Description

ZOO Digital Group PLC (“ZOO” or the “Company”) is a $90M revenue/ $14M EBITDA UK-based company, listed in the US under “ZDGGF” and UK under “ZOO”. The fiscal year ends March 31, reporting is on an IFRS basis and USD is the functional currency since most revenues are generated from the big streaming companies (e.g. Dinsey+, Netflix, Amazon) through localization services. We use GBP to display the share price development as the listing in the US is quite illiquid (unless it is sourced in the annual report).

Localization means adding subtitles and vocal narratives (i.e. dubbing) to content. The Company is paid per minute and hence, is indifferent to whether this is a blockbuster movie or a cheaper-to-produce series. ZOO performs these tasks through the cloud using ZOOstudio. This software manages the content from the post-production phase to the localized content that will be delivered to streamers. Translations are done by a pool of freelancers of around 11,500 people. The services that they deliver are divided as follows:
- Localization: this is the core business with subtitling (35% gross margin) and dubbing (25% gross margin) services. Dubbing is the growth engine (starting from a low base) as dubbing revenue is typically 10:1 compared to subtitling as this involves much more effort
- Media services: preparing a “turnkey” product/file for the streaming company where ZOO makes sure that they use the correct format, perform artwork in the local language/culture, include metadata in the file with cast info, etc. Highest gross margin business (~60%) and will grow in line with minutes produced
- Software: a license fee charged to affiliates to use the ZOOstudio platform. This service line is phased out as the company made a strategic shift towards owning local offices instead of partnering with affiliates. So this revenue will go to zero

Investment thesis

Company stock is hammered after the Hollywood strikes and the cost-cutting exercises by the big streaming companies (the release of ChatGPT did not impact the share price, more in the risk section). The market is not appreciating the strong fundamentals of the company and we believe a 2-4x upside is available in the coming years.

In line with the market, we do believe that the order flow has dried up in the last months and that fiscal ‘24 will be a tough year. However, the high degree of variable costs together with a resized OPEX will soften the blow significantly and allow for higher margins in FY25 and beyond. TTM fixed cash OPEX is ~$22M (incl. capitalized staff costs), so in the worst case, the company has to cushion part of this amount for a couple of months. The cash balance at the company was $23M ending June 2023 after a fundraising in April. The company has no interest-bearing debt, only capitalized leases of ~$8M.
Short-term cost-cutting from streamers together with the need to provide more content provides an interesting dynamic for localization services. Streaming companies with a large inventory of existing content will be incentivized to introduce this to their platforms and in multiple regions worldwide (similar to the COVID-19 situation with closed studios). As localization costs are around 1-3% of content spend this is a very compelling business case for streamers and localization companies.
In addition, we believe that ZOO finally nailed to dubbing proposition which will increase the share of wallet with existing customers and accelerate significant growth in the years to come. This service started in 2017 and took quite some time for the market to gain trust. Last fiscal year the service took off with a 73% growth rate. Streamers see ZOO as a serious competitor to the other global players (four parties) and this trust is accelerated after their turn to local hubs from the affiliate strategy in early 2022.
Finally, growth will be further propelled by the secular growth in the streaming market ($1.5B market to $3B market in 2030). Management aims to increase their market share from 6% to 14% which implies $400M in sales.

Short note on the unique dubbing angle from ZOO:
- Traditional process: brick-and-mortar operation with central recording location consisting of a live room/control room, recording engineer, digital audio workstream, and a dubbing director. This is a tedious process whereby every line of a script is recorded (usually in multiple takes) and judged by the dubbing director
- ZOO uses her proprietary platform in which actors can work from home and only need to purchase a microphone for around $300 and make the room soundproof for a couple of hundred dollars. Since these freelancers also do other jobs they usually do this for a full-time living and have made the necessary investments. The platform has a cue stating what line to phrase and also indicates how the words should be pronounced (e.g. the width of the word on the screen indicates how it should be pronounced). The result is a high-quality output at a fraction of the costs

Brief history of ZOO
- Listed in 2001 at the London Exchange (AIM). The company has a strong tech focus. In the early days, the core proposition involved, amongst others, licensing the DVD-EXTRA product to produce CD-ROM-like content using standard DVD-video technology
- In 2003 they ventured into the USA for the first time although the majority of revenue was still in the UK and mainland Europe
- During this period revenues grew substantially from $1M ending 2001 to $16M ending fiscal 2006 (March). Cash burn was also considerable requiring $35M in debt and equity funding
- 2007 marked a turning point when ZOO completed the first version of their software that led them toward localization services. Former CTO Stuart Green was responsible for this tech and took the helm as CEO after a very tumultuous year (revenue fell to $3M ending March 2007). In the first years, this revolved around a menu regionalization tool used for DVDs. The first major customer was SDI Media (currently IYUNO-SDI). In this period ZOO acquired the LA-based Scope Seven Inc. business (asset deal for $2.8M in cash and deferred consideration of max $2.1M) which further entrenched ZOO in the DVD production market (not the physical production but compression and authoring services to Hollywood studios)
- With Stuart as CEO the company embarked on a strong growth trajectory riding the tailwind of the DVD market until around 2011 (~$14M revenue and first small profit). This year the company pivoted to its cloud-based localization service what is now known as ZOOstudio. The first products were ZOOsubs (subtitling service) and ZOOcore (workflow management). Although not formally confirmed in the market the first major customer was believed to be Disney (landed in 2008 in the DVD era through a 15-year contract)
- Launched an affiliate partner network which allowed ZOO to access local talent and offer global services. This also resulted in a royalty/license revenue stream from affiliates that used ZOOstudio (in 2022 ZOO pivoted to own hubs to compete better and this revenue stream will dry up)
- In 2017 ZOOsubs was gaining traction with localization revenue moving from $8.6M ending March 2017 to $21.4M ending March 2018. A little later in July 2018 the share price reached an all-time high of GBP 1.66. A little earlier they raised ~$3M for $0.11 per share resulting in a significant dilution (certain loans were also converted) more than doubling the share count from 33 million to 74 million shares (unfortunately they had no crystal ball)
- Growth stalled for three years and the share price tanked only to recover during the COVID-led streaming boom during 2020-2021
- All this aside: the most significant development that I did not cover in detail yet was the introduction of ZOOdubs in 2017. This product was designed to disrupt the localization industry by performing dubbing services from home through the cloud (a.o. reducing the number of takes through intelligent scripting. For instance, the width of the words on the screen indicates how to pronounce a word). Major studios such as Netflix and Disney had little confidence in the ability to record high-quality sound from home and the tool was not fully developed yet. The company has not disclosed any revenue for the dubbing service line but this product is the main growth driver of ZOO going forward
- After ~18 years at ZOO, Helen Gilder stepped down as CFO and was replaced by Phil Blundell. No sign of friction as she took on several non-executive roles and started her own consulting services
- ZOO reached $90.3M in revenue during the fiscal year 2023 (share price reached high during March 2023 of GBP 2.20). As part of the new hub strategy, ZOO raised $12.5M in April 2023 at GBP 1.60 per share (13.5% discount). Together with the initiation of the Writers Guild of America (“WGA”) strike on May 2th, the share took a hit (GBP 1.04 in July) after which the decline accelerated with the trading update of 14 July (GBP 0.66)

Competitive landscape and ZOO strategy
The localization market consists of a large number of local subtitling and dubbing players and a small (5 incl. ZOO) number of global end-to-end players that serve the big streaming platforms:
- IYUNO-SDI: the result of a 2021 merger between IYUNO and SDI. Biggest localization firm globally with estimated revenues of $400M and 67 offices in 34 countries. Received $160M funding in April 2021 from Vision Fund 2 (stake not disclosed)
- Deluxe Entertainment: chapter 11 in 2020 and now PE-owned. Owns two dubbing studios and generated ~$180M pre-COVID sales
- VSI Group (London): owns and operates 25 dubbing studios in Europe and the Americas. Pre-COVID sales ~$100M
- Pixelogic: US-based business established in 2016 and majority owned by Japanese Imagica (former parent of SDI)
The addressable market is around $1.5B in 2022 and is expected to grow to $3B in 2030 (current share 6%). For a few years, consolidation has started in the market where competitors such as IYUNO-SDI acquire local subtitle/dubbing players to establish a presence in key markets. This allows the companies to offer 1) global solutions to the big streamers, 2) attract local talent and 3) win new contracts. Initially, ZOO took a different approach with the affiliate strategy rooted in the belief that a local presence was not necessary with the cloud-based solutions (technically true, but customers demand local presence). In 2022 ZOO quietly pivoted to a hub-based strategy where they establish and acquire companies in key markets (in 2022 acquired Vista India for ~$6M granting access to a vast market and performing repetitive tasks that were previously performed in the USA and Europe, Ares Media in Turkey for $0.3M (20% stake) and Whatsub Pro Inc in South Korea for $0.7M and 550,000 shares). To accelerate the dubbing proposition in Spain and Portugal they acquired AM Group (30% stake) in 2023. The acquisition of a Japan-based firm is still pending and will be executed when there is more clarity on the strikes (management estimates October 2023).
ZOO prides itself on the cloud-based platform, especially for dubbing services. Although it is true that IYUNO-SDI and Deluxe Entertainment also have cloud-based solutions it appears that ZOO finally got the traction it has been looking for since 2017. ZOOdubs sales grew 73% in FY23. We estimate this is from a low base, but not insignificant; probably mid-single digit $M. We believe that the market is not appreciating this acceleration and that together with the new hub strategy the company is finally positioned to move along the growth curve envisioned in the October 2022 Capital Markets Day. The aim is to grow to $400M in revenue in 2030 (14% market share) driven by ZOOdubs.

Customer concentration
The elephant in the room with ZOO is that Disney is the biggest customer with 74% of FY23 sales. The second largest customer only had 4%. Although ZOO services all major Hollywood studios they have not been able to diversify revenues in recent years. Earlier in 2023 ZOO announced a second major customer that will also integrate the ZOOstudio platform (creating a lock-in). Management did not announce the name but indicated it is one of the following three: Peacock, Max, Paramount Plus. Obviously, the market is a bit nervous with Disney announcing at least $5.5B in cost cutting. We believe that Disney has a strong relationship with ZOO (reflected party in the fact that ZOO scores 100% on-time delivery and 0.61% redelivery rate – based on Netflix data. These are best-in-class scores). Lower spending drives customers towards marketing existing content (same as during the COVID-19 period) as it is relatively cheap to use these services (typically 1-3% of content spend).

Valuation
The company currently trades at an EV/TTM FCFF multiple of around 6.5x and compares to historical multiples in the range of 10-15x. We believe that ZOO will rerate once the FCFF capacity is restored in FY25 (or visibility thereof increases in the coming months). Taking a more technical angle we also performed a DCF analysis where we made a couple of assumptions:
- The Japan acquisition will go through for $10M, at an assumed 1x EV/Sales
- Organic decline in FY24 of 10% (flattish incl M&A)
- Rebound to a growth trajectory of around 10% during FY25 and beyond (conservative as management estimates high 20s growth
- EBITDA margins improve slightly through operational leverage from 15.4% (TTM) to a forecast average of 17.2% (management assumes EBITDA margins towards mid-twenties)
- Net cash of $20M: cash of $23M (30 June), plus non-consolidated investments of $5.1M (incl. $1M after balance sheet date 31 March), minus capitalized leases of $8M, plus recognized ($1.9M) and unrecognized tax losses @20% estimated at a rounded $5M (gross amount $31.5M tax losses)
- Net working capital/revenue: stable based on TTM data, and in line with prior years
- Discount rate of 13% to take into account the small size of the company and current rates
- Share count of 97.8 million: we took the undiluted share count as the options outstanding (10.1 million of which 7.8 million are exercisable) have an average strike price that is out-of-the-money and hence, when exercised would result in a cash inflow and this way compensate for dilution
The outcome from the above results in a price target of $1.8 (2.5x). It is not hard to imagine more upside if operational leverage kicks in harder and the dubbing proposition lifts off.

Risks
- High customer concentration with FY23 Disney sales at 74%. This should be mitigated somewhat with the new large customer (revenue delayed as a result of the strikes)
- AI could pose a threat in time. Since AI progression moves in a non-linear way this is somewhat hard to predict inflection points in the ability. A comforting thought is that both high-quality subtitling as well as dubbing require a high degree of nuance and cultural touch to make it work and AI is not there yet. We do see AI as a human substitute in subtitling for non-emphatic/cultural content such as documentaries or low-quality content and generating some parts for script writing (part of why writers are on strike)
- Security: although ZOO adopted the industry benchmark TPN+ standards a content leak would be disastrous. We view this risk as very remote but with a big impact
- Hollywood strikes drag on. This increases the dependency on existing content and foreign content. Not a disaster, but a drag on growth. A little word on the duration and number of strikes: WGA had 6 strikes since 1960 with an average duration of 104 days excl. the current strike (longest 154 days). SAG-AFTRA had 6 strikes with an average duration of 69 days (longest 183 days). As of writing the former and the latter have been on strike for 142 and 69 days. Of course, past strikes do not have perfect predictive power but indicate what to expect. At the moment parties are still far removed where actors demand 2% of revenues and writers also demand royalties and agreement on the use of AI in scriptwriting

Catalyst

- Continuation to “business as usual” when strikes are resolved
- Consolidation in the localization market continues and ZOO is acquired at a significant premium
- Accelerated client diversification (initiated earlier this year)
- Growth of the ZOOdubs business