Vislink — Update 28 October 2016

At £5.4m, H116 PBS software division revenues were very slightly (1%) lower than H115 because of lower than expected revenue in Q216 arising from delays to orders. Divisional operating profit reduced by £0.6m (35% y-o-y), reflecting investment in development and sales activities to support future growth. Order intake rose by £1.9m (53%) to £5.4m. This was followed by news of several significant new orders at the IBC show in September, supporting management’s and our expectations of a stronger second half and modest (7%) revenue growth for FY16 and FY17. We leave these divisional estimates unchanged.

PBS’s positive order book is a reflection of supportive industry trends. PBS is in a different sector of the broadcast market to VCS. Unlike VCS, PBS is actually benefiting from the cost pressures on the global broadcast industry as these are causing the broadcast distribution paradigm to shift from processing content using dedicated hardware to processing content using specialist software hosted on standard hardware located either at the broadcaster’s premises or in the cloud. Demand for PBS’s products is therefore growing. Broadcasters are under pressure to launch new channels that will potentially attract niche advertising budgets. These cannot be launched without playout software, so PBS products can therefore be regarded as mandatory in nature. Moreover, PBS is a relative newcomer on the global stage with plenty of scope for gaining sales through partnering with Harmonic, a major North American supplier of broadcast distribution hardware.

At the full year results presentation in March, management stated that PBS, though substantially smaller than VCS, was the growth engine for the group and where investment would be prioritised. The proposed disposal of VCS or the alternative radical restructuring of the VCS division (see below) accelerates this transition.

VCS division revenues fell by £4.0m (18%) year-on-year to £17.2m. This resulted in a £2.7m reduction in profits to an adjusted operating loss of £0.8m. Discussion with management suggests that the main reasons why VCS H116 revenues were lower than expected were specific to that division. Some new products were launched later than expected. There were delays in deliveries of some of the older satellite communications products because of issues with a supplier that have now been resolved. Demand from the surveillance sector, which remains key but has always been volatile because of the large scale of some of the projects worked on, was weak (£2.0m in H116 vs £4.3m in H115). Finally, some potential customers delayed making purchasing decisions while they determined their strategy for migrating to HDTV (high-definition TV) and IP transmission.

While some of these issues have been fixed, the market environment for broadcast contribution businesses such as VCS continues to be difficult. During H116 broadcast order intake fell by £8.0m (36%) year-on-year. Broadcasters are experiencing severe pressures on costs because of the movement of advertising expenditure from TV to online formats. While VCS products such as miniaturised camera transmitters help broadcasters create compelling content that will attract larger audiences and advertising income, they are essentially discretionary in nature, so sales are vulnerable in a downturn. Management estimates that the broadcast hardware market shrank by 10-15% during FY15. Equipment that helps broadcasters cut costs is doing better. Where possible, established broadcasters are shifting content transmission from traditional microwave and satellite links to IP-based networks. VCS has introduced several ranges of products to address this trend, although these took longer to bring to market than management had expected. For example Vislinknewsnet is an innovative IP-based system designed specifically for electronic news gathering. It enables reporters to edit material in the field as though they were in the studio, and producers to take content from multiple points of view without lengthy link set-up, thus delivering more high-quality outside content. Vislink ViewBack returns video from the studio to the field, enabling camera operators to see studio output and perfect their shots accordingly. The SatWare IP-based computing platform extends studio workflows to the field, enabling reporters across the globe to share files and video content.

In response to the structural changes in the market, management has begun to implement a far-reaching restructuring programme of the hardware division with the intention of making it profitable and cash generative again. This involves more than simply cutting costs (which will affect H216 rather than H116). It is about taking a hard look at the product portfolio, prioritising investment on the equipment needed as the broadcast contribution industry transitions to IP-based transmission, making sure that VCS retains its market-leading position, and culling legacy technology. The first phase of this restructuring programme resulted in significant exceptional non-cash charges being recognised in the H116 results, as discussed below. The programme is expected to return the division to modest profitability in FY17, should the proposed disposal not go ahead.

At the interims, management announced a portfolio of measures (see below) to improve the cash position. This included potential disposals. Noting the structural shifts in the global broadcast industry, which favour software rather than hardware, management’s stated strategy has been to build up the software division, while realigning the VCS division to meet the requirements of a rapidly changing market. Given this stated focus on software, VCS was the logical candidate for disposal. On 20 October, management announced that it had entered into a conditional agreement with xG Technology, a provider of private mobile broadband wireless networks, to sell the VCS assets for $16m. The transaction is likely to be subject to shareholder approval and to complete by end FY16. Importantly, the group will be substantially debt-free on completion of the transaction.

On 13th October, Finance Director Ian Davies resigned from the Board.

The weak performance in VCS resulted in a £4.0m (15%) year-on-year fall in group revenues to £22.6m. Gross margin declined by 6.8pp, reflecting pricing pressure and product mix in the VCS division. R&D costs increased by £0.8m (30%), as investment was made in both divisions to keep up with the evolving broadcast landscape. This rise was balanced by a £1.2m (28%) reduction in administrative costs resulting from the restructuring activity in FY15. The group shifted from £2.2m adjusted operating profit in H115 to £1.1m adjusted operating loss (after deducting share-based payments of £0.3m in both periods).

In July, management noted that it intended to thoroughly review the VCS product portfolio. This resulted in a £23.3m reduction in the carrying value of VCS goodwill (now zero) and acquired intangibles, £5.5m VCS inventory write-down and £0.8m write-down of capitalised VCS inventory. (A similar calculation was performed on the PBS goodwill and no impairment was required.) Redundancy and restructuring costs were minimal (£0.1m) during H116 as the restructuring was not announced until early July. The scope of the restructuring depends on how trading progresses during H2. We estimate £0.6m costs associated with restructuring during H216.

The shift from a positive to a negative operating result had a deleterious impact on net debt, which increased from £5.7m at end December 2015 to £8.8m at end June 2016. At the end of September the group’s rolling credit facility of £15.0m was fully utilised. Management noted that the group was forecast to breach its banking covenant at end September, but remained in constructive discussions with its bankers. Management has proposed a portfolio of measures in addition to the ongoing VCS restructuring to improve cash generation:

Given that the VCS disposal is subject to shareholder approval, we have revised our estimates on the basis that the VCS division is an ongoing business. We will adjust our estimates to show the impact of the disposal once the disposal is confirmed. We provide a top-level view of the group’s potential performance without VCS in the valuation section. The key changes we have made to our estimates are:

The combination of these changes results in a 19% year-on-year reduction in group sales to £46.9m during FY16, despite the 10% PBS revenue growth. This generates £1.2m loss before tax (adjusted for goodwill amortisation, share based payments and exceptional items). If the proposed VCS disposal does not go ahead, we expect group revenues to reduce by a further 2% to £46.1m in FY17 as PBS sales rise by 7% but the VCS product portfolio is reduced to focus on new technologies. A mixture of margin improvement from the focus on newer technology products and the impact of the cost reduction programme is expected to return VCS to modest (£0.5m) profitability for FY17, enabling the group as a whole to return to pre-tax profitability. Assuming that the VCS disposal goes ahead, our analysis (Exhibit 2) indicates that the group will be profitable during FY17 in this scenario as well.

Since management is consciously not cutting back on R&D to secure future profit growth and paid the FY15 dividend in July 2016, we expect net debt to increase to £10.5m at end FY16. This is equivalent to 73% gearing following the significant impairment of intangibles and write-down of inventory that affected net assets at end H116. This debt would be substantially eliminated by the receipt of $16m (c £13m) for VCS.

The stock, which had been underperforming since the July trading update, picked up on the announcement of the proposed VCS disposal as this gives a route to resolving the potential breach of bank covenants. Since the disposal remains conditional, our estimates model VCS being retained in the group, but we believe it is helpful for valuation purposes to model the group’s performance with VCS stripped out.

If we compare the share price multiples for the revenue, EBITDA and EPS estimates associated with a group comprised only of the software division (Exhibit 3), Vislink’s prospective EV/Sales and P/E multiples are in line with the sector mean. We note that on an EBITDA basis Vislink appears to be trading at a discount to the mean, but this may be caused by variations in defining EBITDA. This suggests that the VCS disposal is probably already priced in, although there is potential for share re-rating once the disposal has completed and the recent spate of PBS orders has translated into divisional revenue growth. We will revisit our valuation once the VCS disposal is approved.