PhotoChannel: Strong cash generation, but

Photochannel today announced their 2010 Q1 results. The numbers were very good.

– Generated $2.7 of EBITDA in the quarter
– Top line grew by 8% (16% if you account for currency changes)
– 5.6 million transactions were recorded, a record for the company
– Expenses look like they have stabilized, even decreased in some areas
– Ended quarter with over 6M of cash
– Board has approved share repurchases

The quarter was very good in terms of cash generation. Also, the cash balance has increased substantially and the share repurchase is a strong signal that shares are undervalued. With the Q1 EBIDTA of $2.7M, we would expect the company to make around $7 EBIDTA cash for the 2010 fiscal year. The board’s repurchasing of shares is a good signal that management is utilizing the cash in a very prudent manner. If they were to spend the entire $2.7M cash generated in the Q1 towards share repurchase, management could buy back around 5% of the company.

Now here comes our ‘but.’ Our initial investment thesis was based on our expectation that the online retailer-based photo processing business was a huge market. We predicted a substantial move by customers towards retailer’s online services, leading to strong growth potential for Photochannel. Photochannel had only 8% increase in revenue in the quarter. We don’t buy management’s argument regarding currency, it is part of the nature of their business so we don’t think it is right to not consider it. So the increase in top-line makes us question our initial thesis about the target market.

We get a sense that our initial take on the market was likely wrong. The online retailer based market might be much smaller than we expected. The market is likely a niche market with a tough sell to get customers to switch away from other online photo finishing services. A smaller market would mean the top line growth for the company will be much lower than we expected, impacting our valuations.

On valuation, we see the company making $7-8M of EBITDA this year. The transaction revenue for the last 12 months is $18 million. Let’s take into account 15% growth for the next 3 yrs, you get to $27M for transaction revenue. Lets say 70% of the transaction revenue growth hits the bottom line, so an additional $6M EBITDA. So we are looking at around $13-14M in EBITDA in 3 yrs. Lets slap a 10x multiple and we see a $130M market cap. Take into account the accumulated cash and we can see the company worth around $150-160M.

Now this is still a 3x from current prices. Although we realize that our investment thesis has changed substantially. One of the biggest inputs in our initial analysis has changed. Also, we are not confident that the company can grow top-line at the 15% clip. If the market is infact a niche market then 15% growth might be tough to get, we are assuming no major retailer is added.

Overall, we quarterly results are great and company is moving in the right direction. Although our initial investment thesis has changed substantially. When the reason for investing changes, then it is time for us to leave. We will likely head towards the exit door on this investment.

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