| 2015 | 2016 | ||||||
| Price: | 22.59 | EPS | 0 | 0 | |||
| Shares Out. (in M): | 52 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 1,175 | P/FCF | 0 | 0 | |||
| Net Debt (in $M): | 84 | EBIT | 0 | 0 | |||
| TEV (in $M): | 1,259 | TEV/EBIT | 0 | 0 | |||
Sign up for free guest access to view investment idea with a 45 days delay.
AVG Technologies (AVG)
Summary:
AVG has been written up before on VIC, though the most recent write-up was back in 2013 and the dynamics of the company and its situation have changed. I believe the company has been a victim of a turbulent history since IPO, several business transitions (which it has been and is successfully navigating), and negative sell-side sentiment due to its unsexy growth story. On the flip side, the company has a strong business model as a freemium pioneer, excellent financials and cash generation, and management that is willing and able to put cash to use, either back to shareholders or with accretive acquisitions. I believe the company is cheap both on an absolute basis and relative to peers at an FCF yield of 11.3%. I believe the company should be valued in the high single digits FCF yield (7-8%) based on 2016 estimates, implying a price target in the $30-35 per share range, or about 30-50% upside from current levels.
Company Description:
AVG is an IT security software vendor, focused on the consumer and SMB segments of the market across both PCs and mobile devices. The company employs a “freemium” model, whereby it distributes base anti-virus / security software for free, via CNET’s download center and mobile app stores (Google, Apple, etc), upselling premium features for an annual fee. AVG’s products are highly rated across all platforms and among the most downloaded. As a result, the company has built solid brand recognition.
The company derives revenue from two streams:
i. AVG exited the third-party search distribution business, where it provides toolbars through third parties for an upfront fee, and later realizes search revenue, in the second half of 2013 (more on this later).
The revenue mix has varied over the last few years, but the clear focus is on the subscription business going forward. After accounting for 75% of revenue in 2014, subscription should move up above 80% of revenue in 2015 and hit 90% of revenue in the next few years. By and large, the company’s subscription business has been a steady success, slowly-but-surely monetizing its largely non-paying user-base - total users have increased at a 19% CAGR from 2010-2014 and AVG has managed to maintain paying users around the 10% mark. Additionally, the company has made pushes into mobile (now majority of user-base; expected to account for $50-60M in 2015E booking) and SMB (~16% of revenue, up 19% in 2014 and purely subscription), which have been largely successful thus far.
Competitively, some of the better known players in AVG’s space are Symantec (Norton), Intel (McAfee), Trend Micro, Kaspersky Labs, Sophos, Check Point and F-Secure.
Timeline / Situation Background:
Since going public in February 2012, the company has had somewhat of a turbulent history.
Shortly after the IPO, fears arose regarding whether Google would renew its search relationship with AVG after the expiration of the then-current contract in September 2012. Though the relationship was ultimately renewed, a Seeking Alpha article in January 2013 highlighted changes to Google’s search partner policies starting February 2013. Under the new policies, Google required partner toolbar downloads to be “opt-in” instead of “opt-out”. Meaning, typically when installing AVG software, if a user were to quickly click-through the installation process, they would likely end up installing the AVG toolbar and Secure Search program, as well as the primary security program that was the user’s original intent. This would happen since the installation program would have the boxes indicating interest in the toolbar already checked, such that the default is to install AVG Search. This type of “opt-out” theme was pervasive throughout the software (e.g. when uninstalling the software, the toolbar would remain installed unless specifically checked off to uninstall as well) and ultimately hurt the brand’s appeal.
The change to Google’s policy not only represented a threat to AVG’s search revenue business (since many users ultimately click through installation processes hastily and unknowingly install bundled software), but also sent the company’s short-interest soaring. Additionally, AVG was only partnered with Google at the time and shares soared when the company announced it had added Yahoo as another search partner. However, the addition of Yahoo was likely in response to management’s fears of a material deterioration in Google-sourced revenue.
In putting context around the Platform business, at the time, AVG’s growth was being led by Platform, which grew 92% and 64% in 2011 and 2012, respectively (vs. 5% and 12% for the subscription business in those periods), and 32% in the 1Q13 (vs. 21% for subscription). As a result, Platform revenue was becoming a greater piece of the business, going from 23% of revenue in 2010 to 45% in 2012. However, ultimately, this side of the business was not stable and provided significant uncertainty.
Adding to the uncertainty was the unexpected resignation of CEO JR Smith in March 2013, with no known explanation and no future employment plans in place (at least not known publicly). Understandably so, any CEO resignation, especially when sudden, brings uncertainty to the stock and sent shares crashing down at the time. In the interim, COO John Giametteo made the key decisions. In late July of 2013, Gary Kovacs, formerly CEO of Mozilla and with an impressive resume, was named CEO. Giametteo announced his resignation about a month later, though likely due to disappointment in not getting the nod. Regardless of Kovacs resume, capabilities, and vision, the movement and uncertainty definitely hurt the stock and caused many analysts and investors to move to the sidelines.
Ultimately, on the 3Q13 earnings call, management announced intentions to exit the third-party distribution aspect of the Platform business - which accounted for ~$40-50M annually, and consequently took down guidance significantly. Management cited the increasing competitiveness, poor margins, and bad PR as reasons for the exit. Of course, even though this was a shaky part of the business as it is, many sell-siders / investors viewed the Platform business as the real crown jewel of the company – a strong growth area and a tool for user base monetization that was accounting for nearly half of the company’s revenue and was the faster-growing segment. With the exit of a meaningful portion of the Platform business, those sell-side analysts that weren't already negative, turned negative.
However, the dynamics of the Platform business were always shaky, with it largely being dependent on the whims of search providers as well as essentially tricking users into installation – not exactly hallmarks or a rock-solid business. Additionally, due to the search revenue largely being dictated by what search providers are willing to pay, as search revenue mix shifted away from Google (towards Yahoo, etc), who pay the most, Platform segment margins progressively declined, going from 95% in 2010 to 75% expected for 2013 and likely into the 60s for 2014.
Of course, lost in all the negativity surrounding the Platform business, the strength in the subscription business went largely under the radar. While the stock has recovered solidly since the end of 2013 (+31%), the company has not gotten credit for the strength of its financial model and its successful business transitions toward 1) subscription 2) mobile 3) greater SMB mix. This is largely due to sell-siders harping on risks to the company’s growth story (concerning double-digit organic growth, deterioration of PC, ability to monetize mobile; see below), despite acknowledging the company’s cheap valuation and strong financial model and balance sheet, especially relative to peers.
Investment Positives:
Freemium Model Pioneer
AVG has done an excellent job making the freemium model work, having been able to monetize roughly 10% of its customer base. The existence of the large base itself has many positives, including 1) low customer acquisition costs 2) proof-positive of the company’s strong products / popularity 3) is a form of cheap marketing 4) creates sticky premium customers, since they really know the product and actively pay up for premium features and 5) provides a significant distribution channel and focus group for new and acquired technologies.
Highly-Rated Product Portfolio
See here: http://download.cnet.com/windows/avg-technologies-usa/3260-20_4-10044820-1.html
Shareholder-friendly Management
Management has shown it is willing to act on its strong FCF generation and not just hoard cash. Since 2Q12 (first full quarter after going public), AVG has bought back $89M worth of stock and reduced debt by $287M, compared to $304M in FCF generated during that time. Additionally, AVG has made $169M of acquisitions, though that amount is skewed by the recent acquisition of Location Labs ($140M paid upfront, up to another $80M possibly based on earn-outs). Management is clearly focused on using its FCF to generate shareholder value one way or another. I find this especially valuable considering AVG took on $225M in debt to finance the Location Labs acquisition - I am confident management will pay down the debt load if there are no other obvious uses for generated cash.
Potential as an Acquirer
As noted above and by management, AVG is a willing and able acquirer. While I don’t factor in any synergies to my projections, there is significant synergistic potential for the company’s tuck-in acquisitions based on AVG’s large and loyal user base.
Excellent Financials + Solid Balance Sheet
Putting aside growth for now, the subscription business generates gross margin in the mid-to-high 80% range, as does the Platform business following the exit of the third-party distribution business. FCF as a % of revenue has been consistently anywhere from the mid-20% to mid-30% range since 2010 - for the last 5 years, FCF as a % of revenue has been 35%, 26%, 29%, 32%, 25%. AVG is based in the Netherlands and carries an international tax structure that puts effective non-GAAP taxes at roughly 12.5%.
On the balance sheet, following the debt issuance for the Location Labs acquisition, AVG carries a net debt position of $84M, vs. market cap of roughly $1.2B. Prior to the acquisition, AVG was in a net cash position for the prior 5 quarters. The term loan AVG took out for the acquisition isn’t too expensive either, yielding L+375 with a 1% floor.
Cheap Valuation
See below
Why Does This Opportunity Exist?:
Multiple business transitions
As noted above, the company has had somewhat of a turbulent history as a public company and has grappled with transitioning the business in two major ways and one smaller way. While all these transitions have carried execution risk, I believe the company has shown enough to lower the level of assumed execution risk with these transitions:
Management Turnover
While this is not an ongoing issue once Gary Kovacs took over, the uncertainty hurt the stock in 2013 and the company hasn’t really gotten credit for the excellent job Gary Kovacs has done since.
Worries regarding desktop PC exposure
As noted above, this is a fair criticism, but PC declines are being more than offset by growth in mobile
Doubts surrounding Mobile
The execution risk on making Mobile successful is far lower now. The company has more mobile users than desktop, due to strong organic user growth and the Location Labs acquisition and should account for roughly 25% of subscription revenue by 2016
Sell-side Hate
Most sell-siders have been negative on AVG, including JPM (before Difucci left to join Jefferies), Morgan Stanley, Imperial Capital, and Cowen. JMP Securities and Nomura seem to be the only ones of note that have a buy on the name. Reading the reports, in my opinion, the concerns are generally very sell-side-ish, in that they center around the risks of big revenue growth, despite the cheap valuation (which nearly everyone acknowledges). Growthy names drive trading volume and commissions, long-term value stocks don’t. With the company’s excellent financial model and balance sheet, and without any real going-concern risk (the company is growing, just maybe not 20+%), I find that the company is being penalized for not being a sexy growth story. Ultimately, they generate a ton of FCF and are cheap by the bearish sell-siders own projections. As a result, they shouldn’t be trading at a meaningful discount to peers with worse margins and similar growth projections.
Risks to Thesis:
Valuation / Model:
The exhibits below provide my estimates and valuation. 2015 revenue estimates are based on management guidance. For 2016 and 2017 I assume conservatively that Platform will continue declining at comparable rates to 2015, while Subscription tapers off but remains above 10%. My Subscription estimate assumes mobile and SMB become ~35-45% of Subscription revenue by the end of 2016 and the consumer piece is flat to slightly up.
Margins, capex, and D&A are based on historical trends and tax rate and share count are based on 2015 guidance with no changes. Interest is based on roughly 5% interest rate on $225M in debt. I make no assumptions regarding future acquisitions, debt reduction, or buybacks.
Catalysts:
Buyout
Earlier in 2014, there were rumors of private equity take-out that boosted shares. Nothing came of it, but the fact remains that AVG would be a prototypical LBO candidate due to the company’s strong FCF generation and steady subscription business model.
What They Do With Excess Cash
While the company is certainly always focused on improving its product set, and thus R&D is a top priority, re-engage in share buybacks, even it elevated R&D levels, like in 2014 where it was 19% of revenue, AVG still generated more than $90M in FCF (25% of revenue). With ~$100M of FCF annually (and growing), and a management team with a track record of using its cash, I figure AVG will do something. While I don’t think a dividend is coming, I expect some sort of shareholder-friendly cash usage, be it debt reduction on the term loan used to finance Location Labs, more share buybacks, or more accretive acquisitions. I think acquisitions are more likely, but buybacks and / or debt reduction may accompany it.
Sell-side Upgrades
With several analysts holding non-Buy ratings, I think there is sufficient room for sell-side-based catalysts in the form of upgrades. The primary issues that analysts cite mostly surround execution risk on mobile, Zen, and SMB and the exposure to PC and Platform. As PC and Platform revenues continues to lose revenue share to stronger areas of the business, I think there is strong potential for sell-siders to come around. Additionally, sell-side upgrades could have a double impact of higher estimates + multiple expansion.
Potential Accelerators:
Catalysts:
Buyout
Earlier in 2014, there were rumors of private equity take-out that boosted shares. Nothing came of it, but the fact remains that AVG would be a prototypical LBO candidate due to the company’s strong FCF generation and steady subscription business model.
What They Do With Excess Cash
While the company is certainly always focused on improving its product set, and thus R&D is a top priority, re-engage in share buybacks, even it elevated R&D levels, like in 2014 where it was 19% of revenue, AVG still generated more than $90M in FCF (25% of revenue). With ~$100M of FCF annually (and growing), and a management team with a track record of using its cash, I figure AVG will do something. While I don’t think a dividend is coming, I expect some sort of shareholder-friendly cash usage, be it debt reduction on the term loan used to finance Location Labs, more share buybacks, or more accretive acquisitions. I think acquisitions are more likely, but buybacks and / or debt reduction may accompany it.
Sell-side Upgrades
With several analysts holding non-Buy ratings, I think there is sufficient room for sell-side-based catalysts in the form of upgrades. The primary issues that analysts cite mostly surround execution risk on mobile, Zen, and SMB and the exposure to PC and Platform. As PC and Platform revenues continues to lose revenue share to stronger areas of the business, I think there is strong potential for sell-siders to come around. Additionally, sell-side upgrades could have a double impact of higher estimates + multiple expansion.
Potential Accelerators:
| show sort by |
Are you sure you want to close this position AVG TECHNOLOGIES NV?
By closing position, I’m notifying VIC Members that at today’s market price, I no longer am recommending this position.
Are you sure you want to Flag this idea AVG TECHNOLOGIES NV for removal?
Flagging an idea indicates that the idea does not meet the standards of the club and you believe it should be removed from the site. Once a threshold has been reached the idea will be removed.
You currently do not have message posting privilages, there are 1 way you can get the privilage.
Apply for or reactivate your full membership
You can apply for full membership by submitting an investment idea of your own. Or if you are in reactivation status, you need to reactivate your full membership.
What is wrong with message, "".