Vislink — Update 4 April 2016

Divisional revenues declined by £6.7m (13%) year-on-year to £46.9m. Although market conditions were challenging, broadcast revenues picked up during the second half after a decline in H115. This improvement was driven by sales of new and IP-based products such as HEROCast, UltraCoder and IPLink. Full year divisional broadcast revenues increased by £1.5m (4%), indicating that Vislink is taking market share. As flagged in our September update note, surveillance revenues were substantially behind FY14 (£15.9m vs £7.6m). FY14 benefited from a large Home Office surveillance contract, estimated value £8m, which completed successfully in H115. The non-recurrence of this high-margin contract had a major impact on divisional profit contribution, which fell by £3.1m to £2.8m.

Recognising that it was not feasible to make up for the non-recurrence of the Home Office surveillance revenues in an uncertain broadcast market, management undertook a root-and-branch review of the division’s operations. It has reduced headcount (250 in December 2014 vs 185 in December 2015) and streamlined the manufacturing base by consolidating manufacturing operations. In addition, it has outsourced the manufacture of established products such as satellite antennae to third parties. This programme has cut fixed costs (estimated at £3m annualised, some of which were realised in FY15, some of which will be reinvested in VCS to support the new technologies and additional sales channels, and some of which will be reinvested in PBS) while retaining the flexibility to meet increased demand for product when required.

Our divisional estimates model FY16 revenues at similar levels to FY15. This assumes that demand for the new products incorporating IP technology that were launched in Q415 and further products scheduled for release in FY16 (eg VislinkNews Net, which delivers live video over IP in a virtualised studio environment) will offset lower surveillance revenues (some of the Home Office revenues were recognised in H115) and slowly reducing demand for traditional satellite and microwave links as some broadcasters opt for IP-based transmission instead. We model modest divisional revenue growth in FY17, based on increasing market penetration of the newer IP-based products. Given the major restructuring programme that occurred in FY15, we model a partial recovery in divisional profit contribution during FY16 and FY17.

Divisional revenues rose by 32% year-on-year to £10.9m. This reflects a full year contribution during FY15 (PBS was acquired in March 2014) and strong underlying revenue since the acquisition. Management notes that PBS revenues have almost doubled in the first two years of ownership. Being part of a larger group has given PBS access to global sales channels, including partnership with much larger Harmonic Inc, which has a substantial presence in the US broadcast market. In addition, whereas purchase of many VCS products is discretionary in nature, purchase of playout software is essential for broadcasters intending to roll out new channels, so PBS is not suffering from more general weakness in the broadcast sector. During FY15 PBS secured an order of c US$2.0m with Scripps Group, a US developer of high-profile content for lifestyle media platforms and its first order for Orca, an IP-enabled, software-defined integrated channel, which runs on a virtualised platform.

Noting the industry shift from hardware-based (VCS) to software-based (PBS) solutions, management expects PBS to be the primary growth driver for the group. To support this, it has invested heavily in the expansion of sales capability, software development and the identification and scoping of new products and solutions. Headcount rose from 63 at end FY14 to 75 at end FY15. As a result of this investment, divisional profit contribution remained at FY14 levels. At £3.3m, this is more than half the adjusted operating profit of the trading businesses of the group.

Our estimates model 7% divisional revenue growth during FY16 and FY17 and an estimated £0.6m further investment in sales and software development personnel. This investment is expected to hold back divisional profit growth in the short term, but is part of management’s long-term plan to double the size of the division organically, then double it again through acquisition.

FY15 group revenues fell by 7% year-on-year to £57.8m. This was ahead of our £54.2m estimate, which took a highly prudent view with regard to VCS’s ability to ship product relating to Q4 launches. The sales decline reflects a full year contribution from PBS, strong underlying growth in software (PBS) sales and modest growth in hardware broadcast sales as VCS took market share, all of which was offset by the non-repeat of a major surveillance order that primarily benefited FY14. FY15 group adjusted PBT reduced by 41% to £4.4m (in line with our estimates) as a result of the absence of the major surveillance order and investment in PBS’s sales and software development capability. The dividend was held at FY14 levels (1.5p/share) to retain cash for investment in the existing businesses and to make acquisitions. This is different from our estimates, which modelled an increase in the dividend to 1.6p/share. We note that the small acquisition of a complementary broadcast software business mentioned in our December note has not gone ahead, although management continues to identify and evaluate potential candidates.

We leave our FY16 revenue and adjusted pre-tax profit estimates largely unchanged. Noting that Q415 VCS deliveries were better than assumed in our previous estimates, we raise our group revenue estimate by £0.5m to £59.1m. These show a very modest (2%) year-on-year increase in revenues, with further growth in broadcast software sales compensating for further declines in surveillance and traditional broadcast hardware sales. This is backed by improving order intake. Stripping out the impact of the major Home Office contract (estimated at £8m), this increased by 12% year-on-year to £59.9m. We expect to see the full impact of the cost savings from VCS restructuring programme coming through in FY16. The combination of this programme and the margin improvement generated by an increasing proportion of software sales is expected to result in a partial profit recovery during FY16. Noting that management held the FY15 dividend at FY14 levels to conserve cash for investment, we assume that the dividend is held at this level during FY16 and FY17, rather than being raised to 1.6p/share in FY16, as in our previous set of estimates.

Since PBS adds a software offer to a group that historically has concentrated on broadcast hardware, its acquisition would typically be expected to enhance cash generation. However, this effect is masked during FY15 by several other factors, which collectively have resulted in a switch from £0.4m net cash at end FY14 to £5.7m net debt at end FY15. The key factors are the £2.8m restructuring costs including early termination of a lease on property that is now unoccupied, a £2.4m increase in receivables reflecting the high level of deliveries right at the FY15 year end and a £3.3m decrease in payables, which is attributable to foreign exchange movements, payment of outstanding tax and a reduction in deferred income relating to the first tranche of licences sold to Harmonic in 2014 but taken up during FY15. Our estimates show a decrease in receivables during FY16, as this anomalous debtor position unwinds, and inventory levels remaining at levels similar to end FY15. Based on the anticipated improvements in profitability, our estimates show net debt reducing to only £0.5m by end FY17.

The share price has rallied from a low of 22.375p in mid-February, but is still around 40% lower than the 53p recorded at the interims in September. The share price has been weighed down by concerns about a challenging market environment for broadcast hardware sales in the wake of announcements from Comtech Telecommunications, Harmonic and Vitec. As a result, a comparison of Vislink’s prospective 2016e and 2017e EV/EBITDA and P/E multiples against those of its peers in the broadcast and surveillance sectors shows Vislink trading at a significant discount to the mean (see Exhibit 3).

Given the enhanced margins and improved visibility of earnings that the PBS software acquisition brings to the group, the scale of this discount is not justified in our opinion, although we recognise the validity of some level of discount to reflect the modest market capitalisation. Taking our FY16e EPS as our basis and applying the year 1 mean P/E multiple (14.7x) with a 12% discount (unchanged) for the relatively small market capitalisation gives fair value at 54p (formerly 52p).