DotDigital #DOTD – DOT DOT DOT

DotDigital #DOTD – DOT DOT DOT

Introduction

DotDigital is a provider of software to manage digital marketing and email campaigns.

The software can be used to manage email marketing campaigns and integrates with CRM systems to automate, manage and monitor campaigns and measure effectiveness.

The software integrates with e-commerce platforms and CRM systems (Salesforce / Magento / Shopify).

DOT DOT DOT – AND WHAT

This company has been fairly high up on my watchlist.

  • Revenues and profits increasing approximately 100% over three years in spite of the much dreaded GDPR legislation;
  • Operating margins in excess of 20%;
  • ROCE @25% with Net Cash on the balance sheet;
  • Free cash flow at 60% of earnings;
  • Earnings predicted to grow by 17% to 2020.
  • Market cap £283 million.

I believe that that this is a quality compounder in a structural growth market, and with a certain countercyclical benefit. Digital marketing is cheaper than physical. Therefore in a downturn, you would switch from physical to digital, n’est pas?

The reason I have never held (perhaps should have pushed the button earlier) is that all of this does not come cheap at 28x current year earnings and 24x 2020 earnings.

It has been cheaper in the past (and more expensive!) but I guess that is what makes a market!

DOT DOT DOT – Results

Results were announced on 15th October and all seems well, but there are some items where the dots need to be filled in.

As a minimum, greater discussion and disclosure is needed.

Note 12: Discontinued Operations

Discontinued operations in the current year have seen a threefold increase in non-exceptional administrative expenses and at the same time continuing operations have seen an improvement in margin, especially at the operating level.

In the previous year, this was a profitable business and showed 33% growth in revenue in the current year. Personally, I am not sure I would shut down a business with such performance but management explain the strategic decision.

I accept that there are costs in closing down a business, however, exceptional costs at £750k are nearly 25% of the total administrative expense.

Note 13: Goodwill

The company made an acquisition in the previous year and recognised 9.1m of Goodwill – an element of the acquisition is included in the discontinued operations.

Goodwill is not amortised but tested annually for impairment based on cash flow projections.

“These calculations use pre-tax cash flow projections based on financial budgets approved by management covering a five-year period. The key assumptions for the value in use calculations are those regarding discount rates, growth rates, and expected changes in margins.”

“The pre-tax discount rate used to calculate the value in use is 6.2% (2018: 10%).”

So we have an improvement in margins (a key input) and a 38% reduction in the discount rate – quite the reduction in cost of equity – I read the discount rate as risk and I am not sure how/why the business has become 38% less risky.

I played around with the numbers – with the lower discount rate, the business can generate 10% less cash over a 5 year period to support the same carrying value (assuming constant cash flow each year).

Note 14: Intangibles – Customer Relationships

In note 14, we do see an impairment on customer relationships – representing >30% of the brought forward carrying value of those relationships and more than 25% of the initial cost.

The useful life of these assets (Note 2: Accounting policies) is 3 years. This same useful life was 9 years in the previous year, but you will only find that out if you pull up the prior year results.

NB: It is there in the financial review, but this is a change in accounting policy / estimate and should be disclosed as such.

This alone is a worry for a business that boasts strong recurring revenues as a key selling point, but a reduction in the value of customer relationships on acquisition combined with a reduction in the discount rate used to assess the carrying value of goodwill, is IMHO lacking coherence at best.

Note 14: Intangibles – Development Costs

£10.4m has been capitalised in development costs in 2018 and 2019, and amortisation charged over the same period is £4.7m.

In 2017, £2.2m was capitalised and £1.5m amortised.

On the face of it, I can understand the capitalisation of development costs, but these costs represent 10% of revenue – I dare say they deserve greater prominence – there is only one instance of this mentioned in the financial review.

These costs represent 45% of operating cash flow in 2018 and 2019 and an even greater proportion of profit before tax, adjusted or otherwise!

Inconclusive!

Management incentive schemes refer to total shareholder return (GOOD), but also underlying results and profit before tax. The latter items indicate incentives to be more aggressive in capitalising costs and delaying the recognition of impairments.

Given my comments, one may expect me to suggest DOTD as a short. Not for me – the balance sheet, top line growth and free cash flow generation do not support that view.

I maintain a positive view of the business – it retains its status on the Watchlist, but it is a substantial demotion from “execution” to “monitor”. I will need to see how these play out in future results.

The adjustments/changes/capitalisation might be justifiable (the future will tell), and if so, my initial positivity is justified and scepticism less so…

DOT DOT DOT…

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