Digital Barriers: Growing Market, Great IP, but fragile balance sheet

Digital Barriers (AIM: DGB)

Key people: Zak Doffman CEO, Colin Evans COO, Sharon Cooper CFD

This week's Stock In Focus is Digital Barriers, the AIM-listed video surveillance, security, and safety company. Established in 2009 by some of the team behind Detica Group, now a division of BAE Systems, Digital Barriers began life by acquiring several tech companies and intellectual property rights, including ThruVision Ltd, that it then rolled into a unified platform.

Founded: 2009

Listed on AIM: 2010

IPO Price: 139p

Current Price: 26.5p

Shares Issued: 165m

Market Cap: £42.79m

Digital Barrier's goal? 

"...to establish a high‐momentum surveillance and security technology business capable of generati
ng strong growth by selling proprietary, IP‐rich solu
tions to flagship customers around the world."

What's the investment case?

Digital Barriers has great intellectual property after several sizeable and strong acquisitions; it's also made significant progress since the acquisition of Brimtek and realignment of the business, signing contracts with Axis, G4S, and US government agencies.  

In the Trump-age and with the ongoing global threat of terrorism, border security is getting more attention and increased funding in the West. In this climate, companies like Digital Barriers will prosper and continue to see demand for their products.

However, investors should be wary that the business has had several profit warnings in the past. Its share price is far below previous highs that were driven by investors expecting lots of growth. The firm has struggled to keep costs down, and the latest Trading Update brought another set of expected contracts that have been pushed to the right as procurement processes drag. Based on its current rate of cash burn and debt facility, it looks likely to need further capital injections to support it until it can reach profitability.

Conclusion?

There is clearly a sizeable opportunity for Digital Barriers to prosper, with impressive IP, reputable founders, and a decent growing market potential. There is also fragility in its financial position with the company's current market value at a significant discount to its IPO price. Historically it doesn't have an excellent track record with the timing of what are by definition lumpy contracts, and it has struggled with costs. Based on its current cash burn - there is a risk of dilution through future raises, but if Management can grow revenues and manage costs better, DGB could be poised to start seriously monetizing its IP.

Growing Market

The threats to national and domestic security from terrorism and cyber warfare have increased markedly in the past 15 years, often crossing borders and jurisdictions, exploiting vulnerabilities in electronic and physical security systems, and impacting both public and private sectors.

Trump, Brexit, and "Extreme Vetting"

The European Union and the United States have all faced growing homegrown terrorism in the past few years, with attacks in Brussels, Paris, and in Florida. The rise of populism and protectionism in the Western world has seen countries bolster border security and politicians increase their rhetoric in support of greater levels of security.

After the Paris attacks, Ex-Prime Minister David Cameron unveiled plans to double funds for aviation security and hire 1,900 extra safety and intelligence staff. Donald Trump made border security a cornerstone of his campaign last year and had tried to increase security around the US borders and at airports. He has also said he intends to increase defence and security spending in his first budget dramatically.

The UK and US have recently banned most electronic devices from planes, and the Westminster terror attack a few weeks ago could also lead to increased funding for various UK security services.

Digital Barriers has products that could be of significant value to security agencies, both private and public.

Interesting Products and great IP

Digital Barrier's strengths and my personal interest in the company (I don't currently hold a position in DGB) is the intellectual property it has and the application potential.

What do they do?

Digital Barriers produces covert and remote video recording and streaming products for the surveillance, security and safety markets. It also provides analysis of secure videos and related intelligence. Its video streaming tech has zero-latency over wireless and cell networks, requires less network bandwidth than standard technology, and can operate in some pretty tough environments.

"We also provide advanced video content analysis and body scanning to identify threats to life, safety concerns and illicit activity in real-time. We work with those government security, law enforcement and defence agencies around the world responsible for addressing these evolving threats, as well as with multinational corporations and system integrators. Our solutions have been developed for specialist areas of security and defence, as well as for the protection of high-profile locations such as borders, airports, military bases, public transportation systems and natural resources."

Acquisitions were key to growing its offering

In the three years between 2010 and 2013, Digital Barriers acquired an astonishing 14 businesses with "compelling" intellectual property and operational capabilities, one of these was its now pivotal Thruvision technology. 

It's most prominent recent acquisition was that of Brimtek in late 2015, a US-based surveillance company, which was bought for $25m upfront plus deferred contingent payments, after a successful placing from DGB. Brimtek looks to have been embedded well in the Digital Barriers family, and in its most recent trading update, it contributed half of the revenues, helping the Group post nearly 100% YoY revenue growth.

"Brimtek now fully integrated, with good progress made in evolving its focus from third-party products to the Group’s proprietary technologies; as a result, organic revenue growth in the United States was especially strong in the period, with revenues from the Group’s own solutions up more than fivefold to $5.6m (H116: $1.0m)" 

Buying technologies and companies enabled DGB to enhance its propriety "IP-rich" solutions with new tech, and it has fully integrated its acquisitions into a single platform, which is now the primary strategic offering to customers through the "Solutions" division.

ThruVis (ThruVision Ltd) - Great IP

Ten years in the making, ThruVis is one of Digital Barriers most powerful technologies. It was initially developed as ThruVision at Oxford’s world-famous science research facility Rutherford Appleton Laboratory for the European Space Agency to detect objects made of almost any material in space.

DGB bought ThruVision Ltd for £950k in 2012, and it has since progressed the technology to create ThruVis. It's a video sensing technology that's able to detect varying levels of natural THz energy (Terahertz) emitted by people's bodies and use this to form a video picture that can be screened for weapons. Terahertz radiation can be used in surveillance because it can penetrate fabrics and plastics, so ThruVis can see concealed weapons, if there are any, on a person.

While the camera can detect objects at a distance, it isn't able to show human body parts, thankfully.

Without getting too geeky, one of the particularly valuable traits of this electromagnetic wave range is that different materials have unique "spectral fingerprints" meaning different materials (or types of weapon) can be detected. The firm recently announced that ThruVis can now screen up to 1,000 people per hour with a 100% detection rate (in blind trials with government agencies in Asia Pacific).

Technology like this provides Digital Barriers with a sizeable economic moat, but it needs to be able to successfully roll-out these products consistently.

Management focus on Solutions, not products

Since fully updating its product in 2014, the company has worked on developing an end-user capability so it can offer companies "solutions", not products. This means it can more easily acquire customers without the need for third parties. As part of this restructure, the company has disposed of its old Services division and is now just focused on the Solutions group.

"This evolution from products to solutions has significantly eased the deployment of customer solutions and has allowed us to exercise more control over the quality of user experience for our customers. An example of this would be supplying pre-integrated vehicle video surveillance solutions to police agencies around the world, rather than providing video streaming hardware that a customer would then integrate with third party cameras, antennae, modems and other peripherals."

This looks to be the right direction with sales growth gaining momentum in the Solutions division, which delivered organic revenue growth of 53% last year. In H2 of the last financial year, the Solutions division grew revenues 72% versus H1, with international revenue increasing 113% to £15.1m.

The group says it is "now clearly an export-led business", selling into major customers in the US, EMEA, and APAC, and reducing the risk from exposure to few customers or markets.

"The Group's Soluti
ons Division is focused on the advanced surveillance market. This covers image and data capture... a range of processing and enhancement techniques... and image transmission, and a range of analytics algorithms."

Fragile Balance Sheet and high operating costs

All seems great so far, so why isn't DGB's share price hitting highs? Simply put, the company has a track record of profit warnings and looks like it has trouble keeping down costs. Its Balance Sheet is weak, and operating expenses are high. As a result, its cash burn has been exceeding revenues for several years.

The company is growing sales and winning contracts and judging by its 2017 half year results and the consensus expectations; it is progressing at a fairly decent rate. But the firm still seems to be struggling to keep costs down, burning a lot more cash than it's earning.

The latest Trading Update on 24th March announced a delay to a raft of contracts pushing around £10m of revenue that was expected to be booked before the end of March 2017, into the following year. That's a big bite for a company that only generated £21m in Revenue over 2016.

Looking at FY16, the firm generated revenues of £21m, but costs of sales came in at c.£10m and admin costs at a whopping £17m. While in the first half of 2017, revenues grew 96% to £13m and total costs increased 60% to £19m. The firm is clearly still some way off breakeven.

Cash flow from operations was an outflow of £7.1m over 2016 and another outflow of £7.2m on H1 2017.

Interestingly, the gross profit margin looks reasonable at 50% in 2016 but with a deterioration to 33% over H1 2017. However, the admin expenses the company is racking up are killing cash generation and earnings. The lion's share of admin expenses is down in the full-year report as "Solutions Administration Costs", which is sales, marketing, and R&D costs. 

"In total Solutions administration costs in the year have decreased 3% to £11.8 million (2015: £12.2 million). This decrease reflects continued tight cost control within the Group following a restructuring exercise undertaken at the end of FY14. Investments have been funded through targeted redeployment of cost savings made on the prior year. Central costs, excluding acquisition costs and share-based payment charges, have grown only marginally year on year (up 0.5%). This increase reflects expansion of the central delivery team required to support the significant revenue growth. Overall administration costs have remained broadly flat year on year at £17.5 million (2015: £17.7 million)."

 

- FY16 Results

The rest is listed as the amortisation of intangibles, central costs, board, operations, finance facilities, and share-based payments.

Asset-based valuation

DGB had net asset value (NAV) of £50m as of September 2016, but if you strip out £24m of goodwill and £11.5m of other intangibles, this falls to a Tangible NAV of £14.5m. With a market cap of about £43m, this means the firm is trading at a slight discount to NAV (0.86x) but nearly 3x Tangible NAV.

It is helpful in understanding how underpinned a company is by its tangible assets and should act as an absolute floor. It is also overly punitive as a methodology for companies like Digital Barriers, and so I wouldn't dwell on it too long.

There is a lot of value in the IP of R&D heavy companies that is not captured as a line on a Balance Sheet. R&D gets expensed every year in the year it is incurred because its monetization is inherently uncertain. However, the value of that IP can drive revenue and earnings for many years.

Price-to-Sales valuation

It is a methodology few people like because it hides all manner of sins, with no accounting for the differing level of margins achieved from one company to the next. However, consensus revenue expectations according to the FT are £27m. I would assume this has not factored in the recent profit warning so will drop that down to £17m. The market is, therefore, putting a Price-to-Sales multiple of 2.5x. This is relatively low, but again it factors in the loss-making status at this time.

Conclusion 

This might seem like a negative write up on DGB's finances and performance, and the financial position certainly doesn't look healthy, but it is important to consider the transition the company has gone through, and the excellent intellectual property that it holds. 

Admittedly, cash flow is worrying, and while the revenue stays at current levels and contract wins get pushed to the right the business will continue to need fresh capital injections.

Consensus expectations were for breakeven to occur by 2019; this may now have slipped. However, if the flow of contract wins accelerates, the earnings will be highly leveraged on the upside.

The fantastic IP that can let security services scan around 1000 people per minute means this company is firmly on my watchlist but the fragile Balance Sheet and inevitable future dilution events mean I will sit on the sidelines for now