Zedge Stock: GuruShots Represents Perfect Long Term Strategy (NYSE:ZDGE)

I invested in Zedge (NYSE:ZDGE) hoping that they would harness their global reach as a source of snackable content and shared experiences. GuruShots appears to be a cautious move in this direction while powering low-risk, near-term profit expansion. This makes Zedge significantly more attractive following the GuruShots acquisition both from a concrete perspective and because this reduces the likelihood of bad acquisitions and increases the likelihood of good ones.

Previously, Zedge was a smartphone customization app with a huge moat in the form of 10m 4.6 star reviews that create ~60m installs per year as billions of people buy Android phones. While this advantage is enormous, Zedge’s content and in-app features were not commensurate, causing a high churn rate and low revenue per user. This started to change in 2020 under CEO Jonathan Reich as revenue per user month began to consistently increase. Since Reich became CEO ARPMAU has more than doubled and MAU increased approximately 25%.

Without GuruShots, operational enhancement in the Zedge app would continue to boost ARPMAU, and the 15-20% growth rate of mobile ad spending in Zedge’s end markets would be a tailwind as well. This would produce over 20% earnings growth because of the high margins and operating leverage. The stock is undervalued pre-GuruShots at <10x PE, not including substantial cash.

With GuruShots, Zedge can become a significant global company. First, the GuruShots’ ARPMAU is $3.5, more than 50x higher than Zedge. While a GuruShots user coming from Zedge would likely have a much lower ARPMAU than the existing GuruShots’ user base, Zedge will also be enhancing the GuruShots’ ARPMAU. Users are already coming to Zedge with an intention of browsing photos, so Zedge has a relevant audience. For these purposes let’s say that the ARPMAU of a GuruShots’ user coming from Zedge is only $1 per month. If Zedge can convert 1/250 Zedge signups to GuruShots’ users, that is potentially 240,000 users, per year, $240k per month, or about $3m in incremental revenue per year, and this would accumulate. It seems possible that Zedge could also convert 1/150 users, for example, to a Gurushots’ user.

Second, GuruShots will provide Zedge with a large amount of very high-quality content from more than ten thousand competitive photographers producing content everywhere in the world, in real-time. Whereas previously Zedge had about 2000 artists producing content, GuruShots should more than 5x this number while also increasing the quality. This will enhance the quality of the Zedge app and hopefully further improve the monetization of Zedge. There is also the potential for GuruShots to add a real-time component to Zedge content as photographers take pictures of things happening on a daily basis.

Third, GuruShots will grow because Zedge can pay GuruShots’ photographers more for their content than they were making before. These three factors together might approach an additional $10m per year of very high margin revenue.

Finally, management intends to expand into video and other verticals over time, and on a very high level, Zedge can now build a globally leading gamified, monetized ecosystem for creating and consuming snackable content at a smartphone scale.

The value of such a global ecosystem is probably in the direction of $1B over time. Management may have had the GuruShots acquisition in mind when they agreed to an incentive comp that is 70% contingent on the market cap exceeding $451m by September 2024.

Deal Structure And Valuation

Because of the structure of the deal, Zedge’s market cap has only increased ~15% while revenue has increased by >30% before synergies, and likely >40% or more after.

The purchase price is $18 million in cash upfront plus a $16.8 million earn-out in either cash or stock at Zedge’s discretion.

Conversations with management support the statement during the call yesterday that the earn-out targets are “aggressive” as the top end of the range assumes dramatic growth over FY2022 revenue levels. The earn-out is ratable so if $16.8 is reached Zedge will have a very impressive performance and the acquisition will appear to be very much worth it, otherwise it will be less than $16.8.

Also, with Zedge’s very high margins, it is likely that the earn-out portion of the acquisition will to a minor extent pay for itself. For example, if the top end of the range is an additional $10 million in revenue over two years and incremental margins are 60%, then the real payment is $10.8 million. This is complicated by paid User Acquisition which will probably take most of the excess profits in the first year but comes with constraints around minimum return on ad spend which will ensure that it is profitable. Since Zedge is currently generating roughly this much cash every year, and the earn-out is over two years, this should be very digestible and management has stated clearly multiple times they believe they can realize large benefits from this acquisition without raising capital.

There is also an $8 million retention bonus pool for GuruShots’ employees payable over three years, half in cash, half in stock. At current rates, Zedge will generate the cash portion of this in just two quarters.

Assuming Zedge elects to compensate GuruShots with $9m worth of stock in the earn-out and an additional $4m of stock from the retention bonus pool, that is about 15% addition to the market cap at current prices. However, this will hopefully happen at significantly higher prices, so it’s easy to see it being less than a 10% addition to the market cap. It is also possible that Zedge elects to do the entire earn-out in cash as they are continuing to pile up cash on the balance sheet and just received a $2m integration fee from Apptopia.

In this scenario, the current shares outstanding are ~17 million in one year, for a market cap of about $100m at today’s prices. GuruShots currently has $8m revenue and $1m loss every year, and there will certainly be integration costs, so Zedge profits this year likely decrease from about $10m to about $8.5 because of this acquisition. It is a complicated equation because the stock will hopefully go up over the next year, as will revenue and profitability, potentially explosively so on both counts. The higher the stock goes the less dilution there would be, and they may also pay all remaining obligations outside of $4m in cash. A bullish case would be that the stock triples, they pay out only $4m in stock, and that represents only a 2% increase in market cap, while a conservative case is about a 10-15% increase in market cap. With all this in mind, the stock is around 11x earnings post-acquisition, not accounting for potentially very significant synergies from the acquisition that could very easily make it trading at 7x earnings within 9 months and with strong growth.

Finally, it is a positive sign that Zedge decided to not pay anything upfront in stock, despite management actually being incentivized to do so because of the comp structure.

GuruShots’ Overview

You could say that GuruShots is the world’s most powerful way to generate very high-quality photos very fast at scale. GuruShots could potentially be used to generate local photography. For example, if you want to find high-quality photos of your neighborhood or recent local events. It is a very flexible and powerful platform harnessing potentially millions of global smartphone users.

Today, GuruShots is probably the world’s biggest photography competition, holding live exhibitions worldwide. GuruShots has over 140m images, which puts it in the same order of magnitude as Shutterstock which has ~400m, as part of Zedge it may grow larger. GuruShots currently has $8 million in revenue, paying users an average of $50 per month. This is clearly a hardcore group of photographers. This indicates there are about 14,000 paying GuruShots’ members and about 200,000 MAU in total.

One weak point of GuruShots is that the voting system in photo competitions could probably use some work. It is currently a little too easy to just upvote every photo.

Near Term

The near term will likely be strong but not spectacular as Zedge begins the integration. The near term will be about basics like expanding GuruShots into languages other than English, adding subscriptions, advertising revenue, and NFT revenue for GuruShots. On the Zedge side, there will be benefits from the new ad mediation platform and social features in the main Zedge app. There should also be a substantial benefit to the Zedge app once it starts to include content from GuruShots, and GuruShots should see growth as creators on GuruShots get paid by the consumption of their content in the Zedge app.

Zedge should also add NFT trading at some point this year which should provide a boost and some public attention. There are live physical exhibitions of the top photos on GuruShots all over the world, potentially positioning Zedge as one of the world’s largest photo galleries. This is the perfect place to sell NFTs of top photos. If NFT adoption continues Zedge is now well-positioned.

Medium Term

The medium-term is where it gets spectacular. If Zedge can start to get even 1% of its users to engage with GuruShots, the bottom line impact should approach $10m. Also, if the improved content from GuruShots can increase the stickiness of Zedge by just 30% it would represent an additional 10m MAU for Zedge.

I think the next big step is that if Zedge is able to continue their strong record of execution, they may be producing the largest amount of high-quality photography in the world in the most distributed, and real-time way possible. There is a huge range of partnerships that could result from this. Just one example is travel advertisers. If you want to see the highest quality crowd-sourced photographs of a popular travel destination or festival, you are a very attractive customer for a travel company with relevant services. There is also potentially a large opportunity to connect artists in the developing world with consumers in the developed world who have no problem spending sums that would go a long way in the developing world.

Risks

The main risk is that GuruShots is not capable of expanding beyond its current user base of hardcore photographers. Zedge believes there are more than 30m amateur photographers in the world, and the universal ability to take a picture of your experiences on your smart phone and share it with the world (and get paid for it!) via Zedge will hopefully expand this number.

Another risk is that Zedge may have mis-assessed the trajectory of GuruShots in a larger sense. An examination of GuruShots on Google Trends will show that it has been declining in terms of search popularity since 2018. Hopefully, this is a reflection of the service coalescing around a very productive core rather than a larger problem. We know that GuruShots has roughly 200,000 MAU and consistently growing revenue per paying user.