Microcap Ideas: Photochannel Networks

By Jonathan M. Heller

One of the interesting microcap ideas presented at the Value Investing Congress West in May was Canada-based Photochannel Networks, whose business is providing online digital photography solutions for retailers.  If you’ve ever electronically sent photos to a retail store for pick up, you may have used Photochannel technology.

Aaron Edelheit, of Sabre Value Management, presented the bull case for Photochannel , stating his belief that the company will continue to align with major retailers, and partners, pushing company growth.  The company recently announced deals with Kodak China, Kodak Australia, Sams Club USA. A previous agreement with Costco (COST) is expected to launch this month.

Earlier this month the company announced record revenues of $3.3 million, up 147% from the same period last year, and a loss $2.6 million (vs. $718K).  The loss was attributed to ramp-up costs, and the company believes it will be cash flow positive in the near future.  Perhaps the best news of the quarter was that transactional revenue-the catalyst for growth- nearly tripled to $1.9 million.

Shares of Photochannel currently trade for $3.67, up 22% in the past year.  Prospective investors need to keep in mind that Photochannel is an extremely tiny company, with a market cap of around $120 million, and light trading volume of less than 100,000 shares per day.

Disclosure: None

Comments

[Michael Goode:]

How is this a value stock? The company is trading at an absurd P/S ratio (even assuming the Costco contract doubles revenues, the forward P/S is still 4.6, and the company continues to lose huge sums of money), and last I checked, this business is highly competitive and it is DYING! Everybody and their mother now owns a photo printer. Online / mail-order services such as Shutterfly are cheap and high-quality. There has been a clear progression in the industry from everyone going to the photo developer to people printing photos themselves. Sending digital photos to be printed by a store is an interim stage that will see gradual but steady declines in volume over the next decade. Back while in college I worked at an independent photo shop that experienced the digital transition, so I have some understanding of the economics at work here.

Even if Photochannel continues to grow sales, earnings will likely never amount to much because this is a low-margin business. All Photochannel does is offer a website back-end. There are many other companies that have similar programs (such as the aforementioned Shutterfly). There is no reason to believe that Photochannel can outcompete them.

For example, from the company's last 6k, network costs and sales and marketing ate up 61% of revenue. So the company's gross margin is about 39%. Once you add in the necessary high R&D expenses and the G&A expenses, there is little hope for a double digit net margin. I do not believe that Photochannel is an attractive investment at these prices and in fact I am betting against it.

(www.sec.gov/Archives/e...)

Disclosure: I am short Photochannel (PNWIF).

2008 Jun 23 05:25 PM

[ravinsu:]

Michael Goode,

After reading your bear case I had a few questions to ask you.

a) "There has been a clear progression in the industry from everyone going to the photo developer to people printing photos themselves"

Do you have any stats to back up your argument?You mention that more and more people are going to print their pictures at home instead of having it printed somewhere else, but have you calculated the economics of printing pictures at home? I believe its way more expensive to print pictures at home than having it printed commercially. Do you believe that as time goes by, the cost of printing at home will come down and will be more viable than third party printing?

b) "and last I checked, this business is highly competitive" - and you just named one competitor. Are there more than 3 big players in this industry for you to say that its cut-throat competition out there?
You mention that online services like Shutterfly are cheap and high-quality. I don't disagree with that argument- though they are not necessarily cheaper than printing at stores. But have you taken into account the fact that for services like Shutterfly to be competitive, they have to spend tons of money in marketing & advertising to get more customers every year? Have you ever considered that their photo finishing expenses are heavily commodity driven? When silver prices go up and Fuji/Cannon increase the prices of photographic paper ,that will squeeze their margins like anything. Also have a look at Shutterfly financial statements, you will see periodical operating losses.
On the other hand, a company like Photochannel doesn't have any of the above mentioned expenses. It does no marketing and it doesn't have any photo finishing expenses. It gets a transactional fee which can be substantial on high volumes. Snapfish is a real competitor, but recently they lost their Costco contract to Photochannel. What are the chances that they will retain their Walmart contract given the fact that Photochannel runs Walmart photofinishing almost everywhere other than US? I recently emailed Walmart customer service and asked them why Snapfish is giving a better deal online than Walmart even when they were partners and the representative didn't have an answer. (This in no-way means that Photochannel will get US Walmart, but if it does, make sure you cover your short!)

c) On what basis do you say that there cannot be double digit net margins going forward? If you had read the 6-K completely, most of the network costs and SG&A incurred were attributed to the acquisition of Pixology and setting up infrastructure for datacenters to faclilitate the new contracts the company got. So is your assumption is that these costs will not come down or even they will go up going forward?

2008 Jun 23 09:17 PM

[Daniel W:]

"There is no reason to believe that Photochannel can outcompete [its competitors]."

...except for the fact that they've been outcompeting them and that their business model doesn't put them in direct competition with the retailers.

PhotoChannel's business model is the reason they've been able to outcompete the others and can be expected to continue to.

But it is also the reason it will post excellent gross margins--no money needs to be spent on marketing, as the above commentator noted, nor on the latest, up-to-date machines. What you see in the rear-view mirror is a lot different than what you will see out of the front window. Now and for many quarters to come.

At least that's my best guess. Though I can't wish you well in your short, as I'm long, I hope you do very well in other areas of the market, i.e., no hard feelings. If PhotoChannel does win the Wal-Mart contract, you may need those winnings to help you cover...

2008 Jun 23 11:20 PM

[bigcdog:]

Michael, why are you hating here? Your arguments are mostly baseless as you are attempting to short the stock and as the previous posts have mentioned your are completely wrong about your assumptions. With all the groundwork currently being laid, This stock will be a big winner becuase it is eating all its competitors lunches. (And their dinners too for that matter!)

2008 Jun 25 02:16 PM

[Michael Goode:]

Well, so far I've been right. :)

I covered my short before the stock fell much, though, so I didn't profit from being right.

2008 Oct 21 12:48 PM

[ravinsu:]

Michael,

You could have thrown a dart at IBD stock tables, shorted them and still would have been right in this kind of crazy volatile market. That hardly proves that you are right. Looks like you don't have any kind of response to the arguments presented above.

2008 Oct 21 09:17 PM