As the use of the internet expands in our technology driven world our security will be under increased risk. Mobile banking gives criminals avenues through mobile into easy cash among many other dangers on smartphones utilizing the internet. Along with an increased need for mobile cyber security, security for the PC which was once considered unnecessary is now practically required. Longer PC lifetime cycles also increase the need for clean up and performance products. Alas, trading at a significant discount to intrinsic value AVG Technologies(AVG) provides internet security products for individuals and stands to benefit from the aforementioned trends.
Through a “Freemium” distribution model AVG has acquired a base of 172 million active users, described as users who have contacted them AVG in the last month. From these users they can offer paid subscriptions and acquire revenue attributing customers at a close to zero cost. As a testament to the business model, on revenue of $400 million over the last twelve months the company generated 143 million in free cash flow. The impressive business margins and free cash flow conversion rates are pulled together by AVG’s line of security products, SMB business and secure search platform.
AVG’s business is split into two distinctive categories, which are their subscription and platform businesses. From the subscription side of the business a new 2014 product portfolio was launched in September of 2013. The following is a list of the key products by AVG for subscription based revenues:
Courtesy of AVG Media Center:
1.AVG AntiVirus FREE 2014: the new version of AVG’s award-winning free solution includes the brand new File Shredder feature to help keep sensitive data private. Provides peace of mind by detecting and removing viruses and protecting users while searching, browsing, social networking and emailing.
2.AVG AntiVirus 2014: includes File Shredder and also Data Safe, which encrypts and securely stores valuable files on a virtual disk on your PC. This is advanced protection for people who don’t shop or bank online, but still want to search, surf, email and download safely.
3.AVG Internet Security 2014: ultimate protection for anyone who wants complete peace-of-mind online. Extended Data Safe functionality offers multiple secure virtual drives, while smart performance technology helps you play games and stream video without lags caused by scheduled updates and scans.
4.AVG Premium Security 2014: not just for your PC, this is the very best in protection, privacy and performance, updated for 2014 to cover multiple Android TM devices by including Premium Mobile Security and Premium Tablet Security. This bundle also features proactive identity protection through AVG Identity Alert, while AVG Quick Tune helps your PC to restore peak performance.
5.AVG PC TuneUp® 2014: monitors and automatically maintains your PC to ensure trouble-free operation, with less crashing and increased speed, disk space and battery life. Based on customer requests and research, there are improvements across the board to the most popular features, a much improved UI, and new capabilities to clean up your hard drive and further extend battery life: Duplicate Finder, Disk Cleaner, Browser Cleaner and Flight Mode.
6.AVG PrivacyFix™ puts control of your personal online privacy back in your hands. Available on your PC, mobile and tablet, it allows you to check, manage and personalize your privacy settings across popular sites such as Facebook®, Google®, LinkedIn®, as well as overall tracking across websites in general, all from one easy-to-use central control panel.
7.AVG AntiVirus PRO v3.3 for Android™ is the latest version of AVG’s market-leading application for Android smartphones and tablets. It helps to protect your devices by combatting viruses and malware so you can download media and apps, and browse the web with confidence. The advanced anti-theft features also help you to find your device if it’s lost or stolen.
The products above all fall into the category of Subscription based revenue. To make clear distinctions the company provided the following chart from their investor presentation on Q3 of 2013 at a Morgan Stanley conference in Barcelona:
Mobile / Tablet Protection and Optimization
Social Life Manager
Description and Revenue Model:
Endpoint Security Subscription Software
PC and Internet Performance Optimization Products
1 – 2 Year Subscription Licenses
Cash Received Upfront
(Search and Advertising)
Proprietary Threat Data
In the first quarter of their fiscal year 2014 they will be launching a unique suite to pull their products together, users will have a one-stop destination to manage all security issues from performance to parental controls and antivirus. This one stop destination is important as AVG looks to simplify the users experience and product offerings, allowing them to integrate their mobile, PC and desktop products on the suite. The one-click destination will provide a simple way for customers to manage their AVG products and allow AVG to target their customers with increased simplicity.
In the third fiscal quarter of 2013 the company reported subscription based revenue growth of 66%. Of which a large amount was due to their acquisition of TuneUp. The product TuneUp, rebranded for AVG’s purposes, is a computer performance product. As PC users upgrade less and less frequently performance products such as TuneUp that increase PC lifetimes are perfectly positioned to fit the needs of this market. Consumers are increasingly choosing to clean up their computers for a small fee instead of spilling out money for new computers. Subscription growth has also been driven by product offerings to their strong 172 million user base, offering multiple products to users at a close to zero cost. In response to a question about strong subscription growth at a Goldman Sachs conference John Little AVG’s CFO said, “More products, more ability to extract value from our current products(customers), plus the SMB, plus pivot to mobile…means we see a good continued future for that business.” The SMB business mention by John Little has returned to growth recently after past declines as they moved their offering to the cloud and launched AVG Managed Workplace. In the third quarter of 2013 AVG Managed Workplace positively added 500,00 new paid users.
Mobile will be a large part of AVG’s growth in the future. With over 100 million downloads of their antivirus in the Google Play store they are the highest downloaded app that is not a game or Facebook. The user count for their mobile application stands at 57 million, representing a significant opportunity for growth. The company is currently testing strategies to monetize their growing base of mobile users. The CEO has a vision to not monetize per device but monetize per user in the cloud, pricing on some component that scales on the users use across all devices in a subscription base. Mobile will be a source of growth for AVG for multiple years to come as they begin to monetize users, continue to grow users and results begin seep into their top and bottom line.
While the subscription side of the business has and will continue to demonstrate strong growth their platform business is declining as the company looks to change its strategy in that market. As described by AVG’s CEO, the platform business is comprised of two main parts, inorganic and organic. The organic aspect of the platform segment is where AVG is staying and the “good” side of the platform business, where as they are exiting the inorganic. The organic platform business is when a customer downloads a product from AVG they will be offered the option to download a toolbar that will give them a search ability that is AVG secure search. Meaning all the links and attachments are scanned and the searcher is protected by AVG. So the user can still use Google as their search tool but in settings use AVG Secure Search and be protected from malware and tracking and other types of possible harm to the user. From these searches AVG will obtain a portion of the money earned from google when users use AVG Safe Search while on a google search engine, or Yahoo! and Seznam, their two other major partners in the space. The inorganic side of the platform business was when instead of a consumer having the option to download AVG Secure Search from an already downloaded AVG product, AVG piggybacks on something else that got downloaded, not from AVG. And the downloader of this other product would have the option to download AVG Secure Search as well. However the economics of this business changed as instead of downloadees having to uncheck an already checked box to download AVG Secure Search, Google changed their terms of service forcing the user to manually check a box to download AVG Secure Search. This in turn led to a significant downturn in the inorganic side of the platform business. Also, other players in the segment put a bad mark on toolbars as the technical barriers were low and bad reputations were established by abusing the users privacy. As the economics of the businesss began to slide and business practice of competitors took a turn for the worse as well, AVG decided it would be in their best interest to leave the inorganic side of the platform business and take the short term hit on results. A beneficial long term move by management at the expense of short term results in the platform business. The company has also attempted to diversify away from Google as they held the majority of platform revenue, diversifying to Yahoo as well as Google, relying on two major players instead of one, which can be seen in the latest quarter as Yahoo! had a higher percentage of the platform revenue mix than in the past. The company also receives a portion of platform revenue from the Czech Republic search engine Seznam. As a result of the exit from the inorganic platform business the growing subscription business is expected to climb above the current 60% of overall revenue in the third quarter. However, the organic side of the platform business will be a steady one and is expected grow along with the user growth.
Understanding the Freemium business model of AVG is a key component to breaking down their success. The margins that flow from such a business are astounding as the cost of distribution is close to zero as well as cost of acquisition and production. As the company exits the inorganic platform business margins are expected to increase as the inorganic side was producing gross margins of 60% in the latest quarter, below traditional gross margins of 80%. The inorganic business had a lower gross profit in the most recent quarter than the rest of AVG’s operating profit. Showing the potential for margin expansion as the business is scrapped. While many investors are looking for higher numbers in ARPU from AVG it is not so critical to the business as some may perceive. The company has lower ARPU because of such a large number of users and a low cost base for those users based on a freemium business model. Of the 172 million active users on AVG, 16 million pay AVG, a good conversion rate for a freemium model. The freemium model being built around acquiring users through a great product for free and then using techniques to upgrade and convert these free users into premium and paying users. The whole business strategy is about acquiring a user through a leading free product and then up selling them into a paid user and offering them the onslaught of security and performance products offered by AVG.
While AVG has a substantially low valuation for it’s strong margins, growth and user base there are a few risks inherent, as in any investment. First, if management is unable to continue to monetize existing users and acquire new users than results will take a hit. However, I view this event as unlikely as customer needs expand and management has shown a history of growing users and solid monetization. The other risk is the move to mobile where the company holds 57 million active users, if the company is unable to monetize those users. The move to mobile is critical to company’s plan for the future as mobile devices are used more and more. As this user base is largely untapped at the moment it is not short term risk, only a long term one if the company cannot find a way monetize them and increasingly more time in spent away from PC’s. However, I also view this event as highly unlikely due to significant presence of AVG in the mobile market and market leadership as well as brand strength. I believe they will be able to successfully integrate subscribing mobile customers who manage their AVG products across all their devices on the platform to be introduced in the Q1 of 2014. Also while a lack of monetization for mobile may be a risk, successful monetization will result in huge upside, a favorable asymmetrical risk profile.
Management has also showed solid capability after ceasing operations in a business with low margins and bad brand image. Showing willingness to take short term hits in favor of longer term benefit for the business, not worrying about the stock price but about overall economics of the business. New CEOs such as AVG has with Gary Kovaks can be hard to evaluate, but with a strong long term decision to move out of the indirect platform business Kovaks has started out on the right food. He also has a solid vision for the company of a provider of multiple computer products coming from a one-click destination to be launched in Q1 of 2014. Management has thus far shown to be adding shareholder value.
As mentioned the business model of AVG yields spectacular margins, resulting in an extremely fundamentally attractive investment. Along with strong margins are a business growing both its top and bottom line and producing strong cash flow.
Projected by management for Fiscal Year 2013 (Last Reported Third Fiscal Quarter Of FY13)
•Revenue of ~$400 million
•Non-GAAP Net Income of $112 Million, $2.00 per share
•GAAP Net Income of $63 million, $1.13 per share
•Operating Cash Flow $143 million
•Unlevered Free Cash Flow of $133 million
*Please note that management projected figures such as in the case of revenues, between $398 and $402 million, I chose the middle ground of their given guidance.
In growth terms the above figures translate into 13% revenue growth, 45% net income growth and 18% cash flow growth, great figures for any company let alone one with the AVG’s low valuation(see below), strong business margins and low valuation. In the fiscal third quarter of 2013 the company achieved operating margins of above 30% as well as subscription business gross margins of 90% and an unlevered free cash flow conversion rate of 21%. For the year 2014 as of their third quarter call management called for at least $400 million in revenue with 75-80% of this revenue coming from the high margin and predictable subscription business. I expect the company to exceed it’s cautious revenue guidance of at least $400 million and for the bottom line to benefit from an increase in the subscription business mix.
Despite the companies fantastic fundamentals and solid growth the company is trading at an extremely low valuation.
FY13 GAAP P/E
FY13 Non-GAAP P/E
FY13 Market Cap/Op. Cash Flow
FY13 Market Cap/Unlevered Free Cash Flow
For a company with significant opportunities for growth and strong fundamentals the business is selling at an unwarranted low valuation, representing a great investment opportunity. I believe shares could be conservatively valued at a 16 FY 13 Non-GAAP P/E multiple which would be 100% upside from these levels. I believe NON-GAAP is appropriate in valuing AVG because the majority of margin changes are due to amortization of acquired intangibles and restructuring legal costs. Both of which are do not reflect accurate results of the intrinsic business in question. In the latest quarter restructuring and legal costs plus amortization of acquired intangibles equalled 7.4 million of the NON-GAAP adjustment as opposed to just 2.5 million of employee stock compensation. This small amount of stock compensation could be much more than covered by net cash on hand on the balance sheet that was purposely not included in my value and ratio calculations to account for stock compensation.
As a growing and profitable subscription based company AVG is one of the most undervalued companies I have found this year, (along with my pick of MYGN which is up over +30% since my write up). I believe the move out of the inorganic platform business has led investors to misinterpret the value of a company with a growing high margin business and strong free cash flow generation as well as a leading user base. At the current price of ~$16 dollars AVG has a great margin of safety and potential for upside.
I will most likely initiate a long position in AVG in the next 72 hours.