Gamble of the Week: how to profit from digital cameras

Have you bought a new camera recently? If so, then my guess is it was digital. Not only are digital cameras more feature-rich than their film-based cousins, but many shops, such as Dixons, have stopped stocking traditional film-based products.

This trend has led to a seismic shift in photo processing: it's expected that in the UK this year there will be more digital photos developed than alternatives (ie, analogue). Digital printing is cheaper, more flexible and produces sharper quality pictures. Another important feature to note is that, although consumers are being more selective regarding which photos to develop, they are also taking lots more snaps, thus maintaining the overall size of the market in volume terms.

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Pixology is the UK market leader in software for retail digital printing, and services four of the top five UK retailers: Asda, Boots, Jessops and Tesco. Tesco have recently signed a four-year deal, valued at more than £1m, while Jessops is rolling-out further software in its shops. Pixology's strengths lie in retail and kiosk processing, which accounts for about 70% of digital print volumes. Home printing, due to its higher cost, represents about 15%, with the balance attributable to online orders.

Although currently loss-making, management are targeting break-even in 2006 as recurring revenues increase. At 39p, the business is valued at only £8m. In my opinion, this is incredibly cheap, especially as it had £5.5m of cash at the year end and has unrelieved tax losses of £11m. Pixology's technology is patent protected and it also owns some clever software, called IRISS, which removes the problem of red-eye in flash photography. IRISS has recently been embedded into Olympus's new range of digital cameras. Finally, Pixology has just launched a new in-store gift-kiosk service, which lets consumers create personalised gifts such as posters, greeting cards, mugs, mouse mats and puzzles from their favourite photos. This appears to be a sensible strategy as it moves the business into higher-margin products.

Unsurprisingly, given Pixology's low valuation, takeover speculation is in the air although nothing concrete has yet materialised. But what are the downsides? Clearly, being a small company in a highly competitive industry, the firm is a risky investment. Moreover, there is continual pricing pressure within the standard six- by four-inch image sector, causing UK retailers to drop their prices to as low as 5p per print. Obviously, there is a chance that Pixology will not move into profitability, although its healthy cash balance will at least allow it to weather most storms in the immediate future. Additionally, Pixology's US business is currently sub-scale and could become a drain on resources if it's not beefed up.

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.