Description

Investment thesis

Avid is a somewhat controversial name that is well-known from the VIC community. The company is approaching the end of its turnaround that we believe will finally highlight the significant free cash flow generation of the business and in all likelihood will herald a sale of the company in 2018. Over the last few years, the company went through a management change, a long accounting restatement, a change in business model and is now executing on a significant cost reduction program that should end towards the end of 2016. Pro-forma of its recent refinancing, AVID has an enterprise value of around $355 million and a market cap of around $240 million. The company shared some long-term guidance when they recently announced their Q4 results. 2017 EBITDA guidance is between $80 and $95 million and 2018 EBITDA guidance is between $90 and $105 million. The company also provides free cash flow guidance. 2017 free cash flow guidance is between $25 and $40 million and 2018 free cash flow guidance is between $40 and $60 million. If the company comes even close to reaching these numbers, the stock will be a homerun. Just as an illustration, if 2018 EBITDA is $75 million, $15 million below the low end of the company’s guidance, at a 10x multiple (which would be conservative in our opinion for a number of reasons including the fact that they won’t be a tax payers for years) and without assuming any FCF generation in the meantime, the stock would be at $16 per share, an upside of 150%. We think that the downside is limited here and the investment is a bet on the management team hitting its cost savings target.

Description and history of the company

Avid is a leading technology supplier to the media and broadcast industries. The company revolutionized the film and video post-production process in 1989 with the introduction of Media Composer, a digital nonlinear editing (NLE) system that allowed studios to piece together digital files to produce video content. Since that time, Avid has expanded into many verticals serving the media and broadcast industries including storage and server solutions (approx. 22% of revenue), media asset management (approx. 7% revenue), digital audio software (approx. 14% of revenue), live sound systems (approx. 10% of revenue) and notation software. The company has a good reputation and our calls with customers highlight the reliance of these customers on AVID’s products. The media and broadcast technology market is an approximately $65bn industry and is very fragmented. Avid’s current addressable market within the media technology industry is about $8bn and growing in the low-to-mid single digits. Through Avid Everywhere (more below) the company is expanding into adjacent markets that will increase the addressable market to approximately $20bn and provide an opportunity for higher growth. Other technology suppliers to the media and broadcast industry include Belden’s Broadcast Solutions segment (in particular Grass Valley), EVS Broadcast Equipment, Adobe Systems and Evertz (less of a comparable, but still some insight into the media and broadcast technology market). In Tier 1 (large enterprises) and Tier 2 (SMB), Avid has the largest market share as most media professionals are trained on AVID’s products.

In 2013, Avid hired Louis Hernandez as CEO and shortly thereafter was forced to delist in order to restate its financials due to software revenue recognition changes. The company relisted in late 2014 and has been executing on the new management team’s vision to transition the business from a perpetual license revenue model to a recurring subscription revenue model. As part of this transition, Louis introduced Avid Everywhere, a common services platform that digitally connects all the workflows in the media/broadcast value chain. Part of Avid’s strategy is to engage customers with this offering and then cross sell its solutions to its customer base. At the same time, the company is also engaged in a significant cost cutting program. We believe there is significant room for value creation as the company completes this transition over the next 18 months and emerges as a more profitable and higher quality business. As an illustration to that transformation, bookings are increasingly recurring which we believe make the company more valuable and the results less lumpy. 38% of full year bookings are recurring in 2015 from 18% in 2012 and 26% in 2014.

Avid currently benefits from high market share in its core markets and moderate switching costs in tier 1 and tier 2 markets where there is a level of standardization around its products. However, the historical perpetual license revenue model has many challenges. Because the industry is relatively mature, most product changes are incremental, forcing Avid to compete against its own installed base of products during new launches. Under the new license revenue model, Avid engineers will be able to integrate new features into the product in real time instead of being forced to wait for the next version upgrade. In other software providers, we have seen this dynamic lead to an increase in the cadence of innovation and the ability to more fluidly push price increases.  Perhaps most importantly, it will incentivize solution selling instead of point-to-point sales. In this industry, solution selling embeds the product deeper into the customer workflows which reduces the substitutability of competing point solution products. Adobe recently went through a similar business model transition and realized the benefits mentioned above as well as an increased addressable market due to the lower entry price of licensed products.

Cost savings program

The company has announced a $68 million cost cutting program to be fully in run rate by the first quarter of 2017. The cost savings come from a number of areas including 1. reduction in duplicate spending while Avid built out its MediaCentral Platform for Avid Everywhere, but still had to support its point of sales solutions (sale of individual products instead of the platform)  and 2. Rigorous facilities and personnel realignment. The CFO has experience with cost cutting exercise from his time at Open Solutions where he worked for Louis Hernandez. We understand from talking to management that they have gone line by line and have good visibility on the $68 million. The current CFO was previously the CFO of Open Solutions during the great recession where he had to do a lot of cost cutting so this is not the first time this management team engages in a cost savings program. Also private competitors have much better margins giving credence to the fact that there are significant cost savings.

Complicated accounting, financials and free cash flows

The company has complicated accounting and we will refer to the prior write-ups and Q&A to provide context. The company also has some presentations to explain the different issues. The main point to understand is that the company still needs to recognize pre-2011 revenue which flows 100% to the bottom line even though this revenue doesn’t have an economic reality at this point. This overstates the real economic EBITDA of the business. So in 2015, adjusted EBITDA was $55 million but pre-2011 revenue was also around that number implying that the real economic EBITDA was around zero. For 2016, the company has guided 2016 EBITDA between $60 and $75 million but there will be around $20 million of pre-2011 revenue implying economic EBITDA of $40 to $55 million of EBITDA. In 2017, most of that pre-2011 revenue will be gone and the adjusted EBITDA that the company has provided will be close to the economic EBITDA. We believe that this complexity is part of the opportunity as few investors take the time to understand what is going on.

Here is an illustrative EBITDA bridge from 2015 to 2017 (sorry for the formatting). As one can see, the bet at this point is mostly about the company being able to meet its cost savings target – we like to bet on things management has control over.

2015 Adj EBITDA                           55

pre 2011 revenue for 2015            -55

Cost savings                                 40

Revenue growth                             5

pre 2011 revenue for 2016            20

2016 Adj EBITDA                         65

 2016 Adj EBITDA                        65

pre 2011 revenue for 2016            -20

cost savings                                 25

revenue growth                           10

pre 2011 revenue for 2017            5

2017 Adj EBITDA               85

With current bookings of around $520m, we believe once the business model transition is complete in the middle of 2017, the company could be earning north of $1.25 in free cash flow per share and be worth substantially more than implied by the current stock price. This is not currently obvious because the financial effect of the transition to a recurring revenue model is to push out current sales and cash collection resulting in a temporary period of reduced cash flow generation.

One of the reasons the stock sold off so significantly in 2015 is because of the significant underperformance in cash flow generation compared to earlier expectations. The company generated negative $30 million of free cash flow in 2015. This happened because more customers switched to the subscription model (compared to earlier expectations) which put pressure on free cash flow. Also the operating environment across the industry was difficult which lead to bookings being pushed out, also impacting free cash flow. As value investors, we typically would not touch a company with this profile, however, the fact that most of the improvement comes from cost cutting (Avid has always been thought of as a bloated company and peers operate at significantly better margins) gives us a lot more comfort, combined with the attractive valuation and the strategic value of the business.

Valuation

We believe management projections are realistic and use these projections as a basis to value the business. If 2018 FCF is $30 million, $10 million below the low end of the guidance and applying a 15x multiple, one gets to $11 per share. Using 2018 EBITDA of $70 million and a 10x multiple yield a $16 stock price. The upside is obvious. The issue is the downside. Assuming the business is worth 10x EBITDA (which I think is justified for a business that will have an increasing proportion of recurring revenue and won’t pay taxes for years), the current enterprise value of $370 million implies a 2018 EBITDA of around $37 million versus the company’s guidance of $90 to $105 million of EBITDA. Given that the economic EBITDA is currently around zero for 2015 and they have announced a $68 million cost savings initiatives, I think that achieving $37 million should be pretty doable. Also it is important to note that the company just raised debt so that it has the runway to go through this transformation.

Potential M&A target

We wouldn’t be surprised to see market consolidation and a sale of the company once the transformation is done. The CEO sold its prior public company Open Solutions to private equity in 2007 and then sold that Company to Fiserv in 2013. He was also a board member of Unica, a public company that was sold to IBM. Our channel check indicates that the CEO is a very commercial guy and, is not emotional about his companies and will sell at the right time and price. The Company recently added his largest shareholder Blum Capital on its board. Blum owns around 20% of the Company and will likely also favor a sale at the right time. For example, Belden Inc., a large competitor has been acquiring companies in an effort to consolidate the market and exert increased negotiating leverage on the larger media and broadcast entities. While we are not underwriting this event, Avid’s product suite could make a good addition to Belden’s portfolio and result in an attractive premium for investors. Once the company has switched to a recurrent revenue model, other companies like Adobe may also be interested.  

Catalyst

1. company starting to generate real FCF in 2017

2. sale of the company in 2018 (hopefully!)