Following Maynard’s recent write-up, I have taken an initial stake (c. 25%) of a full holding in System 1 (S1). (I used to avoid this approach, but I have done it a couple of times recently and I’ll see how it goes.)
As always, Maynard has provided an excellent write up: Maynard Paton | SYSTEM1: Remarkable Q2 May Lead To 8x P/E And Potential Recovery Helped By ITV Progress, New Clients And Net Cash
I’ll try not to rehash Maynard’s work (but, inevitably there is some repetition) and provide a few thoughts by exception.
I look for understandable smaller businesses, where the principals have significant shareholding (i.e. in same boat as shareholders), that I believe can be materially bigger over a reasonable period (e.g. 5 to 10 years). My approach is probably a bit more similar to Richard Beddard than Maynard.
While S1’s current EV is £27m, I believe it could be a materially larger business of c. £150m or more in the medium term (of course, I may well be wrong!).
William Leverhulme (d 1925), the founder of Unilever, is famously said to have remarked: “Half the money I spend on advertising is wasted and the trouble is I don’t know which half”. S1 seeks to address this issue by quantify advertising effectiveness (see below).
I looked at the business when it was BrainJuicer. At that point, I hated the name and, possibly wrongly, concluded it was unscaleable and bespoke business, more driven by an advertising, rather than hard-nosed business, culture. The costs in these types of business often grow quicker than revenues. Having watched Mad Men it seems that advertising folk prefer to operate (aka consume cocktails) in London, New York, Sydney and Singapore rather than in, say, Bolton or Oklahoma. These folk and their operations do not come cheap. While some of this culture may linger, my investment is based on the belief that S1 is becoming an efficient systematic business exploiting a market-leading niche based on a unique database of advertising effectiveness (i.e. it is increasinlgy replicable, scaleable and profitable than a bespoke project consultancy).
At the current valuation, even if I am wrong, I believe I will at least get my money back.
As Maynard points out, S1 does not explain itself particularly well. S1 contends that consumers respond to adverts in an instinctive emotional way rather than entirely rationally. Based on Daniel Kahneman and Amos Tversky’s studies, behavioural psychology holds that System 1 (the instinctive and emotional response) is much more powerful that the rational System 2 (which is apparently System 1’s “lazy policeman”).
Unlike many others who analyse adverts rationally, S1 measures consumers emotional response to adverts and gives each ad a star rating. The rating is based on S1’s proprietary analysis of thousands of adverts. We are bombarded with ads and forget most very quickly. S1 measures the consumers’ view on the product’s fame (do I know it? If I don’t the ad is wasted), feeling (do I feel good about it?) and fluency (can I find it quickly?).
Encouragingly, the star rating provides tangible feedback. For a 2 star ad, S1 would expect a 0.5% increase in market share for every 10% “extra share of voice” (i.e. increase in relative marketing spend). A five star ad would increase the share increase to 3% for the same ESOV. Only 4% of ads are rated five star, but the difference between two, three and four starts is meaningful. This provides immediate and quantitative feedback on the creative process.
My initial research could not shed light on how the ad appraisal actually works and I worry there a bit of “black box” magic about this. Maynard’s piece has more on methodology the panel, process etc… but I could not find it on the website. I wonder how robust and consistent the process is. Also, while a lot of the commentary has focussed on TV (and particularly ITV), I think this will work on all video advertising (and I note Facebook is a client). If that’s right, it could be really important.
Mark Ritson (a well-known marketing writer, professor and consultant - see below in people) believes that S1’s product is differentiated.
I am not sure to what extent the client or decision maker is the advertising agency or the “brand owner”. It appears S1 has an impressive customer list ITV, Adiddas, Facebook, etc., but it is not clear on what basis these clients use S1. I am also not sure about the model. Are the apparently cheap Ad or Brand tests leaders into other business (e.g. how to improve test score)? All insight gratefully received.
S1’s materials suggest Kantar is the dominant player in the market, but blogs etc… suggest that its main competitors are Ubiquity (https://ubiquitygroup.co.uk) and Analytic Partners (https://analyticpartners.com). Apparently, S1 is differentiated in the Ad appraisal segment.
This aspect may have been underestimated by commentators and bulletin board participants.
I think Stefan Barden’s appointment as CEO is hugely significant. John Kearon’s LinkedIn feedback on Stefan is fascinating. Stefan Barden appears to be very different from the typical advertiser. I think he was a Unilever fast-track, McKinsey consultant with significant CEO experience mainly in large food-related multinationals. He was a very successful CEO of Wiggle, where I understand he made tens of millions. After that, he went plural mainly advising interesting private businesses – most of the fun, with much less of the responsibility. I am not sure his c. £0.5m investment is that significant – while it not “chump change”, I don’t think it is a material percentage of his net worth. It is much more significant that he has taken the title of CEO of a (small) public company after effectively going plural. The financial investment may be de minimis but the reputational one is significant. I doubt he would do that if he did not think S1 had material growth prospects and that his structured approach was both welcome (i.e. from the founder and the team) and important in the value creation. The impact is already visible: office rationalisations, systems’ implementation, net over gross profit, cost control and a data/system based strategy.
Mark Ritson is a well-known figure in the marketing world: he has been a leading business school professor for over 20 years (he is a brand expert who wins awards at every school he teaches at - he even taught me when he was starting out), he has consulted to many major corporations and he writes for both leading professional and academic publications. Notwithstanding that Mark appears to be mates with a few of S1’s principals, if he believes S1 is differentiated, it probably is.
Maynard covers this in some detail, so I will not repeat.
At the moment, at the tail of Covid, it is often difficult to establish sustainable earnings. For what it is worth, I think S1 makes c. £4m of pre-tax operating profit purely on the basis of adjusting for the dire FY22 Q1. S1 had not lost money in a quarter for the last five or six years, so even adjusting that quarter to £0.5m profit (low by historical standards) seems conservative. There are lots of arguments both ways: revenue momentum is positive, but costs may be under-stated and the advantages of government support are arguably not sustainable.
If you accept £4m, an EV of 7x is not punchy especially given increased earnings from database and lack of appreciation of ITV/Euros benefit.
If S1 becomes a better version of its previous self, I suspect it will be worth more than it is now. If it transforms into a unique data led service, it could be worth much more.
I still have many unanswered questions that include:
- How does the ad rating database/system really work?
- How difficult is it to replicate S1’s system? [They have spent £5m+]
- Who is the ultimate client and how much is the S1 analysis in an entire project?
- How big is S1’s actual market (ad testing)?
- What is realistic long term cost base?
- Has the culture really changed to a hard-nosed profit/cash focus?
- Should S1 invest in exploiting the unique market opportunity rather than buy back shares or paying dividends (i.e. is founder putting his needs ahead of business)?
- How related are consulting sales to the system? If so, what proportion are systematic rather than bespoke?
- What happened in 2018 (pre Covid)?
- Is labour properly allocated to projects? (i.e. what is project contribution margin rather than GP?)