Description

PNI Digital Media has become a deep value play with a market cap of just $12 million despite $5.7 million in cash on the balance sheet with no debt; this valuation with $25 million in sales with 59% gross margins and cash flow positive financials.  The company has suffered from multiple adverse trends in recent years including the strengthening Canadian dollar and the decline of the traditional 4"X6" photographic print.  They've also made some of their own mess including pricing the growing personalized products less profitably and botching the development of their new social stationery and business printing product lines.  However, all of these problems are beginning to alleviate and the valuation is compelling if business improves.  The chairman of the board and some other directors own significant stakes and will not allow this company to lay at these valuations forever. 

The PNI business was created in part by a former Kodak executive, Peter Fitzgerald, who now serves as the Chairman of the board of directors.  He assisted in transforming the business of a failed company with significant tax losses into the current business assisting large retailers with photographic prints.  In 2001, PNI introduced the first 1 hour web-to-print service with retailers in Canada.  In 2006, PNI wrested away large US retailers Costco and Sam's Club from competitor Snapfish owned by Hewlett Packard.  The business was primarily building and running websites under the retailers brand name that stored customers digital photos and wired photo print orders to printers located at the closest retail location for customer pickup.  PNI got (and still gets) revenue for storing the photos but also a few cents for each print bought by the customer.  Other personalized products such as coffee mugs with pictures, photobooks, cell phone cases with pictures, large canvas pictures for hanging on the wall, and myriad other photo-related products have been introduced in recent years.  Expansion into business printing occurred in 2011 with small retailers in Canada.  In 2012, Social Stationery, which prints web-customized invitations, cards, calendars, and the like was introduced with Walgreens as the first retail client (www.foldedwords.com).  See prior write-ups on this company on VIC for further information.

This company was quite profitable and growing revenue rapidly for a while and the stock price reflected that success trading above $1.50 a share for most of 2010.  Revenues have remained flat to down since then and profitability has fallen.  Disgusted investors have dumped the shares bringing the valuation metrics to the current deep value numbers.  The company has retained and renewed contracts with almost all of their retail customers, however, and the transactions processed by the company has continued to increase albeit modestly.  So why has revenue flattened and why is profitability down?  Will the root causes of this continue into the future or might this turn around?  Can the company regain at least some of their former revenue growth and profitability to more than justify the current deep value stock price?

PNI's business suffered from a strengthening Canadian dollar in recent years.  PNI's revenues are primarily in U.S. dollars while their expenses are primarily in Canadian dollars.  The strengthening Canadian dollar hurt revenue and margins.  In the last year, however, the Canadian dollar has weakened somewhat.  Additionaly, the company has moved some expenses into U.S. dollars by outsourcing programming expenses to the U.S.  If the Canadian dollar again strengthens this headwind could return but perhaps not as severely.

The main driver of PNI's profitability issue in 2011 and 2012 has been the decline of prints.  Sending prints to the local CVS costs PNI very little.  The same software code is used to send the prints in 2012 as in 2009 so there's little expense in taking orders for prints.  The couple of cents a print drops to PNI's bottom line.  Print volume has declined significantly beginning at the end of 2010, however.  While the rate of decline fell somewhat in 2012, it is likely that print volume will continue to fall at least somewhat for years to come.  Customers are making photobooks or other specialized products instead of prints or simply viewing photos on improving mobile device screens.  Total transaction volume is actually up somewhat as sales of higher ticket photobooks, calendars, and other personalized products is growing double digits.  While these items are higher revenue to the retailer, PNI's contracts are such that PNI actually receives less revenue per transaction then prints.  It's not that they're a lower percentage of revenue, it's that they are actually lower revenue per transaction.  PNI's management notes that these contract terms helped them to reach profitability quickly years ago as they were growing and transactions were overwhelmingly prints.  Now the contract terms are working against them.  Even worse, is that marketing personalized items requires more programming effort.  There's lots of personalized items including continually new items that require frequent programming effort to update websites and databases.  With revenue per transaction down and costs up the margin is significantly less.  With print volume falling and personalized items growing rapidly revenues are flat and profitability is down.

The good news here is that print transactions has now fallen to less than half of total transactions on an annualized basis.  The decline of print volume also has moderated recently although its not clear yet if that is a new trend.  If personalized item volume continues to grow rapidly as it has recently and is expected to going forward, revenue growth should return.  Furthermore, the CEO, Kyle Hall, notes in the most recent conference call and confirms again recently on the phone that margins on personalized items are improving.  For some items, he notes, the margins are up a lot.  Print volume can only decline to zero.  If personalized items continue to grow at double digit rates, revenues will eventually begin to rise again.  With margins on personalized items improving, it's only a matter of time before profitability also begins to rise.

The social stationary launch has not gone well.  It was originally planned for launch in 2011 but that did not happen.  Then Walgreen's was to launch in Q1 2012 followed by additional retailers at a rate of one per quarter.  Walgreen's launched late and there has been no other customer launches.  The company's chief technical officer, Chris Tivel, left the company in September of 2011.  The scuttlebutt at that time was that the company's software code was a mess.  Poor documentation and poor architecture made it very inefficient for programmers to modify it.  In December 2011, the chief operating officer, Aaron Rallo left as well.  A new vice president of technology, Zack Wickes, joined in January, 2012 and made recommendations to spend $4 million dollars correcting deficiencies with the code (from his resume available on line).  On July 25, 2012 he resigned and joined another company in October 2012 as a software engineer rather than management.  A new chief operating officer, Patrick Nangle, joined the company on July 17th 2012.  According to CEO Kyle Hall in a phone conversation, Mr. Nangle did really good things to improve their operations.  However, he resigned effective January 2, 2013 to take a job as CEO of another company.  In summary, this whole software development program has been a mess with cost over-runs and launch delays prompting employee turnover.  It's also driven R&D costs high eating away the profitability of the core business.  Since the company has been aware of the problems since Fall of 2011, one would hope that they have mostly corrected the issues with the code.  First hand testing of Walgreen's site was very smooth with orders processed without problems and delivered as promised.  This doesn't necessarily mean that the code is efficient so that a second retailers site can be launched cost-effectively however.  I hope this mess is fixed and that new customers can be launched cost-effectively in 2013 but I haven't been able to get the scuttlebutt to confirm that.

Can digital photo be a good businesses going forward?  This is an asset-lite businesses that is primarily a software businesses although there is some customer service as well.  Like software businesses, the photo business offers significant economies of scale.  Much of the code that works for Costco also works for the Wal-Mart Canada website.  It's not economically feasible for individual retailers to write all this code themselves.  To be efficient the same code must be shared across many retailers websites.  Naturally, there will be only a few players that develop this code and offer it to retailers (Snapfish and PNI are the biggest players).  A large retailer can't take a chance on some startup as they have an established customer base that they can easily lose if there are technical or customer service issues.  A startup can't afford to develop the software anyway unless they have numerous retailers lined up to use it.  Retailers won't line up to use it unless the startup can demonstrate they have the code that works. 
The catch-22 ensures that it's unlikely that any new players will enter the market.  Furthermore, it's difficult for retailers to switch providers.  All customer photos are stored on servers owned by PNI and transferring all those pictures and re-acquainting their customers with a new website layout without incident or losing customers is challenging. PNI stole Costco and Sam's Club away in 2006 only because of significant customer dissatisfaction with Snapfish.  Even that provider switch resulted in a transfer process that took much longer than expected.  Kyle Hall confirms by phone that substantially all of their customers have renewed contracts in the past and are continuing to renew their contracts as they expire.  So the business is an asset-lite software business with significant economies of scale that limits competition to the few existing players.  Customer switching costs prevent the few players from getting into a price war.  The photo business can be a decent business.

The social stationery and business printing business are also asset-lite software businesses.  PNI is the first company to offer these services to retailers.  The strategy espoused by the company is to take market share away from strictly online players (like VistaPrint) by using the marketing power of the well-established retailers. This is exactly how they built their existing photo business from nothing in the 2000's decade.  PNI expects margins to be better from these business than from photo and they have no competitors currently so this seems possible. These new businesses haven't gone well to date, but if the company can clean up their act these businesses have potential to offer a high ROI as well. 

PNI's management doesn't own many shares and haven't bought much even at current prices.  They are granted fairly generous stock options so there's some incentive to perform.  Past stock option grants are well out of the money and many past managers are gone.  Kyle Hall will tell you that the turnover in management is understandable because they have grown their staff so much from 30 to 130 employees as the business has grown and they've expanded into social stationery.  I think the turnover is because the board of directors has been dissatisfied with the slow and inefficient progress.  The chairman of the board, Peter Fitzgerald, owns a big chunk of shares as does other members of the board.  This is an important aspect to this investment.  Management might be content to draw their salaries and run the company into the ground.  The board of directors isn't going to allow it.  I would expect performance to improve or their will be further management changes or the company will be sold.

Finally I'll note that despite all these issues the company will be cash flow positive for the 2012 year ended September 30, 2012 according to CEO Kyle Hall.  Furthermore, R&D costs going forward will be stable or falling according to the CEO even as the company rolls out more retail clients for social stationery.  With the improvement in the core photo business and hopefully at least some revenue from social stationery the company will begin generating cash again going forward.  The company is not the disaster that the current stock price would suggest.  Results for 2012 are scheduled to be reported on Monday January 7th after the market close followed by a conference call.  Note that this financial report is late because of accounting issues that I think are not significant.  You might want to look into the issues for yourself, however.

In summary, headwinds of currency, the decline of the traditional 4X6 print, poor margins on the growing personalized products, and high R&D costs and delays related to social stationery have hurt revenue growth, margins, and bottom-line profitability.  The stock has declined to reflect these issues but excessively so to deep value metrics.  The print volume decline will alleviate going forward revealing double digit personalized product growth in revenue with improving margins.  The improvement is from cash-flow positive levels so this company will likely begin to generate significant cash going forward.  The current enterprise value of just $6.3 million is too low and patient investors are likely to do well.

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