Roo Group Gains Momentum: Add this Smallcap to Your Pouch

| About: KIT digital, (KITD)

I’ve written a bit about Roo Group (NYSEARCA:RGRP) in the past, mostly to note the amount of speculation and hype surrounding online video. However, there appears to be a change in the winds because while the company had historically given back its gains as speculators cashed in, the recent price action indicates that investor expectations about the company have changed significantly. RGRP has held onto recent gains quite stubbornly, and with that in mind, I think it is time to take a deeper look.

Profile (from 2006 Annual Report):

“We operate as a digital media company in the business of providing products and solutions that enable the broadcast of topical video content from our customers’ Internet websites. We specialize in providing the technology and content required for video to be played on computers via the Internet as well as emerging broadcasting platforms such as set top boxes and wireless devices (i.e., mobile phones and PDAs). Our core activities include the aggregation of video content, media management, traditional and online advertising, hosting, and content delivery.”

How they make money: Roo is essentially a play on the growth of online digital video. They design online video solutions for major media corporations and other large companies. They have 3 streams of revenue:

1) Customers pay Roo on a per stream basis to provide them with online video solutions.
2) Customers can subscribe to gain access to Roo’s syndicated content, such as videos from the Associated Press or one of Roo’s other content providers. This allows Roo’s customers to expand the range of content they can provide.
3) Roo provides advertising services as a way for these customers to monetize their video content.

Roo is also in the process of developing a fourth revenue stream by working to optomize video search and drive traffic to its customers. Their recent acquisition of MyVideoDaily is an effort to enter this field.

2006 Review: Roo Group remains unprofitable, and losses have actually accelerated in 2006 vs. 2005. However, revenues have been increasing at an accelerating rate, and the accelerating losses are largely due to increased sales and marketing costs, which have roughly doubled in 2006. The increase in these costs, which have primarily gone toward hiring more sales personnel, can be viewed as an investment in the future of the company.

The company has yet to release 4th quarter and full year results, but at yesterday’s Roth Capital presentation, RGRP’s CFO stated that he was “comfortable” with the analyst estimate of $9.3 million in revenues for 2006. Assuming that he already knows the number, it is pretty clear that they will meet or exceed $9.3 million in revenues for the year, which means the fourth quarter revenue will come in at approximately $3.3 million. This represents consecutive quarterly growth of 46 percent, and that is a huge jump. It is possible that revenues for the quarter may exceed $3.3 million as well. It seems to me that the company is really beginning to see the positive effects of its increased sales and marketing expenses from earlier in the year, and the fourth quarter of 2006 could represent a turning point for the company.

2007 Outlook: At Wednesday’s presentation, the CFO said that the company’s goal for 2007 was to achieve consecutive quarter growth of 20 percent. Assuming that the company does $3.3 million of revenue in the fourth quarter of 2006 and grows at 20 percent each quarter thereafter, the company is looking to do revenues of about $21 million for next year. That represents 100+ percent revenue growth.

By looking at the headlines since the new year, it appears the company is well on its way toward meeting or exceeding its goals for revenue growth. Major deals with (TSCM), News Corp (Fox) (NASDAQ:NWS), Network Ten in Australia, and a host of smaller deals have all been announced since January 1st.

What is more difficult to predict is when the company will become profitable, simply because we it remains to be seen what happens with gross margins and SG&A costs. The CFO said in yesterday’s presentation that gross margins should be increasing and that the target is for 55 percent gross margins, but at the moment, it seems like Roo is more likely to be in the 45 to 50 percent gross margin range for the next few quarters.

That being said, if the company is able to keep SG&A expenses relatively stable around $3 million, they should be looking at breakeven results when they can reach $7 million in revenue for the quarter. If the company meets the revenue goals laid out yesterday by the CFO, that would be in the fourth quarter of next year. But keep an eye out here, because the company has shown excellent operating momentum thus far in 2007, and I think there is a good chance that revenues are going to surprise to the upside, especially if Fox’s online TV initiative takes off.

Risks: There are two major risks for Roo: dilution of the share count, and competition. As far as dilution is concerned, there are a number of warrants floating out there from recent equity financings, so this is guaranteed to take the share count up above 30 million by the end of 2007. However, the company completed a private equity financing of $15 million in November, and this should provide enough cash to sustain operations for at least all of 2007. My estimates, which show the company breaking even in the fourth quarter, show an operating loss for all of 2007 of about $4 million, so the November financing should be more than sufficient to get the company to a point where it is cash flow positive. That being said, Roo has acquiring smaller companies like crazy, so they may choose to do another PIPE financing in order to do an acquisition in 2007.

On the competition front, the danger comes from the possibility of large media companies entering the space by developing their own proprietary online video platforms rather than using Roo. However, because Roo has already designed its online video platform, there are cost savings to be had by using Roo. It seems to me that the fact that Fox has signed on with Roo indicates that using Roo is a better solution for most media companies than developing their own proprietary online video platform, because Fox has the resources to develop its own platform but chose not to.

Conclusions: Roo Group really appears to be gaining operating momentum in recent months. Fourth quarter revenues are going to come in very strong, and the company is forecasting consecutive quarterly growth of 20 percent for 2007. Although RGRP is not yet profitable, the investments made in hiring new sales personnel in 2006 really appear to be paying off, and the fact that News Corp. has taken a stake in the business helps to validate Roo’s business model. If Roo can build upon its recent successes and book more customers in 2007, I believe there is a good chance that it will break even earlier than the fourth quarter, and revenues for the year have a good chance of exceeding $21 million.

In spite of all the good news, I am not about to run out and establish a large position immediately, because this remains a very speculative stock. My conservative estimates still don’t have the company breaking even until the fourth quarter, so I would prefer to wait for 2006 results to be released in order to confirm my sentiment that the company may be able to achieve profitability earlier in 2007. However, RGRP is definitely a company to keep an eye on in the next few months, because it appears to be at turning point in the quest to profitability.

RGRP 1-yr chart

Full disclosure: Author holds no position in RGRP.OB.

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