7digital Group — H2 step increase in revenues underpinned

Total revenues increased by 9% to £5.9m and 17% before foreign currency translational effects. 24-7, acquired in June, contributed £530k to revenues, which implies solid organic constant currency revenue growth of approximately 7%. With the bulk of revenue growth from higher-margin licensing and creative revenues, gross margins expanded to 71% (H116: 61%) and gross profit increased by 27% to £4.2m. Despite the consolidation of one month of 24-7’s cost base, operating expenses decreased by 4%, as the group continues to see the benefit of the efficiency programme initiated last year and cost synergies following last year’s acquisition of Snowite. Consequently, the H117 EBITDA loss was reduced to £1.7m (H116: £2.6m).

Licensing revenues increased by 33% to £4.0m, and MRR (monthly recurring revenues, which excludes one-off revenues, ORR) increased 38% to £3.2m. The annualised exit MRR, which is more relevant for gauging the group’s outlook, increased by 113% to £11.5m, of which streaming MRR increased by 180%. Much of this increase is due to the acquisition of 24-7, which is expected to contribute £5m to revenues this year (mainly in H217) and £8m next year. However, there was also solid organic growth momentum across a number of verticals:

Creative revenues increased 17% to £1.0m driven by renewals of long-terms clients (BBC Radio 2’s Pick of the Pops, The Folk Show, The Golden Hour) as well as new clients and services; for example, it is starting to see some synergies between divisions with the use of its curation skills for the creation of playlists for its streaming customers (Electric Jukebox).

Content revenues decreased by 18% to £1.1m and continue to provide a headwind to total top line growth. The prior year comparison includes project based revenues from a major label to use 7digital's platform for the sale of music downloads direct from an artist's own website. Excluding these revenues (which are now classified as B2B revenues within licensing), content revenues decreased by a more moderate 3%. These are very low-margin revenues and have little impact at the group’s gross profit level. The H117 gross margin was 3.2%, lower than the 5-10% typical margin due to the catch up of expensing credit card charges.

Excluding MMS, contracts with a lifetime value of c £4m were signed in H1 (some of which are renewals), which will contribute to revenues from H2. Furthermore, since the period end, 7digital has announced several client wins: Global Eagle Entertainment (Nasdaq-listed inflight entertainment content to the airline industry), Deedo SAS (for a new music streaming service across 27 markets in Africa and Asia) and US group Fan Label. In parallel with its results announcement, 7digital also disclosed a new contract with Fender (a leading musical instruments company).

The second half of the year will also see the full benefit from the acquisition of 24-7. As well as the ongoing business acquired (three-year contract to run the Juke! music services and other third-party business for £6m pa), MediaMarktSaturn (MMS) has widened its relationship with 7digital, committing to a new contract worth £6m to develop new digital music services. Management has reiterated its expectation that the 24-7 acquisition will add £5m of revenues, mostly in the second half of this year and more than £8m in 2018. In total, 24-7 brings approximately £18m of contracted revenues over the coming three years. This estimate excludes the potential to develop the acquired business, an area where the group is feeling increasingly confident it can drive concrete revenue synergies; for example, additional work is currently under discussion with MMS.

Overall, the solid H1 performance, a developed pipeline and the full impact of the 24-7 deal should result in a step change in revenues in the second half, in line with our forecasts. While the cost base will also rise as 24-7 is integrated for the entire period (we factor in an 80% increase in the cost base in H217 from H1), the synergy opportunities are considerable; work is underway to consolidate the technology platforms and a full review of all of 7digital’s European offices should lead to additional savings next year. Consequently, from the second half of 2018, we expect the majority of new revenues to convert to EBITDA, underpinning our forecast for EBITDA profitability and positive operating cash flow next year.

Revenue visibility is good. Approximately 65% (£7m) of our H2 revenue forecast is contracted and all of our £11m H2 forecast licensing revenues are considered “highly secure” (Exhibit 3). Growth in creative revenues is tracking ahead of our full year forecasts and the reduction in content revenues is as expected. We make no change to our estimates.

Net debt at June was £0.5m, including cash reserves of £0.9m (FY16: net debt £0.7m, cash £0.8m). This includes only £0.8m of the £5.7m pre-payment for existing services and setup fees agreed as part of the MMS contract. A further £2.2m was received in July, £1.4m in August and £1.3m is expected in October. This also explains the £3m increase in trade debtors and corresponding increase in accruals and deferred income.

While the cost base is forecast to increase significantly in H217, this should be covered by the incremental revenues and we expect operating cash outflow to decrease. On this basis, the extra working capital from MMS should, if carefully managed, be sufficient to see it through to Q118 or Q218. That said, it is dependent upon astute working capital management and the integration process proceeding to plan. Given the already long payables cycle, additional short-term facilities may be advisable to provide some flexibility until the anticipated cost savings (as a result of the integration of 24-7) are fully realised, which we expect to bring the group to positive cash flow in H218, in line with management’s target. We have assumed an additional £2.0m short-term financing is drawn in our FY18 estimates (we had previously assumed £0.5m).

7digital offers unique exposure to the rapidly growing music streaming segment in Europe (H117 streaming MRR +180%), which will be increasingly in focus following Spotify’s mooted IPO later this year.

The group has made considerable strategic and operational progress over the past year. The transition to a licensing business is complete, a number of strategically significant customer wins have been announced and the acquisition of 24-7 consolidates the group’s leading position and should enhance profitability. Via this acquisition and a focus on higher tier customers, the quality of 7digital’s revenue base has improved considerably, which should also help mitigate past issues relating to customer loss through bankruptcy.

There is still work to be done to deliver to forecasts; however, revenue visibility is strong and provided management’s EBITDA targets can be met in FY18, the shares look very attractive.

Please refer to our initiation report Stand and deliver for more information on 7digital.