XLM

XLM: A Valuation of XL Media PLC

XLM are something of a media darling at the moment, in more ways than one.  Their “materially ahead” trading statement on November 21st was music to holders’ ears, and led non-holders (myself included) to question why they aren’t invested already.

I actually looked at XL Media last year, and again earlier this year when researching Taptica (a company working in similar field).  A quick discounted cash flow model suggested the company was trading at a massive discount to its intrinsic value.  However, it’s up over 100% year to date, so is this still the case today?

XLM

I must admit I have so far steered clear of this company, for two main reasons.  It operates in the online media space, similar to Taptica.  And it operates in the gambling sector, similar to Plus500 and Playtech.  Suffice it to say these are areas well covered in my portfolio currently.

That being said, one of my rules when it comes to selling an existing holding is if I find a better opportunity elsewhere.  Could XLM be that opportunity?

Like many innovative media companies, XLM is fairly new to the party having been incorporated in 2008, and listed on AIM in early 2014.  The share price is up over 184% during that time, with performance to match.

So, what does it do?

As mentioned, XLM operates in the digital publishing space, and act primarily as a ‘gateway’ of sorts for customers seeing suitable gambling platforms.  XL Media generate their revenues by driving traffic to these platforms and operators, earning either a fixed fee or revenue share.  They do this via three main business segments:

Publishing

XL Media manage and maintain over 2,000 websites designed to attract customers and drive them towards their clients.  XLM analyse data on traffic and SEO (search engine optimisation) to ensure these sites remain visible and appealing to customers and clients alike.  Income is primarily generated via revenue share, leading to high margins.

Digital Media Buying

Alongside their bank of websites, XLM are also involved in the dissemination of targeted media campaigns to attract customers.  These campaigns drive traffic either to their own sites, or directly to clients’ websites or web platforms.

Affiliate Network

Lastly, XL Media coordinate an impressive array of affiliate marketing partners who again help drive traffic either directly to clients or by way of their own web platforms.  As with publishing, this segment is based on a revenue-sharing model via commissions earned by the business.  This offers an ancillary benefit to affiliate marketers who also earn based on traffic they generate.


Management & Ethics

Chairman Chris Bell is former CEO of Ladbrokes, having worked with the bookmaker for 20 years.

CEO Ory Weihs created XL Media in quite an interesting way.  Weihs began in 2002 by creating his own affiliate network, which over time became what we now know as XLM.  In 2008, he met the other co-founders, who at the time had a business focused more on the advertising and media aspects of the  current business.  He is also co-founder of Webpals Enterprises, which until earlier in the year held a substantial number of shares in XL Media.

As requested by Uncle Albert Trotter (@Uncle_Albert_T) on Twitter, I’m also interested in highlighting non-executive director Jonas Martensson.  Martensson is currently CEO of Swedish game developer Mojang AB, who you may be familiar with as the creators of Minecraft.  (If not, ask your kids).  Martensson also has pedigree as founder of Mobilebet.com and as head of mobile at billion-dollar operator Betsson.

XL Media have an impressively diversified client base, with over 150 operating partners located across twenty countries worldwide.  If you’ve read this far, some of you may be sensing that bad taste in your mouth.  Yes, XLM operate in the somewhat controversial gaming and gambling sectors.  This I can absolutely understand.  As investors, we all draw our own lines as to what we consider acceptable investment opportunities.  Defence, tobacco and gambling are just a few of a number of sectors in which some will not invest.  It is not for me to judge, I can only tell you what I would do.

So, if you’re still reading, good stuff.  Hopefully we can make some sense of the numbers.


The Numbers

XL Media currently trade on the current valuation metrics:

  • P/E – 19.3
  • P/B – 4.6
  • P/S – 4.2
  • P/CF – 12.8
  • PEG – 1.04
  • Yield – 3.3%

Broadly speaking, the company trades on a reasonable valuation given these metrics.  19 times earnings for a company growing at a five year revenue CAGR of 37.7% is encouraging, with Digital Look suggesting this dropping to a P/E of 14.9 next year.  I tend not to pay a huge amount of attention to forecast earnings.  Net income growth isn’t quite so stellar at 24.57%, but still very impressive none the less.  There’s also the inviting yield of over 3%, which is somewhat surprising given the growth of the company at the moment.  Due to the nature of the business, it has very little by way of physical assets, however it is extremely cash generative.

Operating Margin

XLM
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Operating margins have fallen in the past few years, with a slight recovery in 2016.  I have no concerns regarding this, due to the make up of revenues in the business.  As mentioned, XLM operate three separate segments, with wildly varying margins.  For example, ‘Publishing’ returns gross margins above 80%, ‘Media’ between 20-30%, and their ‘Partner Network’ in the high single to low double digits.  Margins have fallen in past years due to the larger proportion of revenues being generated by their ‘Media’ part of the business.  What does appear to be a growing trend is the lowering revenue return from their low-margin affiliate network.  Should this continue, margins will likely fluctuate in the middle ground between 30-80% depending on future revenue breakdowns.

Regardless, margins remain strong and relatively stable (hi Theresa).

Return on Invested Capital

XLM
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Due to the small debt levels of XLM, the return on invested capital mirrors closely the return on equity generated by the company.  As a measure of quality, XLM generate healthy returns from the capital invested by shareholders.  After an initial high return, ROIC seems to be levelling out at between 20% and 25%, with TTM figures suggesting this trend will continue.

XLM have not been buying back shares , and debt has not been increasing.  They have, however, been increasing shareholder equity whilst maintaining robust return on that equity.  This suggests quality, and a business able to generate consistent healthy returns, even whilst it is growing.

Balance Sheet

XLM
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XLM
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As mentioned, XLM are highly cash generative, leading to a growing asset base for the business.  The remaining proportion of their assets are in intangible assets, such as proprietary technology and web domain ownership.  Receivables have been growing for the last few years, which is something to keep an eye on.  I am curious as to how they have valued the domains they do own.  All I can find in the notes to their 2016 annual report is the following:

“The recoverable amounts of domains and websites were determined based on a value in use calculation using estimated cash flow projections”

As a reminder, they own over 2,000 sites, with a heavy focus on search engine optimisation and web ranking to drive traffic, which increases the value of these domains.

This is clearly a high value market.  During 2017 alone, XLM spent $19.2m on new websites and domains.  For reference, the most expensive domain ever purchased was ‘insurance.com’ and cost $35.6m in 2010.

Cash and short term investments more than cover all current liabilities, with no debt.

Cash Flow

XLM
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XLM
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XLM generate consistent free cash flow, and ongoing requirements in property, plant and equipment is very low (less than $1m annually).  This leaves them free to make regular investments in growing their domain and website portfolio.  This investment should theoretically increase their reach, particularly into new countries and markets.  In fact, the largest regular payout is to shareholders via dividends.  This payment appears sustainable, with a payout ratio of around 50% of income.


Valuation

Having looked at the business, it’s time to attempt to figure out a discount cash flow valuation. Here are the calculations:

XLM
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  • Free cash flow is somewhat inconsistent, though broadly it is growing.  As an average over this period, I shall initially use £7.78m (converted from USD).
  • Net income has grown, as mentioned, at 24.57% for the past five years.  If the trend towards consistent higher margins and return on equity continue, growth seems relatively predictable.  Regardless, I will drop growth to 20% for the next five years.
  • As I usually do, I assume growth slows to 3% after these five years to reflect an implied average inflation rate.
  • My discount rate, i.e. my required annual return on this investment will as usual be 10%.

Based on this calculation this gives a potential intrinsic value of £1.20, against a current valuation of £1.83.  Based on this, the current price trades at a premium of 34.4% to the suggested intrinsic value.

This would suggest the current price is considerably above its intrinsic value, offering no margin of safety.  And identifying a margin of safety is what these valuations are all about.  I’m not saying XL Media is worth £1.20, by any means.  In fact, if we tweak the numbers a little, we can obtain quite different outcomes.

For example, if growth can continue at 20% for ten years instead of 5, the intrinsic value jumps up to £2.10.  A premium of 14.75% to the current price.  If it continues for ten years at 24.57%, the IV goes up to £3.03.

Conclusion

I like this company.  It is cash generative, debt free, and trading on reasonable valuation metrics.  The crux for me is on what your expected growth rates are for the business.  A chap named Paul (@pjames2017) was kind enough to send me his DCF calculations a few days ago.  I have purposely not looked at them until after I had done mine, and I am somewhat surprised to find I have been even more optimistic than him.  Our calculations and outcomes aren’t drastically different, however, which I find reassuring.

I would like to think that the inconsistency in their growth in income and free cash flow will subside as the business moves towards deriving their revenues from their higher-margin businesses.  If this is the case, it’s possible growth will pick up, with a corresponding favourable movement in intrinsic value.

However at present I’m inclined to pass on this company, due to the valuation.  A good business is a good business, but pay too high a price for it and it will impact your return.  That being said, I’ll be keeping an eye on it.

Happy investing!

 

If you’d like to discuss anything contained in this article, contact me on Twitter @britishinvestor, or leave a comment below.

Disclosure: Taptica is a constituent of the portfolio.

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