With its existing customer base,
tiny Photochannel has the opportunity to make $124 million in annual revenue
and could earn close to $2 in EPS annually. Further, there is an opportunity to
get an additional large client, Costco in the U.S., which could get them another
$1 a share in earnings. With a comparable trading for 70 times earnings and
Photochannel experiencing triple digit revenue and earnings growth,
Photochannel is a steal at eight times my 2008 estimate, and 15-20 times my
2007 estimate. Within two years, Photochannel has a shot at trading for $20 a
share, making it one of the best risk/reward potentials I’ve come across in a
long time.
What does Photochannel do?
Photochannel manages the front
and back end of a retailer’s photo processing website. They are basically a
private label version of Shutterfly (NASDAQ: SFLY). Using the example of CVS
(NYSE: CVS), a consumer will go to CVS.com and then choose photo, then “Get
started.” Photochannel takes over from there and handles all of the uploading
and storage of pictures, then forwards those pictures in the right format to
that customer’s local CVS and in one hour those digital pictures are ready to
be picked up by the customer. It is important to make the specific distinction
of what Photochannel does. They do not own the equipment in the retailer such
as CVS. They only help process, store and send the photos as consumers upload
the photos to the retailer’s website. They also handle email lists and email
marketing functions for their customers as well as it relates to photos.
Their customer list is pretty
impressive for a Canadian microcap company:
1) Wal-mart Canada
2) Costco Canada
3) CVS (U.S.)
4) Black’s (Canada)
5) Kmart (U.S.)
6) Eckerd’s (U.S.)
Photochannel provides the same
web/photoprocessing service for all of these clients.
How Photochannel gets paid
Their payment varies depending on
the size and type of photo, but the average is 2 cents for your average 4 X 6
photo that sells for 19 cents to the consumer. Photochannel is basically getting
10% of the gross proceeds for use of their technology and service. The bigger
the picture the more money Photochannel gets. A rough rule of thumb is 10% of
the gross payment.
The only place where this rule is
not the case is on gifting items. Gifting items are personalized mugs and
calendars with your own pictures on them. These items normally cost anywhere
from $10 to $20, and Photochannel gets only 5% of gifting items or anywhere
from $0.50 to $1 a pop.
Gift items are actually a growing
element in photo processing. As consumers are finding out what they can do with
their digital pictures, they are buying more and more of these personalized
gifts. What grandparent wouldn’t want a mug with a picture of their grandkids?
Consumer education dealing with online uploading will drive revenue and
earnings
Right now anywhere from 50-60% of
all photo processing is for digital photographs. Of this amount most retailers
have a very tiny percentage that is currently processing digital pictures
online. That means that a vast majority of those processing digital pictures
are trudging into the store, waiting in line and working with machines and
staff to get the pictures uploaded. This is a complete waste of time. It is
simply much easier to upload pictures from your computer, where your pictures
are most likely stored anyway.
The retailers are now starting to
gear up and educate consumers to do their uploading of pictures online for a
variety of reasons. Online delivery makes the process much, much easier and
allows the retailer to process more pictures as employees aren’t involved as
much in customer service. Also with the convenience and ease of the online
service, it puts retailers in a much better competitive standpoint to online
alternatives such as Ofoto (owned by Kodak, NYSE: EK) and Shutterfly (NASDAQ:
SFLY). With those alternatives you have to wait for the photos to be mailed to
you and you have shipping and handling charges. With Photochannel and its
retailer network, when you upload your pictures, they are done for you in one
hour, and there are no additional costs.
Retailers are starting to
advertise both in the store and on their websites to drive consumers to change
to online processing of photos. Walmart.com typifies what is going on and how
growth is exploding for online photo processing. Walmart.com told Thinkequity
analysts that they expect triple digit annualized growth in online delivery of photos
for at least the next three years. Photochannel saw 150% increase in photo
processing from Walmart.com in Canada
in 2006 over 2005. And Photochannel doesn’t see this triple digit growth
stopping. Why? Because in 2006 only 6-8% of all of Walmart Canada
customers uploaded photos in 2006. There is simply a lot of growth ahead and it
could accelerate even faster.
Potential Revenue for Photochannel with existing customer base
If you were to look at a static
picture based upon the last twelve month’s revenue and balance sheet or even
calendar year ending 2006 numbers, you would think this is just another
outrageously priced stock. I estimate that 2006 will see about C$5-6 million in
revenue for the whole year. With about 31 million shares outstanding and about
a C$3.50 stock price, Photochannel trades for about 20 times revenue!
But here is the rub, Photochannel
has enormous revenue opportunity and its revenue should grow triple digits the
next few years. It is much easier to understand by breaking down each client
and looking what should Photochannel’s take should be.
Customers:
|
% of mkt
|
CAD$ amount
|
Dig
|
online 06
|
$ amount
|
Wal-mart Canada
|
30%
|
$
300,000,000
|
50%
|
7%
|
$
21,000,000
|
Costco Canada
|
22-25%
|
$
225,000,000
|
50%
|
3%
|
$
6,750,000
|
CVS (U.S.)
|
10%
|
$1,180,000,000
|
50%
|
1%
|
$ 11,800,000
|
Black's (Canada)
|
6%
|
$
60,000,000
|
50%
|
15%
|
$
9,000,000
|
Kmart (U.S.)
|
2-3%
|
$ 295,000,000
|
50%
|
0%
|
$ -
|
A couple of notes should come
first. The U.S.
photofinishing market is about USD$10 billion and the Canadian market is about C$1
billion.
Photochannel’s five customers
represent more than C$2 billion in photo processing. At least 50% of this
amount is digital pictures, or C$1 billion. Of C$1 billion in digital photo
processing, only about C$50 million is delivered online. This obviously
represents consumer ignorance. You can easily create a spreadsheet to estimate
what % will eventually be digital and how many will upload online.
In three years, digital photo
processing will probably be 80% of the market. And it is not hard to imagine
that 75% of that 80% will be delivered online. My estimate is that 60% of all
photo processing will be digital and will be uploaded online. I don’t think
that is an aggressive estimate. This means that Photochannel’s existing
customers alone will be doing C$1.236 billion in online photo processing. A
very rough 10% estimate of that produces $123.6 million in annual revenue to
Photochannel.
90% Gross Margins and Expense and capex requirements small, Cash
machine
The real beauty of Photochannel is
its gross margins of 90%. Further, it doesn’t take much in G&A expense to
ramp up what the company processes. There is not too much sales expense,
because of its small customer base. Basically, Photochannel is at the breakeven
point right now and all additional growth will flow right to the bottom line.
In short, Photochannel is about to turn into a cash machine.
Just to show you the upside.
Let’s assume that my above revenue scenario comes to pass in three years. I
estimate that the company would earn close to $2 a share in after tax earnings
with C$123 million in revenue.
Conservative estimates
However, the potential may be,
let’s try to be conservative. I estimate the following:
CAD
|
%
|
Photo's
|
%
|
Photo's
|
%
|
Photo's
|
Customers:
|
online 07
|
take
|
online 08
|
take
|
online 09
|
take
|
Wal-mart Canada
|
13%
|
$ 3,900,000
|
25%
|
$ 7,500,000
|
48%
|
$14,400,000
|
Costco Canada
|
7%
|
$ 1,575,000
|
14%
|
$ 3,150,000
|
28%
|
$
6,300,000
|
CVS (U.S.)
|
5%
|
$ 5,900,000
|
10%
|
$11,800,000
|
20%
|
$23,600,000
|
Black's (Canada)
|
30%
|
$ 1,800,000
|
45%
|
$ 2,700,000
|
60%
|
$
3,600,000
|
Kmart (U.S.)
|
2%
|
$
590,000
|
5%
|
$ 1,475,000
|
10%
|
$
2,950,000
|
Eckerd's
(U.S.)
|
|
|
|
|
|
|
Total
revenue
|
|
$13,765,000
|
|
$26,625,000
|
|
$50,850,000
|
These are rough estimates, but
the important number is the % of photofinishing that each retailer does online.
Using Walmart.com’s guidance and Photochannel’s current expectations and
guidance, each customer should grow about 100%. I believe these percentages to
be very conservative. Online should be a much higher percentage much sooner.
Here are my rough earnings
estimates for Photochannel:
|
2006
|
2007
|
|
2008
|
2009
|
Estimates
|
|
|
|
|
|
Revenue
|
$5,445,000
|
$
13,765,000
|
|
$
26,625,000
|
$
45,765,000
|
Expenses
|
$6,700,000
|
$
6,700,000
|
|
$
7,370,000
|
$
8,475,500
|
Pre-tax
earnings
|
|
$
7,065,000
|
|
$
19,255,000
|
$
37,289,500
|
|
|
$ 0.22
|
|
$ 0.57
|
$
1.07
|
Shares
outstanding
|
30,500,000
|
31,500,000
|
|
34000000
|
35000000
|
These are pre-tax numbers because
Photochannel has substantial NOLs, and they should be able use them through
2008. In 2009, they will probably have to start paying taxes. Regardless, this
stock is so cheap, make them fully taxed now and its still a low valuation.
Comparables and competitors
There are two comparables to
Photochannel: Shutterfly and Snapfish. Shutterfly is public and has a market
cap over $300 million, trades near $14 a share and is expected to earn $0.18 in
2007. Shutterfly trades for more than 75 times this year’s estimates. Now it is
important to note that Shutterfly has a slightly different model. Whereas
Photochannel is a private label company, Shutterfly operates a business to
consumer model of its own brand. Shutterfly operates all of the storage and photo
management as well as prints out the pictures itself.
The other comparable, probably
more comparable, is Snapfish, which is private. Snapfish was bought out 18
months ago by Hewlett Packard for $180 million. I’m pretty sure that Snapfish
had Photochannel type revenues 18 months ago.
Valuation upside is multiples of current stock price
Photochannel has so much upside
that many things could go wrong and investors could still make money at current
prices. Consider if Photochannel only had CVS as a customer. If eventually only
30% of CVS’ customers go online to process their digital photos, I estimate
that Photochannel would earn after tax over C$0.40 a share just from CVS!
At a minimum, I think by year’s
end they should trade at 15 times my estimate of C$0.57 in 2008, which would
give you a price of C$8.55, or $7.25 in the U.S. Obviously, it could trade for
much more. In fact, with triple digit earnings growth expected for the next
three years, it could easily trade at 30 times earnings or C$17 a share. But
there is much more that could drive the upside even higher.
Kmart, Costco and Rite Aid
Kmart is a client. Photochannel
just hasn’t officially announced it yet. It seems Kmart was so anxious for customers
to be able to upload pictures online that they rushed Photochannel’s service
out before the official contract was signed. But you can see for yourself, by
going to Kmart’s website and seeing that the photo processing goes through “pnimedia”
wesbites, which is Photochannel. In talking with Photochannel, expect to see a
press release any day.
Photochannel has Costco Canada, and there is a very real possibility
that Costco (NASDAQ: COST) in the U.S. comes up for bid as early as
March. Costco currently uses Snapfish in the U.S. and word is they may not be
happy with Snapfish’s service and responsiveness. Costco may be interested in
offering a “global” solution for both Canada
and the U.S. and this may
make Photochannel more appealing, as the company currently services customers
in Canada and the U.S. Costco
U.S.
does about the same in photofinishing as CVS ($1 billion), which makes them a
whale of potential client. Let’s just say that if Photochannel gets Costco as a
client, the stock could easily double.
Another near term opportunity is
to get Rite Aid (NYSE: RAD) as a client. Rite Aid does about $50 million in
photo processing a year. Not a large client, but with the potential to make a
couple of more million dollars at 90% gross margin, every client is a value
booster.
CD burning, DVDs and more opportunity in the future
There is actually more to the
Photochannel story than just photos. The company is testing a project to roll
out an online CD making service. The idea is that a consumer would go online to
walmart.com, pick 10-15 songs that they really love, pay $0.99 a song, then pay
an extra $2.99 and then go to their local Wal-Mart and pick up their own
personal CD with a jewel case and a nicely printed song list. This music
service would use Photochanel’s technology and service similar to its photo division
to direct the order to the correct store.
I think this type of service
could be an innovative niche offering, especially as a gifting option.
Photochannel is only spending $400K on developing this, so if it fails, there
is no big financial fallout.
This music service would not be
exclusive to Wal-Mart and opens Photochannel to other potential retailers and
clients. Imagine if Starbucks (NASDAQ: SBUX) offered an option for customers to
do the same thing but at every Starbucks.
Further down the road is the
opportunity to offer a DVD service, in which customers go online and pick what
DVD they want to buy and then walk into the local Wal-Mart and have their own
DVD burned. Retailers would love this as it would mean they would only have to
hold minimal inventory, but could make any DVD for anyone and only keep blank
DVDs in inventory.
There is clearly more than just
photos to Photochannel and the company is not sitting still.
High Quality management from Kodak
Insiders are heavy owners of the
company, collectively owning more than 20% of the company. Further, the company
has financed itself in recent years with strong participation from friends and
family of the owners. Management clearly has skin in the game.
Management, especially the CEO,
have excellent credentials. The CEO, Peter Fitzgerald, was a one of the top
executives at Eastman Kodak (NYSE: EK). Mr. Fitzgerald was CEO of Qualex,
Kodak’s photo processing division. His resume gives me a lot of confidence
towards Photochannel being managed properly. He has run much bigger companies
than this one.
Summary
With no analysts, no coverage and
no exposure, Photochannel represents a rare opportunity to invest in a dot com
with triple digit growth rates at 8 times next year’s earnings. There is a good
chance that with a few more customers and things going as planned, Photochannel
could trade over $20 a share, or 5 to 6 times higher than its current price.