AVG TECHNOLOGIES NV AVG
March 07, 2015 - 7:59pm EST by
Condor
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 $M): 84 EBIT 0 0
TEV ($): 1,259 TEV/EBIT 0 0

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  • Technology
  • Software
  • Europe
  • freemium model
  • Recent IPO
 

Description

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:

 

  1. Subscription (~75% of 2014 Rev) – AVG upsells premium features to its customer base on a subscription basis. While only a small portion of the company’s overall user-base pay for premium features (roughly 10%), the number of subscribers (along with the number of users) is growing and the business model itself provides for extremely low customer acquisition costs. Additionally, paying customers are generally highly sticky, since they are intimately familiar with the free product and actively choose to subscribe to premium features (vs. getting McAfee or Norton based on what the PC came with).

 

  1. Platform (~25% of 2014 Rev) – AVG offers its LinkScanner software, which provides an internet user with threat information when searching the web. The software IDs safe vs. questionable vs. dangerous links, allowing users to avoid potentially harmful sites. The technology is employed when searching the web via:

 

    1. AVG’s web browser toolbar (either via direct download or via bundling with third-party software downloads, for which AVG pays the third-party an upfront fee for the bundling).

 

                                          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).

 

    1. AVG’s search website.

 

    1. By making AVG the default search provider. AVG’s search partners (currently Google, Yahoo, and Yandex out of Russia) pay AVG based on sponsored links / ad clicks.

 

    1. AVG also generates revenue by selling information it gathers from its security software to Microsoft and VeriSign

 

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:

 

  • Away from Platform, Toward Subscription - This was always preferable for the company and the only issue was the difficulty of dealing with the transition. However, with AVG management guiding to ~12-13% overall revenue growth for 2015 (including 25% growth in subscription, of which ~10% is organic), the transition period is largely over. Even with Platform continuing to decline probably into 2016-2017, that part of the business has largely reached its floor and the size and growth of Subscription has put the company back to a net grower.

 

  • Away from Desktop, Toward Mobile - This was one of the primary issues sell-siders have been harping on. The desktop business has suffered, in-line with secular trends away from PCs and towards mobile devices. Once again, AVG was on top of this transition early-on, investing in its mobile platform through development, acquisitions, and AVG Zen, which transformed discrete products from AVG into a singular, multi-platform offering. This has allowed for the easy transition of existing desktop users over to the mobile side. As a result, AVG has been able to grow its mobile user base from 26M users at the end of 2012 to 101M users at the end of 2014.

    Additionally, mobile revenue now accounts for more than 10% of total revenue and is expected to account for $50-60M in bookings in 2015 and more than $100M in 2016. Mobile users now account for the majority of the customer base. Once again, like the Platform-to-Subscription transition, while there is still more room to go, AVG has proven that its Mobile business is a winner and the growth in Mobile is more than offsetting declines in desktop (user growth was up 11% overall in 2014)

 

  • Greater SMB Mix - In expanding the company’s business channels, AVG has ventured into the SMB space, which carries much stronger business characteristics than consumer, including higher ASPs, greater stickiness, strong secular drivers (SMB and enterprise security vendors are raking it in, especially with a security breach hitting the headlines every few weeks), and far greater monetization dynamics (i.e. its all monetized). While SMB is currently ~16% of revenue, its growing at a high-teens rate (19% in 2014, vs. 11% for the consumer subscription business).

 

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:

 

  • Dramatic desktop drop-off, as Zen stalls and paying subscribership dwindles
  • Mobile monetization stalls
  • Platform falls even more than already low expectations
  • Acquisitions blow up
  • Sit on cash or pump it all into an R&D black hole

 

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.

 

AVG Model

 

AVG Valuation

 

AVG Comps

 

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:

 

  • Potential synergies from Location Labs and other acquisitions
  • Greater monetization on the mobile side
  • Better-than-expected platform results
  • Stronger-than-expected SMB growth (where they can take advantage of an underserved market with very strong secular growth drivers)

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

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:

 

  • Potential synergies from Location Labs and other acquisitions
  • Greater monetization on the mobile side
  • Better-than-expected platform results
  • Stronger-than-expected SMB growth (where they can take advantage of an underserved market with very strong secular growth drivers)
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    Description

    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:

     

    1. Subscription (~75% of 2014 Rev) – AVG upsells premium features to its customer base on a subscription basis. While only a small portion of the company’s overall user-base pay for premium features (roughly 10%), the number of subscribers (along with the number of users) is growing and the business model itself provides for extremely low customer acquisition costs. Additionally, paying customers are generally highly sticky, since they are intimately familiar with the free product and actively choose to subscribe to premium features (vs. getting McAfee or Norton based on what the PC came with).

     

    1. Platform (~25% of 2014 Rev) – AVG offers its LinkScanner software, which provides an internet user with threat information when searching the web. The software IDs safe vs. questionable vs. dangerous links, allowing users to avoid potentially harmful sites. The technology is employed when searching the web via:

     

      1. AVG’s web browser toolbar (either via direct download or via bundling with third-party software downloads, for which AVG pays the third-party an upfront fee for the bundling).

     

                                              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).

     

      1. AVG’s search website.

     

      1. By making AVG the default search provider. AVG’s search partners (currently Google, Yahoo, and Yandex out of Russia) pay AVG based on sponsored links / ad clicks.

     

      1. AVG also generates revenue by selling information it gathers from its security software to Microsoft and VeriSign

     

    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.

     

    AVG Model

     

    AVG Valuation

     

    AVG Comps

     

    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:

     

     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    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:

     

    Messages


    SubjectRe: Industry Dynamics
    Entry03/09/2015 07:45 PM
    MemberCondor

    So I want to respond by addressing the key points embedded in your post:

    Anti-Virus (AV) as a Commodity Business / Low Barriers to Entry

    I agree it’s largely a commoditized business with low barriers to entry. In fact, I’d say it’s not much different than any other consumer-staples product, be it baby wipes or razor blades. The barriers to entry are low, but the flip side is there also must be impetus for change. Further, with any consumer staple, when there actually is impetus for change, or when people are picking for the first time, there is often a skew toward 2 things: 1) cost; and 2) branding.

    As you point out, premium products are priced comparably, so there is no pay-up for AVG vs. competitors. However, more importantly, AVG has probably the most recognizable brand outside of McAfee and Symantec for PC and probably even greater brand equity than those 2 in mobile. This leads me to…

    How the Average User Chooses AV

    I disagree with your assessment of how the average user chooses AV, mostly based on reading enough reviews and review websites. While I agree that the average user is not looking to compare the nitty gritty of each provider, I do believe that they look at 2 things: 1) user ratings; and 2) downloads. It seems pretty well accepted that AVG has tremendous brand recognition in the AV space based on reading reviews across multiple websites, including one that used the tagline “Everyone knows AVG” as AVG’s defining factor.

    AVG’s products are highly-rated, even if not number-1, which I don’t believe matters for 2 reasons: 1) I’m not sure people care too much about an 8.5/10 vs. 9/10; and more importantly 2) if you actually look at the differences between the top-rated products and AVG, the issues are generally negligible and not really noticeable or relevant to the average user. I think the ratings relate that it’s a solid product and the huge disparity in downloads (AVG’s downloads are in the millions and most competitors are in the thousands) lends greater credence to the rating number and provides comfort to someone who doesn’t really no the difference and just wants a basic AV product that won’t screw up his computer (i.e. “everybody has it, it must be a good product”).

    Additionally, I don’t believe there is enough impetus for change even assuming minimal brand equity, since AVG’s ratings aren’t crappy, they just aren’t the highest from a technical perspective (see below).

    Finally, it’s easy to say “anyone with the marketing budget” could overtake AVG, but AVG’s sales and marketing expense rivals (or significantly outweighs) what guys like F-Secure or BitDefender make in revenue. Meanwhile, the big guns (INTC, CHKP, SYMC) aren’t exactly tripping over themselves to invest more into consumer-grade security.

    How the Sophisticated Users Chooses AV / Quality of AVG vs. Competing Products

    I agree that more sophisticated users are probably looking at the nitty gritty and are more likely to choose a BitDefender or a host of other options. However, it’s important to realize why one gets rated over the other. Generally, there are 3 areas that most reviewers judge: 1) features; 2) performance; and 3) customer service. In terms of features and service, AVG is generally rated comparably with others. In terms of performance, they are usually under the top of the field based on false positives. In short, the reason why AVG is rated below others is less that AVG is bad and more that others are really good. However, I think 1) most users don’t care and go with what they know (the AVG brand); and 2) in many scenarios (particularly on the mobile side), AVG has more features than most competitors. I haven’t found a review site that felt that AVG’s mobile product features were deficient compared to others, while several have noted that AVG had an absurd (in a good way) amount of mobile features.

    Margin Deterioration

    Margins have moved inconsistently up and down by a few hundred basis points every year, so its difficult to point to that as a definitive sign of them struggling in any way from a pricing or customer-addition perspective. First off, gross margins are actually better than they have been in the past, so its difficult to cite pricing pressure. Second, on a dollar basis, the biggest move in opex since 2012 has been in R&D, and rightfully so as the company has been working on its mobile and SMB products. Sales and marketing, which is what I would look at if I were to claim that they were struggling to keep customers, has barely moved on a dollar basis in 2 years ($92M in 2012, $96M in 2013, and $97M in 2014). I’m not sure I draw anything from a little margin fluctuation (especially when margins are still very high relative to comps and on an absolute basis) other than the fact that they are working on new products and customer sets (i.e. mobile and SMB).

    A Few Other Things

    Market Share – If you look at historical market share numbers from OPSWAT, which I wouldn’t necessarily take as gospel, but are a solid indicator (https://www.opswat.com/resources/reports), you’ll see 2 things: 1) AVGs market share hasn’t really fluctuated much over the last few years (roughly 9%); and 2) Companies like BitDefender have been around way longer than you realize and have failed to materially eat away at AVG’s market share. In fact, AVAST seems to be the biggest player outside of MSFT, SYMC, and INTC (larger share than AVG), though that’s old news and they haven’t eaten away at AVG either.

     

    Mobile is a New Market – Within the mobile market specifically, I find it difficult to make the argument that AVG is an incumbent that higher-rated newcomers will eat away at, for the simple reason that the mobile AV market is brand, spankin’ new, with AVG entering in 2011. Basically anyone involved in the mobile market today was involved when AVG got involved, yet AVG still has grown its mobile user base at an astounding rate and has, by far, more downloads than almost everyone (including the usual suspects you might quote) at last check on Google’s app store. In fact, using BitDefender again as a proxy for a highly-rated competitor – AVG has nearly as many PAID downloads (26,343) as BitDefender (27,135) has free downloads. I think that says a lot about AVG’s brand equity in a new market. (In case you’re wondering, AVG’s free mobile AV product has ~3.2 million downloads; AVAST has ~2.5M for its free product, which also carries a higher technical rating.)


    SubjectAgree, a few other comments
    Entry03/10/2015 12:14 PM
    MemberSlackTide

    Condor, we agree with the write up and believe the points Dali is making are very well known and already embedded in the stock price.

    A few other things we believe are worth pointing out:

    1) Their autorenewal program is going extremely well, if you believe the CFO. First he cited "strong renewals on the desktop business" early in the call, then elaborated that the acceptance for auto-renewal had reached "high 80s, approaching 90s", up from mid-70s.  While those can fluctuate, if you're getting 90% of subs to check the auto-renewal button there is a little more visibility on future revenues.

    2) While PCs are in secular decline and we don't think anyone pitching AVG would argue for major PC desktop user growth, there is a mini-secular tailwind for AVG occuring within PCs if you buy that the PC replacement cycle is elongating.  Basically for AVG, whenever someone buys a new replacement PC, it's at best a neutral event for them.  At worst, they have to go out and reacquire the customer since they aren't shipped with the OEMs.  So...as people hold onto their PCs longer and longer, not only does their PC TuneUp product become more useful (BTW, a material part of op income now), they have to acquire new customers less frequently.

    3) Margins are fine.  In the last quarter, there was some acquistion related noise, but they reiterated at least 30% operating margins, which they did last year and soundly beat.  Their SMB biz will have lower margins, maybe that is what Dali is referring to.

    4) Although it's a little early to call, they have at least appeared to stabilized their Search business, which was the source of all the hand wringing and anxiety from sell side.  Sell side has now turned to being skeptical about their mobile revenues, which strike me as pretty conservative given they are just a little above their acquisition's run rate.


    SubjectRe: Downside
    Entry03/10/2015 07:33 PM
    MemberCondor

    Because I don’t know how to write short responses, I’ll start with the quick answer. My downside scenario is something around $16.50 or about 25-30% downside from here.

    The way I get there is by looking at the different core components of their revenue, in my opinion – mobile, SMB, desktop consumer and Platform. In a downside case, figure desktop consumer declines roughly 15% / year (I estimate it at roughly $280M now), as opposed to my current assumption of around 0-8%, which would put it at around $200M in 2016. Figure Mobile growth expectations of going from $50-60M in 2015 to $100M in 2106 are too rich, and they end up at $75M. Remember, they did $11M in mobile revenue in Q4 and that’s only including a piece of Location Labs, so they are basically already at a $50M run-rate and I don’t see existing subscribers leaving unless something goes horribly wrong, in which case the thesis may be broken. On SMB – which was up 19% last year – lets assume considerable deceleration and it ends up at $70M for 2016 (9% 2-year CAGR). Finally, add on about $40M from Platform.

    To review: $200M (Subs) + $75M (Mobile) + $70M (SMB) + $40M (Platform) = $385M in 2016 Revenue

    Non-GAAP op margin of 30% = $115.5M

    Less $11M in interest expense = $104.5M

    Less taxes at 12.5% = $91M

    Non-GAAP EPS = $1.74

    9-10x P/E gets you about $16.50, or about 25-30% downside from here (for the record, I started building my position at around $17). For what it’s worth – and I’m the farthest thing from a technicals guy, but the stock hasn’t gone below $16 since 2013 and there seemed to be a floor at the $16 range in the last 12 months whenever things seemed a bit rocky.

    My response to your thinking is that, first of all, downside needs to be properly defined, because there is a difference between a bear-case and Armageddon. With any investment, there are situations where you enter an “all bets are off” scenario that’s beyond the pale of bear-case / downside scenario. For example, its always possible that a company goes bankrupt and the equity goes to zero, but that doesn’t mean I’m modeling that scenario into every idea I have. That’s an accepted risk of not investing in t-bills.

    In this case, I think your downside assumptions are too strong. First, Platform going away I think is going overboard. As it is, the fact that I model 3 consecutive years of 25% declines is likely overboard, considering there are absolutely no indications that its in a free-fall / run-off scenario, just that the third-party distribution business is gone. I don’t think its fair to casually toss away a segment as a “downside case”.

    Secondly, 5% annual declines, a-la SYMC is also inappropriate in my opinion. Why? Because, at the very least, some of SYMC’s declines are due to share loss to AVG (if not more than “some”), so the only scenarios in which both AVG and SYMC are declining like that is if A) the consumer security market goes to hell; or B) another consumer player takes share from everyone. While both are theoretically possible, disintegration of the consumer market is certainly an “all bets are off” scenario to me. Similarly, a new player or new product that doesn’t yet exist entering the market and totally dominating the market to the extent that growing market leaders begin dramatically declining is another theoretical risk that I have no tangible basis for entertaining as a possibility. Further, if subscription was all-of-a-sudden falling 5% for several quarters (when guidance is for 25% growth in 2015), my thesis would likely be broken long before 2017 numbers were in-play.

    I also take issue with is your margin and tax rate – non-GAAP op margin is consistently at or above 30%, even in the worst of years, so I have no reason to believe that it would drop to 20.5% even in a downside scenario. On taxes, management has been clear that it models a 12.5% non-GAAP tax rate. The 30% I have in the top of my model is GAAP, but I model the non-GAAP rate in the EBITDA / FCF section.

     

     


    SubjectRe: Another question
    Entry03/10/2015 07:40 PM
    MemberCondor

    The general income statement is done on a GAAP basis and converted over to non-GAAP EBITDA (and FCF) in the EBITDA/FCF section. If you back out non-acquisition-related D&A (which I model as about 4% of rev), you'll get an approximation of non-GAAP op income, which would come out to 28% margin in 2015, 31% in 2016, and 32% in 2017.


    SubjectQ1 Earnings
    Entry04/30/2015 11:06 AM
    MemberCondor

    For details, see the release and transcript. In general, AVG put up a strong quarter (stock is +10% thus far today), beating exepctations for the quarter, but more importantly, providing good news and implied guidance for the key catalyst areas - subscription in general and both mobile, and SMB. Users continue to grow overall as mobile user growth offsets desktop declines. Plus, even with the desktop declines, desktop consumer revs were about flat.

    I'm happy to answer further Qs, but all-in-all, strong quarter and outlook and the key points of the write-up remain in effect (and are progressing).

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