|Shares Out. (in M):||55||P/E||0.0x||0.0x|
|Market Cap (in $M):||1,065||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||14||EBIT||0||0|
For reasons I will explain below, I think there is a good short term long opportunity in this stock as its very high short interest is likely to come down meaningfully and relatively quickly. Even if I put in very conservative assumptions into a DCF, I cannot generate a valuation that is not AT LEAST 100% upside from here (assumptions for DCF highlighted in the last paragraph below).
AVG is a consumer and enterprise software company that operates using a “freemium” model. In 2012, the company grew Adjusted EPS 37% on 18% sales growth. Despite this growth and consistently beating expectations (the average EPS beat vs Street over the last 5 quarters has been close to 50%), the stock currently trades at less than 10x NTM Street Adjusted EPS. Free cash flow per share has historically been higher than EPS primarily because of the company’s growing deferred revenue balance (subscribers generally pay ahead of revenue recognition). As of the middle of June, the short interest as a % of the float stood at 33%.
The company’s main product offering is free antivirus for desktop computing. AVG primarily monetizes its user base by upselling subscriptions to a portion of its users and through a product called “secure search.” Users of the antivirus software can download a toolbar so that AVG becomes the default search provider. As users click on advertisements, AVG gets a revenue share with the search engine company that is providing the search results. The bear thesis largely revolves around this search business. A good writeup that summarizes the bear thesis can be found here:
Immediately after this article came out, AVG’s short interest jumped from just 751k shares at the end of January to over 8.5m shares in mid-April. The Company significantly beat Q1 expectations when it reported results on April 24th and as I will argue below, the short thesis seemed to have largely played out but the short interest remains very high at 7.9m shares.
In q4 2012, almost all of AVG’s search revenue came from its Google partnership. In February, Google made a policy change so that all new downloaded toolbars needed to be “opted in.” Bears were correct in concluding that this would change would force AVG to move all new users to Yahoo, which still has an “opt-out” policy. However, they were incorrect in the financial impact this would have. Bears argued that since Yahoo monetizes search significantly (up to 50%) lower than Google, AVG’s search related revenue would have a sharp fall. This argument made sense at the time, but the evidence does not support the bear case. In Q1, the company reported that Yahoo represented 9% of search related revenue. Moreover, AVG said that Revenue per Thousand Searches (RPM) stayed flattish sequentially and guided for this to be the case for Q2. The bears are failing to recognize the fact that while Yahoo likely monetizes less, Yahoo’s new management views getting increased scale in search as strategic and is very likely giving up more in revenue share than Google was. I estimate that AVG’s revenue per search is only about 15% less than what it was getting with Google. If it is much lower than that, then RPM would not have stayed relatively flattish sequentially. This estimate has also been confirmed by talking to other toolbar companies. Moreover, if one looks back to the 1st half of 2010 when almost all of AVG’s search business was with Yahoo, the RPM was in the $16-17 range vs the $21 RPM it had with Google in q4 2012. Based on conversations with several people in the industry, I think it is highly likely that AVG’s current RPM with Yahoo is much better than it was in the first half of 2010. First, Yahoo has improved monetization since then. Second, AVG has much more leverage since it has many more users. Third, Yahoo has new management who wants to take share from Google and who views increased scale in search as strategic. While it is true that AVG would have been economically better off if Google did not do the policy change, it does not appear that the lower monetization with Yahoo is enough for the company to miss estimates and at sub 10x FCF, the company needs to miss estimates significantly for the shorts to make money. When the company beat EPS expectations in q1 by over 50%, AVG left full year guidance largely unchanged. This effectively brought down search revenue expectations for the rest of the year and was the impact of the Google policy change. This should become even clearer when the company reports results for Q2 which will be the first full quarter following the Google policy change. The CFO has recently been meeting investors in NYC. In my experience, top management that takes the time to visit investors in the last week of a quarter is much less likely to miss expectations especially when the company has never missed expectations in the past.
While the new Google policy has already impacted Street numbers, there are several sources of large upside optionality that will also become clearer to bears as we progress through the year.
1) AVG has 36m mobile users as of q1. These mobile users grew 100% y/y (83% organically if you adjust for an acquisition). The company is currently not monetizing these users and the Street does not seem to be incorporating any revenue from mobile even for next year. AVG has said that it will start to monetize these users in q4. AVG’s mobile products have gotten great reviews for products such as AVG Security (http://bit.ly/avsec) and AVG Battery Saver & TuneUp (http://bit.ly/avtuneup), both of which received 4.5 out of 5 stars on Google’s app store. In addition, given the privacy climate created by the government’s PRISM project, AVG’s Do Not Track (DNT) functionality has attracted a lot of users to their mobile offerings. I estimate that the company could have close to 95m mobile users by the end of the 2014. In q1, 2013, the company generated $56.6m of subscription revenue from an average of 117m desktop users or close to $2 in annual subscription revenue per desktop user. Even if the company can monetize mobile users at just 10% of the rate it does on desktop, this could imply at least 3% upside to Street revenue in 2014 and because the incremental margin on this revenue would be extremely high, it could imply well over 10% upside to Street 2014 EPS.
2) AVG continues to do well with improving its monetization of desktop users. The company’s desktop subscription revenue growth has accelerated over the last 5 quarters and was 54% of total revenue in q1 2013. This happened despite the fact that desktop users declined sequentially over the last 2 quarters as Google’s toolbar policy change also impacted customer acquisition. I expect that desktop user growth will go back to growing sequentially. After all, AVG is offering a good free alternative to existing Antivirus products on the market and still has a relatively low share of the total PC installed base. PC sales have been weak which is great for AVG as new PC’s are often loaded with trial antivirus from Symantec or McAfee. An aging PC installed base is also good for AVG’s newer Tune-Up products, which appear to be doing well. The company plans to break out Tune-Up users on its next conference call, which implies that it has become material. In q1 2013, the average paying desktop subscriber paid the company at an annualized rate of $15.09, which was up from $12.43 in q1 2012. Given that the company seems to be pushing its security suite, which is priced at $40, there seems to be a fair amount of room with this variable to continue to rise.
3) The company recently made an accretive acquisition of LPI which will add $5m of revenue in the 2nd half of 2013. This deal further diversifies the company away from search related revenue and also does not seem to be factored into Street estimates yet.
4) Finally, since the company is domiciled in the Netherlands and has such a large and growing user base that can be cross-sold other products, it is possible that it could be an acquisition target for one of the many Technology and Internet companies that have a lot of overseas cash.
I am not arguing that many of AVG’s users likely unknowingly opt-in to AVG’s secure search products. However, while the company may do some unpopular things with its search related business, the short thesis appears stale and the short interest has surprisingly stayed high despite obvious evidence that point to the fact that the overall revenues should continue to grow quite healthily. This should become clearer after the q2 results and if shorts have not covered by q4, they will likely cover as we get closer to the big upside optionality of monetization of mobile users. The CEO’s resignation is concerning but the company is likely past its hyper growth phase and it seems like he just wants to do something more entrepreneurial. He has not sold any shares and has not even initiated a 10b5-1 plan. Moreover, he will stay on at the company as an advisor.
In my DCF, I assume that 2014 search related revenue declines slightly as we cycle through the lower monetization from Yahoo vs Google (I model a 25% per quarter churn rate for Google toolbar users vs the 15% churn rate used by the bearish analyst in the article mentioned above). However, search revenue should then go back to growing at least in the low single digits in 2015 and beyond. The company has said that it plans to generate platform revenue in other ways than just search such as ecommerce and advertising. I have not factored any of this. I model desktop subscription revenue growth to decelerate from 21.5% y/y growth in q1 2013 to the low teens in 2015 and single digits thereafter. If you play around with the key variables (% of active users that pay and revenue per paying subscriber), it is very difficult to even envision this level of deceleration given historical trends. I expect that by 2018, they get to the same number of mobile users as desktop users today – again a very conservative assumption given the current growth rates of mobile users. I also assume that by 2018, the company generates about 40c in subscription revenue per active mobile user (vs about $2 and rising in subscription revenue per active desktop user today). I use a 30% ebit margin in my terminal year vs the 37% ebit margin that was reported in q1 2013 and 33% historical ebit margin. I fully hit the company for options expense as if it were a cash expense and do not give credit for the positive change in deferred revenue. Finally, I use a 10% discount rate and a 10x terminal multiple. I think a 10x terminal multiple is very conservative especially since I expect in just a few years, the vast majority of revenue will be coming from subscription revenue. The company’s auto renewal rate on subscriptions was at 77% last quarter and has been consistently rising (it was just 44% in 2011). With all these conservative assumptions, I still get AT LEAST 100% upside to the stock.
I welcome any comments from people who are short to understand what I may be missing.
|Subject||domestic vs. international|
|Entry||06/27/2013 05:19 PM|
Thanks for posting an interesting idea. I actually saw that article back in December, did some work on the company and ended up buying the stock although I am out of it now. I think a decent part of the move from 13 to 19 was the shorts (who I do believe are wrong) feeling the squeeze, although I have been puzzled that the short interest has not gone down since like you say the early indications are that the severe short thesis is not playing out. PERI and IACI are affected by the same Google policy changes (although IACI does not seem to be complying yet) and like AVG they guided for continued growth- albeit notably slower than the last couple of years- in 2013.
One caveat though- contacts I spoke to said that inside the U.S., Yahoo/Bing monetizes decently well (maybe 60-70% of Google) and could be even better if AVG got an aggressive deal as Yahoo tries to gain search share. However, I've heard that internationally Yahoo is sometimes only 25% of Google's monetization and AVG has a lot of international users. AVG mentioned in its first quarter call that it did a campaign to recapture users during the first quarter and I'm pretty sure they did so before the new Google rules went into effect, adding a bunch of Google users right before the bell.
Therefore, I think it is possible that Q1 was the high water mark (at least for a while) in search/platform revenue. I do agree with you that even if search revenue has peaked, the shorts need a significant decline to get paid and I tend to doubt that is going to happen. This company has a growing subscription business and can emphasize that part more if search gets tough. I model search as flat in 2014 with continued growth in subscriptions and valuation-wise the stock could be quite a bit higher, but this leaves my revenue number lower than the St. for 2014. I don't know what that means for the stock, but once again it seems like things really have to fall apart for the bears to make money.
One point for the bears- the CEO resignation (though he's still on the board) is a little troubling. Any theories as to why the CEO left or who might replace him?
Another potnetial positive is the fact that the company is still controlled by TA Associates and another private equity firm. Obviously their ownership is an overhang but while they are driving the bus the company is likely to do shareholder friendly things.
|Entry||06/28/2013 02:23 PM|
Interesting idea and good write-up. A few questions:
1. Re: valuation - you use a DCF to get "at least 100%" upside, but what do you think the appropriate NTM P/E should be if the current 10x is too low?
2. You talked about the high renewal rates on subscriptions. There was a risk factor in the company filings about the EU potentially restricting auto renewals starting in 2013. Therefore, do you think there is any risk to the renewal rates? Or said another way, are consumers happy enough with this product that they will renew even if it isn't set on auto pilot?
3. Just curious, why does their corporate logo look like a total rip-off of the Microsoft logo flipped around?
|Subject||RE: Few questions|
|Entry||06/28/2013 04:56 PM|
1) fcf multiple is probably more relevant since FCF has consistently been higher than net income. on my numbers AVG trades at about 9x 2013 and about 7.5x 2014 FCF including options expense and I think the top line can continue to grow in the double digits for the foreseeable future. normally, for a company with that growth rate, I would argue for a mid to high teens multiple, but there are 2 things that limit that. first, there is a risk (although very low in the medium term) that YHOO one day also goes with an "opt out" policy. Second, the search product is not popular with consumers. 3rd, search is holding back total revenue growth in 2013 and 2014. So today, I would say it should probably have a multiple around 12-14x, but i think overtime as the search business becomes less relevant and as mobile starts to drive growth and the renewal rate on subscriptions gets above 80%, the multiple should expand.
2) its my understanding that auto renew is "opt-in". its also my understanding that AVG even for subscribers that have opted in to auto-renewal, AVG that sends an email before charging them again to make sure they want to actually renew. the subscription products also generally have decent reviews and are priced competitively. therefore, i don't think the potential EU ban is a big risk.
3) no view on the logo.
|Subject||RE: RE: Few questions|
|Entry||06/28/2013 04:58 PM|
sorry for the typos by the way. just re-read what i wrote. its Friday, but i have started drinking yet so no good excuse.
|Subject||RE: RE: RE: Few questions|
|Entry||06/28/2013 06:21 PM|
Haha . . . thanks for the replies.
|Entry||06/30/2013 08:22 PM|
Definitely correct with respect to search but I believe that is why you have it at this multiple today and one of my arguments is that over time the business will look less parasitic. The reviews for a lot of the subscription products, especially the new mobile ones, are actually decent and more people are opting into auto renew for them. That being said, would I be as interested if the short interest was not so high and the bear thesis so obviously flawed - probably not.
|Subject||IACI and BBYL IT results confirm AVG thesis|
|Entry||07/31/2013 02:01 PM|
BBYL IT - another company that gets most of its revenue from search toolbar related revenue reported strong results overnight. IACI also reported strong search revenue and specially stated, "Yahoo and some of the other guys have really stepped up and made competitive offers to Google which a lot of Google’s partners have chosen to take."
|Entry||08/02/2013 08:14 AM|
As I expected, AVG's subscription revenue offset weakness in search and unlike what the bears expected, search results are still growing. Moreover, the company specifically stated that revenue per search went UP in the Q which implies that the deal they have with YHOO is comparable to GOOG. the company also increased FCF guidance for the year. I believe the bears have now gotten their catalyst. they have seen what a full quarter of the google policy change has done to the search business and it is nowhere near as bad as they thought it would be. Moreover, I think part of the deceleration in search is temporary as the company had an email campaign in q1 to drive that part of the business and will likely do another email campaign in q3. The company also likely promoted subscription products vs search to users which is what you want them to be doing. again the deceleration in the Q was NOT revenue per search but the number of searches, which is more in the company's control and related to what products it choses to promote to its users. In summary, I still think the high short interest is unwarranted. the company is transitioning to a more predictable subscription business and this transition will accelerate as mobile products start to get monetized next year. the transition should result in a higher multiple. the only negative i see is that the revenue guidance appears more back end loaded, but I also think that q3 revenue guidance is very conservative. The implied EBIT margin guidance also appears very conservative relative to what they have been doing. at less 8x EV/FCF for a business that is still growing nicely, it is difficult to understand what shorts are thinking. Would be interested to hear from bears on where I am wrong.
|Subject||RE: RE: AVG results|
|Entry||08/02/2013 11:15 AM|
waiting to talk to the company to finalize my model. will share after but I believe that the q3 revenue guidance seems easily beatable and the 2nd half ebit margin guidance also appears very conservative. i think what people are missing is that the company choses what to promote to its users so looking at search vs subscription may not be the best way to look at it. they are trying to optimize for total revenue, life time user value when they decide on their marketing investments. they could have put up higher search revenue if they wanted and come in line on subscription but that is obviously not most optimal thing for the business.
|Subject||RE: RE: AVG results|
|Entry||08/02/2013 01:29 PM|
tyring to keep an open mind but with respect to your points:
the transition to mobile is also an opportunity. 45m mobile subs that are currently not being monetized. you have to remember that AVG has a relatively small share of the total desktop installed base and the desktop installed base is still growing and most of that incremental growth will be with be with users that better fit AVG's typical customer profile. they are having to pay more for distribution but that is a long term trend impacting most internet companies. it is not a reason to short and should not not cause a cliff in earnings power. even if google cancels the contract, that would only impact new search users vs current users that are using a toolbar powered by google. AVG is transitioning most new users to Yahoo anyway and the economics with their YHOO deal seems comparable to what they are getting on Google. it just signed up Yandex as a partner and will probably also set up a relationship with Bing. I haven't met the new CEO so cannot comment much on him. However, Mozilla seems to have done relatively well when he was there. I have met with the CFO and think he is very competant and has a history of setting low expectations that they beat. they have beaten EPS expectations every quarter since they reported by at least 20% and with a new CEO they probably had a little more incentive to be conservative.
|Entry||08/12/2013 10:11 AM|
after thinking more about this idea and doing some more work, I have decided to exit. While I still think it is cheap and the high short interest is unwarranted, I am less confident in a near term catalyst to squeeze the shorts further given what PERI just reported and the back-end loaded guidance for the full year. The idea was always more of a trade vs investment and I think I got a good portion of the short covering I was looking for over the last couple of months.