this age of increased tension on AI-enabled strategies between China and the US.
In its legacy video-editing software business unit, CyberLink has been slow to move to a subscription-based service but has been consistently profitable and still generates approximately USD$ 15 million of free cash flow a year, even after funding start-up costs for its new initiatives, including Perfect Corp.
The company started its move from packaged software to a subscription-based offering in October 2018. Although this transition is impacting its earnings negatively this year, we are confident it is laying the ground for healthier revenue growth in 2020. The yearly membership accounts for approximately 80% of the full license price net to the company and allows the company to keep a much closer relationship with its user base on top of recurring fees. The company targets its offering to the video-editing “prosumer” community (in between the professional and general consumer) with a library of licensed sounds, music, and images, a major advantage for people generating YouTube channel content for instance.
The benefits of a shift to a subscription-based offering can clearly be seen at Adobe, and CyberLink helpfully highlights that scenario in its Annual 2018 presentation. We have assumed a drop of 50% in EBIT in 2019 before a return to earnings growth in 2020.
Core Business Valuation
The company sports a US$ 205 million market capitalization with roughly a 60% float. The Average Daily Volume (ADV) is $ 200k, but blocks are available. Its balance sheet is very conservative with US$ 90 million of cash and a Grade-A office tower that they lease in the up-and-coming high-tech area of Taipei which is conservatively valued at USD$60 million in addition to its self-occupied office space in Taipei, San Jose, and Tokyo.
Assuming that the office tower is sold over the next year in order to capture one of the most compressed cap rates in the world within the office real estate market, an investor would be buying CyberLink’s core business at trough 2019 earnings under 8x EV/EBIT, or about 16x EV/EBIT on a currently available net cash basis. If we conservatively assume that 2020 EBIT will rebound to their 2018 level, its EV/EBIT ratio would drop to 4x and 8x respectively.
A potential Unicorn for free?
The company’s private spin-off, Perfect Corp, is consolidating its position as the global leader in AR solutions for the beauty industry.
AR adoption encourages women to try out make-up, change hair color and even track the progress of their skincare regimen on their smartphones. The ability to try virtually, personalize, save and share their looks encourages more sales and in turn enables beauty brands to connect with their end customers. This is especially important in an industry largely dependent on third-party retail channels and lately more susceptible to guerrilla marketing from Instagram-enabled Key Opinion Leaders pushing smaller, independent brands sold almost exclusively online.
Perfect Corp’s offering is also the perfect enabler for beauty brands’ own transition to online channels as markets increasingly gyrate towards this distribution model, especially in Asian markets which are discovering make-up and triggering double-digit revenue increase for the established brands. It is estimated that 30% of cosmetics buying transactions in China take place online, versus 10% in the US.
The company has two separate product offerings. YouCam is their consumer app which was launched in 2014 and has since then been downloaded over 700 million times with more than 50 million monthly active users. The app is very strong in markets like Southeast Asia, India, Brazil, and Russia. A number of monetization avenues are being explored such as the introduction of e-commerce capability services with local fulfilment partners, but so far Perfect Corp has focused its monetization efforts on its B2B offering to beauty brands. Perfect Corp’s applications are installed on the brands’ web sites as well as tablets at the point of sales in retail outlets. One would also think that there are ample cross-marketing and e-commerce synergies between YouCam and their B2B offering.
As may be expected for such a user-interface focused offering, looking at it by yourself on (https://www.perfectcorp.com/) and downloading the YouCam app is probably the best way to experience it.
The market is largely unaware of the success of Perfect Corp and its partial ownership by CyberLink and does not consequently attribute any value to the spin-off. Perfect Corp has raised a total of US$ 50 to 60 million across two rounds. The final post-money valuation achieved in the latest one in October 2017 was not made public. But we do know that China Creation Ventures followed up on its initial round and since then, ModiFace acquisition by L’Oréal for an undisclosed amount, the consequent shift of almost all its non-L’Oréal customers to Perfect Corp. and the strong growth that it has recorded must have been quite beneficial to its strategic position and current valuation.
China Creation Ventures is headed by Wei Zhou, who interestingly enough led Perfect Corp’s first round while the managing partner at Kleiner-Perkins China. Perfect Corp was one of the few investments that he retained when moving on to establish China Creation Ventures. Notable investment successes from Wei Zhou over the years include JD, CreditEase and Rong360, which are all listed in the US.
Incredibly, Perfect Corp, which is headed by Alice, achieved its global leadership position while keeping its cash burn under control. Cash break-even is targeted for next quarter (Q3 2019), although we note that costs, which are recorded in Cyberlink’s accounts under non-operating income, went up in Q1 2019.
We think that the announcement of an IPO in 2019 or an investment by a strategic investor could unlock considerable value for CyberLink investors.
As is often the case in Taiwan where retained earnings are taxed another 10% on top of corporate tax, CyberLink had a long history of high dividend payout ratio until 2015 when management reduced it to 50% in order to make sure they would be able to self-finance its new initiatives. The company recently announced that it will increase their dividend payout ratio back up to 80% now that Perfect Corp’s capital requirements from its parent are coming to an end.
The company has also actively bought back shares, redeeming 15% of its own shares over the past three years, most recently from November to December 2018. There are limited stock-options issuance, so the positive impacts on shareholders are fully preserved.
There are good quality presentation materials in English available on their website (https://www.CyberLink.com/prog/company/ir-investors-presentation.jsp).
The whole management team speaks fluent English and there is a dedicated IR contact at both companies but as is often the case in Taiwan, the official financial statements and MOPS disclosures are all in Chinese.
We have listed some of the risks to be considered when investing in CyberLink:
- Although we think that the spin-off of Perfect Corp struck the right balance between the departing team and Cyberlink investors, the exact stake of the management team (including Alice) in Perfect Corp is not known. We only understand that they collectively invested about US$ 15 million from their own pocket in the two rounds of financing. We also take heart in the alignment of interest between CyberLink investors and China Creation Ventures and the fact that Alice has kept her shareholding in CyberLink intact.
- CyberLink has a good capital allocation track-record as discussed above, but it does carry a Grade-A office tower on its book yielding an income of US$ 1.3 million a year, equal to a measly 2.2% cap rate. The office tower was bought in 2008 to house the CyberLink team. As the legacy business started to decline, they wisely opted to rent it out and stay put at the top three floors of their historical office where they remain to this day. The office tower property did appreciate over that time frame but is probably fully priced at this stage. We think that they should sell it and harvest the gains now. There is a small risk that the company does not and rides the valuation down to its entry price.
- The final and largest risk in our opinion lays in a poorly executed or received PowerDirector transition to subscription-based pricing and a failed launch of the FaceMe SDK. In that case, the optimization of the monetization of their stake in Perfect Corp, the sale of their real estate in Taipei and subsequent distribution of excess cash on their balance sheet through share buybacks and distribution to shareholders would become a critical driver of this investment ‘s performance.
While we receive a regular 4% dividend in Taiwanese Dollar (a currency quasi-pegged to the USD from one of the strongest net creditors to the rest of the world), we think that there are a number of potential catalysts on the horizon which could lead to a positive rerating:
- Signs of success on their move to subscription-based offering for PowerDirector and the adoption of FaceMe in a range of third-party applications; leading to a stabilization and hopefully growth of their earnings in 2020,
- Sale of the Taipei office tower investment pushing cash up to US$ 150 million and driving share buybacks, a higher normal dividend payout and a special dividend or capital reduction,
- Announcement of an IPO or an investment by a strategic player in Perfect Corp.
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