The Outrageous Valuations of Social Media Networks And Why I Should Make My Own

Of course, social media is all the craze in todays world of hostages, instant communication and satisfaction. Oops did I say hostages? I meant hashtags, but then again ISIS utilizes social media too. Everyone uses social media and venture capitalists along with the public stock market seem to think this will translate into enormous profits. When you take a look at the valuation of social media firms, from a value investors perspective, you are overcome with a sense of amazement.

Social Network                                  Valuation

Facebook                                            $216 billion

LinkedIn                                              $28 billion

Twitter                                                 $26 billion

WhatsApp                                         $19 billion(bought by FB in Feb. 2014)

SnapChat                                           $10 billion

Pinterest                                              $5 billion

Instagram                                           $1 billion (bought by FB in April, 2012)

 

Coming from a 18 year old who’s still in high school, it looks like Facebook got a great deal on Instagram which has certainly overtaken it’s parent in usage from my generation. But thats assuming we are willing to pay for users and not profit, and assuming the above valuations are rational. For now, I am going to assume they are not so.

First, I am going to quickly evaluate the three public companies with disclosed financial information, then I will move onto the others with less information available.

Facebook sits atop the other social media giants with over a 200 billion dollar market capitalization, roughly ten times greater than its nearest peer.  The company trades at 40 times forward earnings, has a 33x EV/EBITDA and a 1.29 PEG, all according to yahoo finance. Of course, both the forward P/E and enterprise value divided by operating profit ratios are enormous. This is certainly a high growth stock and while I would not invest in the company at the current price, the PEG ratio paints a more modest picture at 1.29. The PEG is not relatively large because it accounts for Facebook’s expected growth. The danger in Facebook comes from when that expected growth does not occur as predicted. Yet, Facebook has a strong hold on the industry more so than any of the other companies. Facebook is used to login into many other social media applications and has a base of users that is quite nearly impossible to surpass. Most importantly, they also have the ability to aquire new threats to their position in the industry, see Instagram.

More concerning to me are the valuations of public peers Twitter and LinkedIn. Neither are currently profitable, as Facebook is, and until that moment comes they are dangerous. Twitter has a forward P/E of over 100x and LinkedIn has one of 81x. These are crazy high growth expectations to put on a company, if these companies are unable to monetize users at a rate which satisfies the market they will be severely punished for it.

Yet, all we have glanced at so far are the public, huge social media companies. What is much more exciting to look at are the private hyper-growth companies such as Snapchat and Pinterest, as well as the purchased ones like Instagram and WhatsApp. Such viral social media crazes are where the real fun is.

Instagram was purchased by Facebook for $1 billion in 2012, back when the start-up had about 30 million users. As many of you know, the app simply gives users a place to share quality photos through the use of filters and frames. At the time of purchase Instagram had zero revenue, but a ton of users who were growing rapidly. The founders of Instagram actually took many parts of an older, failed application to make the new big hit. They simply took the good parts of their prior failed social media app, photo posting, likes and commenting, and added a filter system among other features. All in all, the billion dollar project took them a total of 8 weeks to build. While Facebook may have been warranted in their billion dollar acquisition, as they recaptured the audience of kids my age,  from a purely business sense the valuation is almost reminiscent of the dot com era.

The same can be said for many start-up social media companies which are capturing venture capitalists with the hope of turning users into profits. Almost all of these platforms also completely rely on mobile users.

Pinterest has acquired a large base of users with strong retention and hopes to make a big splash in e-commerce.  Their 5-billion dollar valuation is based on the hopes that their photo-based sharing platform can be a way for companies to share cool products that users want to see. Besides, users are already pinning products of companies they want, sort of creating a wish list. This bussinessinsider.com article explains Pinterest’s business model in more depth. Yet, above all, this is still a largely young company which has yet to produce material financial results.

SnapChat, which is extremely popular among kids my age, has rode the recent craze for not only social media companies, but specifically messaging mobile applications. Vibe, a free calling and texting application was recently bought for 900 million.  WhatsApp, the application purchased by Facebook for 19 billion, is a messaging service. SnapChat has over 100 million monthly users and the expectation is that company can turn these users into advertising revenue. However, they have just begun to include advertising into their platform. It remains to be seen if they can ever find enough advertising dollars to warrant their valuation without ruining their product.

All this nostalgia over the stretched valuations of social media, messaging and mobile applications has gotten me interested in the field of internet start-ups. From Instagram, to Facebook and SnapChat each has had a modest beginning with a few or single programmers. Over the past couple of months I have been learning the swift programming language, which is part of the reason why there has a been a scarce amount of blog posts recently. Perhaps the next viral social media application promising investors that users will turn into millions of advertising dollars will be my very own.

 

 

 

 

 

The Merger of Turtle Beach and Parametric Sound Has Presented An Investment Opportunity

Turtle Beach and Parametric Sound officially merged on January 15, 2014 to create one company focused on audio under the name Turtle Beach Corporation. The action was a reverse merger, as Turtle Beach a private company at the time merged with the small public company Parametric Sound. The company, trading under the ticker HEAR, is currently near 52-week lows at the price of ~$8.8. This post-merger corporation is being undervalued by the market, likely due to a number of factors which include business cyclicality and 2014 R&D among others.

The combined company has two distinct businesses, Turtle Beach gaming headsets and Hypersound. While both of these involve audio, they serve completely different markets and must be analyzed separately.

Turtle Beach Headsets:

This business currently comprises almost all of the companies revenue. Turtle Beach provides headsets in gaming for PC, Xbox and PlayStation, in which the majority of the segments revenue is generated. The company also offers headsets for media such as mobile phones and IPods. Turtle Beach is a clear market leader in the gaming headset industry. Turtle Beach had 49.3% of the market share in the U.S. market in 2013. The next largest competitor to Turtle Beach in the gaming industry is 1/5th their size. The companies dominance is partly due to their strong brand among gamers, but also due to much else.

Gaming headsets are much more technological advanced than regular music headsets. Serious gamers want to hear the footsteps of competitors, be able to talk to their peers in the game and with Turtle Beach also have bluetooth capability to take a call. From the highest price point of $300 to the lowest at $25 Turtle Beach is continually beating out the competition on technology, innovation and brand strength.  Turtle Beach has gotten to their controlling position in the marketplace by continuing to out innovate and differentiate their products. 

Not only is Turtle Beach dominant in the gaming headset industry but they expanded into the media category last year and established a relationship with Apple. Turtle Beach headsets for media are currently being sold in Apple stores around the world, a great opportunity to expand the product reach. This is the same industry that Beats, Skullcandy and Bose play in. The company expects that international sales with help fuel growth as well, Turtle Beach expects to take market share in both PC and console gaming. To go along with new product categories and outreach the company has great distribution platforms. Turtle Beach has great relationships with many of the major retailers and over 16,000 interactive kiosks, adding up to 370,000 points of distribution. Of course, the company also has an e-commerce site.

The gaming headset segment tends have cyclicality with the release of new gen consoles. For example, sales tend to slow after the announcement of new consoles and then grow significantly after the release of such consoles. This is because gamers hold off on purchases until the new gen consoles arrive. After new gen consoles are purchased users tend to make software and accessory upgrades as well. 2013 is the first year since 2005 for a major console transition, in the year both Xbox and PlayStation announced and released the Xbox One and PS4. Because of the new releases console hardware and software sales are expected to grow by 58% from 2013 to 2018. It is also important to note that for the Xbox One old headsets will not be able to work with the new console, further generating sales. This console transition will play well for Turtle Beach sales over the next couple of years, providing significant growth. The following chart, taken from a Turtle Beach investor presentation in May, shows the growth ahead for the gaming market.

Console

Cumulative Sales

2013 to 2018 est.

Turtle Beach Position

Xbox One

2.8 million to 63.5 million

• 23x est. five-year cumulative sales increase

• Produce 3 of 4 licensed headsets on the market

• Intend to expand portfolio over next 18 months

Playstation 4

4.2 million to 85.9 million

• 21x est. five-year cumulative sales increase

• Officially licensed for PS4 as of Jan. 2014

• Intend to expand portfolio over next 18 months

Xbox 360

78.6 million to 92.8 million

• 18% est. five-year cumulative sales increase

• 9 Xbox 360 headsets in core product portfolio

• No forward compatibility to Xbox One w/o adapter

Playstation 3

77.4 million to 96.2 million

• 24% est. five-year cumulative sales increase

• 6 PS3 headsets in core product portfolio

• Many PS3 headsets compatible with PS4

 The benefits of new console upgrades were felt in the first quarter results. For the headset gaming segment, net revenues increased 30% to $38 million, gross profit grew 42% to $12 million and adj. EBITDA increased 142% to $4.8 million. For the full year Turtle Beach expects the business to generate a 24% increase in revenue at ~$220 million, and growth of 134% in adj. EBITDA at ~$32 million.

Hypersound

Hypersound audio technology is commonly compared to that of a powerful flashlight, one can direct the audio in an area without sound bleeding. Hypersound utilizes an ultrasonic beam which allows the sound to be highly directional while maintaining the integrity of the audio over long distances. This type of technology, allowing sound to be highly targeted into a precise audio zone, has commercial, healthcare and consumer applications. The company currently has 26 patents in the U.S. granted and 59 pending which will help protect the technological advantages presented by Hypersound. 

 Turtle Beach sees Hypersound’s highly controllable placement of sound as being attractive to commercial businesses. There is application for this technology in the use of kiosks along with promotional and listening areas. The technology of Hypersound would allow businesses to enhance personal experience and reduce noise pollution, leading to an upgraded in-store environment. In stores that use video to help sell products there is usually no sound because of concern over sound bleeding throughout the store, but Hypersound solves that problem. According to BCC Research by 2015 there are going to be 34 million ATMs, vending machines and self-serve kiosks which would all represent an addressable market for Hypersound. The commercial uses for Turtle Beach’s patented technology are plentiful.

Outside of commercial use, Hypersound has clear potential in the multi-billion dollar hearing impaired market. The technology of Hypersound allows those who are impaired to receive highly targeted, increased volume audio which penetrates the ear canal greater than traditional speakers, while not bothering those around them. The CEO of Turtle Beach made the analogy of water from a hose with the hose on spray as traditional speakers, and then if you focus the water from the hose you get a lot more water where you want it to go. Focusing the sound is what Hypersound does. The main health care market will be in T.V. watching as Hypersound directs audio to the hearing impaired while others receive traditional audio. In a family living room with a T.V. this type of experience is invaluable. There is also a consumer application for the technology. 3-D audio typically takes 5-7 speakers, but with Hypersound great 3-D sound can be accomplished with 2 emitters. This is because with the directional aspects of Hypersound the consumers two ears are hit independently by the separate speakers.  

2014 has been a building year for Hypersound, one in which a 10 million dollar investment was made in the segment. This money is being spent to pursue the commercial market opportunity, product development and prepare for a health care launch. The Hypersound product for commercial applications has been finished and is just starting to be sold, the company expects 1 to 4 million in revenues from the segment this year. The sales team has been rebuilt, yet the company expects there to be a build up of time before meaningful revenue is brought in from the commercial application product. In the health care segment the company will launch a Hypersound product to assist in T.V. watching, as previously described, next year. The company has FDA clearance and there is currently no competitive product on the market. The company is looking to bring out the commercial and health care segments first, while scaling the Hypersound business, and then roll out consumer applications in 2016.  

Valuation and Conclusion:

The valuation of the company is cheap when you simply look at the Turtle Beach Headset business, which is where most of the revenue will come from this year and next. At a market cap of $333 million the company trades at approximately 10 times the adj. EBITDA of the headset business. For a company with such growth ahead due to the recent console transition I believe a higher ratio is warranted. I would have expected that had Turtle Beach gone public, as opposed to a reverse merger with Parametric Sound, they would have commanded a higher valuation than currently being given. This is because of expected growth as well as dominance in their industry, also to a lesser extent expanding into international markets and media headsets. Yet, this does not take into account the opportunity of the Hypersound business. The investments in the Hypersound business of 10 million also mean that the whole company’s EBITDA is only expected to be 20-25 million. However, it is important to value the headset and Hypersound businesses separately, just as we analyzed them separately. Therefore, assuming that the market cap underestimates the headset business alone, the company has even more upside considering the IP property and future revenue streams of Hypersound. With the growth expected from the headset business and the development of Hypersound in a few years, I believe a buy and hold strategy of the stock over multiple years will garner significant returns, especially at these lowly levels of $8.8.

Outerwall’s Stock Has Great Upside Potential

Companies which I find to be intriguing, such as Outerwall, tend to have low valuation metrics and high short interest. Questions over qualitative business strength and high profitability all fit into the lowest common denominator of my latest stock picks. When those characteristics exist in a company’s stock, it presents an opportunity for multiple expansion and movement from short covering in the event of a positive catalyst. Catalysts can range from analyst upgrades to earnings reports, which address the question of qualitative business strength. While questions over a business’s strength may be a risk, the characteristics of high profitability and low valuation metrics act as floors to protect downside risk. Also without these question marks over a business and accompanied low evaluation, the upside would not be present for multiple expansion or short covering once sentiment has changed over business strength. A great example of a company with the aforementioned aspects to its stock is King Digital Entertainment (Ticker: KING). My blog post on June 25th detailed a bullish thesis, where I mentioned company specific qualitative characteristics I believed were not recognized by the market, along with an extremely low evaluation and high profitability. The blog post had great timing. In the following week the company rose over 20%. The catalysts included a positive Deutsche bank report with a high target price and short covering. Although the catalysts were not strong indicators and the price may pop back down, a positive quarterly report should serve to move the stock towards its much higher fair value. As opposed to great things happen to great people, in the stock market, great things happen to companies with characteristics like King and Outerwall. Finally, it is time to get to my analysis of Outerwall.

Company Background

Outerwall operates a number of kiosks located in popular stores throughout the U.S. and Canada. The company has three primary brands of kiosks: Redbox, Coinstar and EcoATM. Redbox, where the company receives the majority of its revenue, is a movie rental kiosk where customers can rent movies, Blu-Ray, or video games for a little over a dollar. Redbox is the low cost producer in the movie industry with 50% of the market in physical movie rentals. The company also runs Coinstar, a kiosk which collects coins and gives the customer cash, while taking a fee in the process. Coinstar has clear dominance in this niche industry and is in a mature stage. Recently the company has started a new venture in EcoATM. EcoATM collects old smartphones and uses impressive technology to give the consumer a fair price on his or her old electronic device. EcoATM has yet to turn to profitability, but was just launched and will contribute to future growth. Finally, the company has joined with Verizon to create Redbox Instant by Verizon Wireless. The project is a netflix like online streaming platform where customers can watch movies instantly on the web.

Thesis Overview

Outerwall is materially undervalued due to a clouding image of Blockbuster and negative sentiment facing physical DVD rentals. The company has a number of factors going for it that include: minimal competition for Redbox, a slowly declining physical movie industry, margin expansion, strong free cash flow generation, new venture EcoATM, continued dominance in Coinstar’s market and Redbox Instant by Verizon Wireless. Despite the naysayers and low valuation, the company still expects Redbox revenue growth of 4-7% this year and next. At and below $60 a share, Outerwall looks to be a compelling buy.

Business Segments:

Redbox

Redbox has a multitude of characteristics that continue to make it relevant in today’s world. For one, the kiosks have newer and a wider range of content than online providers such as Netflix. If there is a newly released movie a customer wants to see, it will come out on Redbox much sooner than Netflix, if the movie even ends up on the streaming platform. Many popular movies do not make an appearance on Netflix or the like. Second, for players such as Itunes, Amazon or Cable, the on demand prices are at least twice if not more than the cost of Redbox to rent for 24 hours. In each case Redbox has an advantage, whether it be through content or being the low cost provider. Redbox also allows customers to rent video games, an undervalued component of the business which no other company does with the same low price and convenience. Instead of buying a 60 dollar game, players can rent it for a night at the cost of $2.00. Adding video games has shown that Redbox is looking to and has successfully taken advantage of its large kiosk infrastructure. Redbox has many competitive advantages that will sustain its longevity, along with a brevity of financial prosperousness.

The strength of the Redbox brand is shown through managements revenue expectations in a declining market, while still cutting back on kiosk installations. In Q1 of 2014 the physical DVD rental market declined about 6%, yet Redbox was still able to generate revenue growth. This is not a company relying on new kiosks to drive revenue and mask a declining, dying industry. This is a company which has been able to maintain and grow revenue through the niche market of cost conscience consumers and content driven rentals. This slight revenue growth is also coming at a time when margins are growing, since the company has focused on monetizing the existing kiosks in place, rather than expanding. CapEx will continue to decrease as most of it becomes maintenance rather than new installations. One important part in analyzing Redbox before the financials is to realize what Outerwall has done with blu-ray. Blu-Ray DVDs cost $1.50 per night, compared to a regular fee of $1.20. In the first quarter blu-ray represented 15.2% of rentals and 17.7% of Redbox revenue. Blu-ray represents a growth segment within the Redbox business, and a potential for increased profitability. The continued strength of blu-ray rentals will be crucial to Redbox’s future financial performance, as profits look to expand faster than revenue.

At the moment Redbox Instant by Verizon Wireless is merely an investment for Outerwall. The appeal of Redbox Instant is to combine both streaming movies and kiosk rentals into one monthly subscription service. A user gets access to digital content as well as rentals from Redbox kiosks for the price of $8 a month. The company has made numerous cash investments into the venture with hopes that it can increase the consumer base and kiosk use. Outerwall is looking to achieve strong financial results through kiosk rentals and dividend distributions.

Speaking of Redbox’s financial performance, here is the latest from the Q1 press release. In the quarter Redbox represented 86% of Outerwall’s revenue. Revenue and rentals both grew 1.5% and 1.2% yoy, respectively. Revenue totalled $515 million off of approximately 200 million rentals. Same-kiosk sales grew 1% yoy and net revenue per rental grew .8% to $2.58. All of which was accomplished while the company cut promotional spending by 38%. Thus, along with blu-ray growth and a focus to decreased SG&A costs, operating income came in at $102.9 million, growth of 11.7% yoy. Operating margin improved 190 basis points yoy. These latest financial results demonstrate the company’s dedication to driving profitability while maintaining and growing sales. Quick to realize how cheap this company is, one must only look at first quarter Redbox operating income, as the whole company only trades at twelve times op. income of the Redbox segment in Q1 of 2014! This is coming from a company which expects to generate over $100 million of core adj. EBITDA in Q2, which is supposed to be a weak quarter for Outerwall and Redbox.

Redbox, and thus Outerwall, experiences strong quarter to quarter financial deviances depending on the expected release slate during the time period. In Q2 there will be eight weeks where there are two or less new titles and in the first week of June no new titles will be released. This compares weakly to Q2 of 2013 as well as sequentially to Q1 of 2014. However, the slate will increase in the second half of the year, driving revenue and profitability to carry the yearly results from quarters 3 and 4.

On June 2nd analyst Andy Hargreaves of Pacific Crest Securities put a sell rating on Outerwall accompanied by a price target of $33. He, as everyone in the bear case does, cited the declining market of physical DVDs. He arrives at such a low price by assuming that annual DVD rental volume declines at approximately 10% annually. Yet, the market only decreased 6% in the latest quarter and Redbox was still able to grow rentals, albeit slightly, but to the large tone of 200 million rentals in the quarter. On a valuation level the price of $33 dollars would leave Outerwall trading at 1.3x core adj. EBITDA for 2014 and about 3x this years expected free cash flow. I expect that analyst Andy Hargreaves along with the 36% who hold Outerwall short will see that Redbox has a niche in the entertainment market and a stronghold that will last for many years, likely to their discomfort.

Coinstar

Although much of the Outerwall discussion tends to focus on Redbox, the other businesses are important to overall financial performance. Originally the whole company’s name, Coinstar is the oldest of the three business segments within Outerwall. As already mentioned, this kiosk service collects coins and gives the consumer an equivalent value in bills, minus commision. I have used the service many times before and it is much more convenient than sorting the change to take to the bank. Coinstar represented 11% of Q1 2014 revenue, admittedly a much smaller part of Outerwall than Redbox. The segment does not face any major competition threats and is very stable in terms of financial performance. The business is far past the growth stage of its life and is in the mature business life cycle.

Perhaps one of the most exciting things to happen to Coinstar in the last year is the rise in commission stated in October of 2013. The increase helped both revenue and margins grow, displaying a healthy business where consumers feel the added value is enough to stomach higher costs. Outerwall also continues to find ways to reinvent their maturing segments. Coinstar recently created Coinstar Exchange which allows customers to trade in gift cards for cash. For the many people who receive unwanted gift cards this will be a useful service and add growth within the older business of Coinstar coin counting.

Per the aforementioned press release, here are the financial results of Coinstar in Q1 of 2014. All results are measured yoy. Revenue increase 5.2% to $68 million. Same kiosk sales grew 3.1% and average transaction size grew 3.9% to $40.76. Operating income grew 22.1% to 22.7 million and operating margin equaled 33.1%, a growth of 460 basis points. Growth and margin improvements were mainly due to the increase in price as well as Outerwall’s continued focus on cost reductions. Undoubtedly not a growth or sexy business segment, but Coinstar has and will be a rock in generating solid revenue and bottom line production.

New Ventures (ecoATM)

The beginning of 2014 was met with large changes in the New Ventures segment by Outerwall. As opposed to the four new ventures of: Rubi, Orango, Crisp Market and Star Studio, management elected to only continue two new ventures, ecoATM and SAMPLEit. ecoATM was fully acquired in July of 2013 and the company is very excited over its prospects. In ecoATM Outerwall sees a large opportunity in the electronic recycling industry. With new records of electronic waste consumers will want cash for their old mobile phones and refurbished electronics. ecoATM gives Outerwall a play in this growing and ever expanding market. Many carriers provide trade ins for new phones where a consumer can often receive more than the old phones worth. Yet Outerwall and I both agree with new upgrades in technology every year there is a large marketplace for a convenient kiosk to pop up and accurately distribute a fair price to a consumer looking for cash.

According to management ecoATM has come in or slightly exceeded financial expectations. In the Q&A section of the Q1 2014 Conference Call management reiterated that revenue, average transaction size and the number of transactions has performed well. Currently the company is making the necessary investments and contracts with retailers to install and scale ecoATM to 1200 kiosks at the end of the year. Part of the reason management expects the year to be second half loaded in terms of financial results is due to ecoATM. Stated in the conference call referred to above, CFO Galen Smith said “We continue to expect this year to be second half loaded from a revenue and profitability perspective due to the continued growth in ramping of the ecoATM business”. Smith also calls on the richer content release schedule previously discussed in the Redbox segment.

I expect ecoATM to be a growth engine for Outerwall in the year 2014 and beyond as it becomes scaled and continues revenue growth. Revenue growth reached 16 million for Q1 of 2014 and accelerated throughout the quarter. Look for that number to grow in the coming quarters. Profitability in the New Ventures segment has not been achieved but as new installations are accomplished and operating expenses are leveraged it will contribute to the bottom line. This is why management noted ecoATM as a piece to the puzzle for a loaded second half of 2014. Note that while SAMPLEit is a new venture, it has very little significance to the overall company at this point.

Valuation

The current valuation given by the market to Outerwall is unjustified and incredibly cheap. At the recent closing price of $55 per share the company trades at eight times this year’s expected earnings, if EPS comes in on the low end of guidance. Outerwall also trades at 5x this year’s expected cash flow. These type of ratios suggest the company is left for dead, presenting upside opportunity for when the company proves otherwise. I anticipate the market will begin to realize the company’s full value as Outerwall meets financial targets for the year demonstrating business sustainability and grows ecoATM. Once sentiment towards the company’s situation regains strength shorts will recover and ratios will expand. My fair value for the stock assigns a P/E of 14 to this years earnings, taking into account the maturation of Redbox and Coinstar, as well as the growth of ecoATM. Unfortunately there are no relative peers to compare with Outerwall’s valuation and it is therefore based purely off of business strength and growth prospects. This P/E ratio would suggest a price of $98, significantly above current levels of $55. I believe my price target is representative of the company’s true value compared to the market’s price. After certain catalysts occur, either upgrades or meeting financial targets, the market will realize this.

Management’s Guidance for FY 14

Consolidated revenue between $2.378 billion and $2.488 billion Core adjusted EBITDA from continuing operations between $487 million and $527 million Core diluted EPS from continuing operations between $6.68 and $7.18 on a fully diluted basis Free cash flow between $200 million and $240 million

Q2 of 2014

As previously mentioned, the second quarter is expected to be a challenging one for Outerwall. Not only is the release slate bad for Redbox but in Q2 of last year the company took a $21 million pre-tax benefit in the Redbox division which will make yoy comparisons difficult. Management also expressed caution in regard to the finalization of ecoATM contracts, which could negatively impact the quarter. The company will report results on July 30th. Normally, such talk invokes a sense of caution, yet after recently running down from $70 to $60 and recently to $55, the valuation is so low it acts as a solid floor to bad results. However, how the market reacts to the results is anyones best guess. When the results are released I will be focusing on guidance for the year and the progress of ecoATM. In the case of a good report the upside will be great. If the market reacts unfavorably to the report, it will be an opportunity to buy more at an even lower cost and valuation.

Conclusion

Usually I would spend much more time and analysis on valuation but in this case it would be a waste of time. The most obvious ratios paint the picture clear enough, Outerwall is extremely undervalued. Outerwall has a market leader in Redbox, a stable business in Coinstar and a growing business in ecoATM. The qualitative characteristics of these businesses, as investigated in this report, show that Outerwall will continue to produce solid financial results and that the market has overestimated the risks associated with these businesses. Such a company is currently on sale.

Disclosure: I recently initiated a long position in Outerwall.

King Digit Entertainment Is A Busted IPO Trading Far Below Fair Value

If you haven’t seen the game Candy Crush Saga being played by someone standing next to you on the subway, bus or on your friends phone, then you were probably too busy playing the game yourself. Such is the popularity of King Digital Entertainment’s hit game, which propelled them into an IPO in March of 2014. Candy Crush Saga transformed King from a miniscule gaming company, into one with 352 million monthly unique users and 600 million plus in cash over the course of two years. However, concerns over King’s ability to produce more hit-games like Candy Crush Saga, which has past its peak in popularity, have led to a large decrease in valuation since the recent IPO. Thus leaving the company significantly undervalued as the company has and will continue to diversify away from Candy Crush Saga, produce significant cash flow and utilize its huge group of monthly players, who are greater than the population of the United States of America, to promote new and quality games.

Qualitative Assessment:

King Digital Entertainment(Ticker: KING) describes itself as “the leading interactive entertainment company for the mobile world”. Thankfully underneath the vague statement is a relatively simple business to understand. First King makes casual games for their online platform royalgames.com at which they have a loyal following of players who serve as a test market for their new games. The players choose from over 180 different games to play on the royalgames.com platform. The games which are favored by the players are put on Facebook’s gaming platform and then launched onto mobile after interest has been built and the appropriate game is developed and adapted for mobile. This type of product development allows King to produce high-quality customer driven games to mobile. The games are extremely addictive and King garners most of its revenue from coins which users can purchase to attain more lives or upgrades. The following is a chart representing game development as of Q1 2014 as shown in a presentation by the company CFO Hope Cochran at Bank of America Merrill Lynch.

As you can see from the chart King currently has five franchises or “Sagas” on the mobile market: Bubble Witch Saga, Candy Crush Saga, Pet Rescue Saga, Papa Pear Saga and Farm Heroes Saga. The company recently released Bubble Witch Saga 2, a sequel to it’s longest running mobile game, demonstrating the ability to produce new content while maintaining a longstanding franchise. The company has also talked about a potential sister game to the Candy Crush Saga. King undoubtedly has more games in the pipeline due to come out for mobile, however it does not disclose specifics for competitive reasons as well as the inconvenience of hard deadlines. Yet the most important takeaways from the chart, as well as all of Q1 of 2014 for the company, is that they are diversifying away from a dependence on Candy Crush Saga by introducing three popular mobile games since mid-2013. Candy Crush Saga as a percentage of overall gross bookings dropped to 67% from the 78% of Q4 2013, and overall gross bookings still increased 1% sequentially.

King Digital Entertainment has further exemplified its ability to produce hit games and create a substantial business moat when looking at the top grossing charts at Facebook, Google Play and the App Store.

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King holds three of the top 10 grossing in all of the three major markets. The circles represent mobile games that have been in the mobile market for less than 12 months and made the top 10 grossing charts. The purpose of which is to show that games that get into the exclusive top 10 tend to stay there and have longevity, as well as illustrate that among the few circled games, most are made by King. This chart can help defend King from its strongest doubters, who argue the company cannot produce hit games and believe the company has no competitive moat. In regards to both questions surrounding the company it has a few very important “moats” that protect itself. For one the company is able to spend millions on advertising new games and the development of new games. Two kids in a garage do not have this capability. King is creating new barriers to entry in the mobile gaming business by spending part of their 600 million plus cash and 600 million in gross bookings per quarter on marketing and development of games. Also, it is much easier to make a free app such as Angry Birds or Flappy Bird which reaches the top installs, yet much harder for those without the size and expertise such as King to make it atop the top grossing charts. The top grossing charts are more solidified by top players in the industry. Currently six of the top 10 grossing in mobile games are split, 3 and 3, between app maker Supercell and King. Such an oligopoly bodes well for King’s future. Michael E. Porter would recognize that King is coming in and changing the dynamics of the industry itself. Apart from substantial cash available King’s ability to separate itself from smaller players is clear through its monthly unique users of whom King is able to pitch new games to for free. Imagine having the ability to advertise your new game to everyone in the United States, of whom already enjoy one or more of your products. Such is the effect of King’s network of users. To illustrate, King’s network was put on a graph with other technology companies of all sorts.

slide8

Because of this large network Farm Heroes Saga, released at the beginning of 2014, jumped into the top 10 grossing games only two weeks after its launch. Farm Heroes Saga also benefits by being a quality mobile game. Even after Candy Crush Saga’s peak King has been able to substantially grow unique users, moving from 304 in Q4 2013 to 352 in Q1 2014. The amount each paying user spends on King’s games has also climbed to an all time high of $18. However, the amount of paying users has declined from a high of 13 million to 11.9 million. This is because of many one time payers who had played Candy Crush Saga, where as payers now are engaged in multiple King games and invested in the games as opposed to one time users.

Much of the negative sentiment towards King can also be traced back to the failure of the gaming company Zynga. Yet for the same reasons that King can prove the doubters wrong, mentioned above, King differs from Zynga. Zynga never learned how to make users pay for their free games and therefore wasn’t able to create the same type of moats in the mobile gaming industry that King is today. Zynga, as shown in the chart above, also does not possess nearly as strong an outreach as King does with a miniscule 86 million monthly unique users, compared to King’s 352 million. Lastly, Zynga has never been close to as profitable as King is today, leading us to King’s financials and valuation.

Financials:

Perhaps the most exciting part about King as a stock is just how much money it takes in. At its core King is truly a cash cow. I made a chart to illustrate the profitability of the company below.

Q4 2013 Q1 2014
Revenue $602 mil $607 mil +1%
Adj. EBITDA $269 mil $249 mil -8%
Profit $159 mil $127 mil -20%

 

While the profit and adj. EBITDA for Q1 2014 are both high numbers some may be concerned with the recent downtrends in margins. These decreases are due to two factors, increases in headcount at King and investments made in Farm Heroes Saga which launched in Q1 2014. The investments also secured business moats previously talked about. Margin concerns are mitigated by the following chart showing the meteoric rise of the company due to Candy Crush Saga.

Q1 2013 Q1 2014
Revenue $206 mil $607 mil +195%
Adj. EBITDA $82 mil $249 mil +205%
Profit $52 mil $127 mil +142%

 

An increase of headcounts is obviously necessary after increasing profit and revenue by much more than 100% over the course of one year. Investments made to consolidate and create successful industry dynamics are also necessary. One should note that adj. EBITDA margins in Q1 2014 were 40% and management expects that to continue to be the case throughout the year.

Management has stated that this is a year of transformation for King. A year in which they intend to diversify away from the Candy Crush Saga as well as position themselves for the future and maintain their great financials. The great circumstance surrounding King’s stock price right now is that even as the company transforms its revenue stream and diversifies away from Candy Crush Saga, they are producing so much cash the valuation is like going to the local florists and buying half-off seeds to a money tree.

Let’s build some assumptions and see how the current valuation stands up. Assuming the company has three more quarters in which revenue and margin stay the same and produce a profit of $127 million, to be added onto this quarter’s profit of $127 million. This would equate to $502 million in profits, at a current evaluation of 5.45 billion, ( the current market cap). The resulting Market Cap/Profit ratio is 11. Assuming the adj. EBITDA stays equivalent to Q1 throughout the year the EV/adj. EBITDA ratio would be 4.77. If profits decline 20% and stay equivalent for the following quarters and the same happens to adj. EBITDA the result is the same, the stock is extremely cheap. The aforementioned scenarios are displayed in the chart below.

Scenario 1 Q1 Q2* Q3* Q4* Total Ratio
Adj. EBITDA $249 mil $249 mil $249 mil $249 mil $996 mil 4.8x
Profit $127 mil $127 mil $127 mil $127 mil $508 mil 10.7x
Scenario 2 Q1 Q2* Q3* Q4* Total Ratio
Adj. EBITDA $249 mil $199 mil $199 mil $199 mil $846 mil 5.6x
Profit $127 mil $102 mil $102 mil $102 mil $433 mil 12.6x

 

Scenario 1 assumes profits and adj. EBITDA stays the same throughout the year. This scenario is a little unlikely since the mobile gaming industry tends to be slightly stronger in January, the industry is affected by seasonality, although it is not typically a large difference. The ratios being used in both scenarios is EV/adj. EBITDA and Market Cap/Profit. Scenario 2 assumes profits and adj. EBITDA both decline by 20% from Q1 to Q2 and then remain there throughout the year. * denotes quarters where the numbers are assumed based on the scenario.

Both scenarios are used to illustrate just how cheap King is at the moment despite being a great company and leader in its space with all the benefits mentioned in the qualitative analysis section. Now here is a table displaying what Credit Suisse believes King will achieve for FY 14 and beyond which was updated after King’s results of Q1 2014.

FY14 EPS(adj.) $2.28 P/E 7.5x
EBITDA(non-adj) $753 mil EV/EBITDA 6.3x
FY15 EPS(adj.) $2.56 P/E 6.6x
EBITDA(non-adj) $947 mil EV/EBITDA 5x

*The EPS here is non-gaap

Shown through the chart above King is simply too cheap to ignore, even if the modest expectations by Credit Suisse are not met. As the market recognizes King for further diversifying their revenue from Candy Crush along with keeping their established place atop the mobile gaming industry I anticipate King will have great returns. Once concerns are alleviated the ratios will expand, with much room to run. A P/E of 15 to Credit Suisse’s adj. EPS estimate would be modest, suggesting upside of 100%. Yet, even if you prefer not to look at adj. metrics, scenario two above demonstrates the great upside potential using a purely GAAP measure of profit.

Thanks for reading!

Disclosure: I have established a position in KING.

 

Accepting A Loss In LeapFrog Enterprises

Three months into 2014, most of my stock picks have done extremely well. Of the four individual companies I have blogged about, one has achieved significant returns while two have risen ~10% in a short time frame. Myriad Genetics(MYGN) has risen over 70% since my bullish thesis was published on January 5, 2014. SodaStream has risen about ~10% since my article a month ago and after my current post on AVG , the stock has appreciated ~10% as well. I am a long term investor and although I am citing short term returns, portfolio management and value recognition are two reasons for all investors to look at short term results. I believe AVG, SODA and MYGN are all securities that are still mispriced otherwise I would replaced them in with new positions or sold them. Also short term returns can indicate a change in the fundamentals of a business. Unfortunately this brings us to the case of LeapFrog(LF), a company I had examined in my first blog post which has since lost slightly over 10% of it’s value. As mentioned in my article When to Sell if a stock I am bullish on declines I will often try to average out my position and buy more at a lower price. Yet in the case of LeapFrog I believe the fundamentals have changed to the point where the company is no longer attractive.

LeapFrog recently announced their fourth quarter results for the 2013 Fiscal Year. The company missed targets by 12 cents and reported yearly earnings of 30 cents as opposed to a projected 40 cents. The company also projected a dismal year for 2014 expecting earnings per share once again in the range of 30 cents. The company cited an increasingly promotional sales environment that hurt their product offerings as well as an overall challenging winter quarter. Management had expected both of these to be present as mentioned in their last call, yet they managed to bomb their own low expectations.

It should be noted that this years winter quarter was a difficult one in retail as weather and low mall traffic hurt most retailers. To emphasize the impact of the holiday quarter on LeapFrog’s full year results, net sales were up 9% in the first three quarters yet sales declined 5% for the full year. This type of reliance on the fourth quarter is typical for the company, yet it illustrated the extremely disappointing results. In the fourth quarter worldwide sales declined 24% and gross profit declined 34% yoy.

For the year 2014 management is projecting normalized EPS of .3. This is flat year over year growth and for the first quarter of 2014 the company is expecting a net loss of 20 cents as compared to a loss of 5 cents in the previous year! The company is citing higher inventory levels and a weak retail climate. With a no-growth projection for EPS for the year, as well as a much lower FY13 EPS than projected I believe my LeapFrog thesis has been compromised. The company was unable to take advantage of their leading position in the kids tablet market and I was simply wrong to think they could overcome the short term challenges. Currently trading just above $7 dollars and a resulting P/E minus cash of 15, I believe the company is fairly valued. The upside is now diminished and I will most likely exit my position soon. I will take this loss as a lesson and learn from it as I look to make my next purchase.

The Art Of Stock Picking

The Art Of Stock Picking

From reading the likes of Benjamin Graham and Warren Buffett, I have learned the key to successful stock picking: investing in companies selling substantially less than their intrinsic value. In order to execute this strategy one must first discover companies to evaluate and establish an estimate of their fair value. This article will outline steps and processes for doing both of these.

Discovering Undervalued Stocks:

There are many ways to go about looking for companies that are worthy of one’s time and due diligence. I usually use stock screens, the days biggest losers, new 52-week lows, as well as keeping my ears open and searching sites such as seekingalpha.com to find new companies. However stock screens are the medium I use most often in my search for undervalued equities. Included in my stock screens are a range of criteria varying from new 52-week lows to past cash flow growth rates and low P/E ratios. Used in different combinations and always changing in an attempt to find the perfect stock screen, here are my most used criteria in finding undervalued stocks:

•Book Value Growth (Average of past 3 or 5 years) >10%

•Market cap >100 million

•P/E Current Year <16, Forward Year 10% (Ranging from 5 to 3 year average growth rates, or over TTM)

•Price to Book 10%

•Cash Flow Growth Rate>10%

•Price to Cash Flow<12

•Price to Sales<1

•PEG Ratio2% (Ensures companies are profitable)

•Revenue Growth

•EV/EBITDA <10 or 8

•New 52-week lows (or within ~20% of last 52-week low)

While these are the main criteria, please note that I constantly change ratios and percentages in order to obtain better results. If I increase growth rates, I may raise the valuation ratios or do the opposite and lower both. These criteria provide a vague outline of the values and measures I use in screens to discover stocks selling below intrinsic value. Also as markets rise and fall some items will have to adjusted as either too many or too little companies will pop up. Yet the principle remains the same, find stocks selling below their intrinsic value regardless of the market.

Evaluating Discovered Stocks:

After looking at the aforementioned criteria and seeing solid numbers, the next step is to see if the industry is one I understand and if so, I research the companies position in the market. Usually I head over to yahoo finance to review fundamentals, then read a few earning call transcripts, 10-Q’s and look at investor presentations. Any bearish or bullish articles I can get my hands on are also investigated at this time (seekingalpha.com is a good resource). Once these steps have been completed I ask myself a couple of questions:

Is the company healthy financially? (i.e. High current ratio, strong net cash position)

Is the company poised for or setting itself up for future growth?

Is the industry one which is growing and healthy for participants? (i.e. pricing pressures, if not refer to next question)

What are the competitive advantages held to hold off competitors and entrants? (Brand strength, pricing power)

Is the company manipulating earnings?

Is the company extremely cheap, if so why?

How is management?

Then after answering the above, asking youself:

Is the company cheap enough when considering the above questions that it is has a sufficient margin of safety?

In order to answer the last question one must determine an estimate of fair value of the company. I attempt to establish such a valuation by looking at comparable competitors, historic ratios, and pairing ratios to growth(like PEG ratio, with 1 being a fair value). By investigating the questions above I can infer if the company should trade at a premium, discount or equivalent to these historic and comparable ratios. Often, however, one must not even compare to competitors or historic valuations as it can be evident for example that a company growing revenues at 30%, should not trade at a 1.2 EV/Revenue, considering it is in a strong margin market.

Many investors use the popular discounted cash flow analysis to establish a fair value. However in using DCF analysis you arrive at a value derived in part from beta and built on assumptions too far into the future. Since I look at the actual business and assets underlying a stock, any use of beta in determining the value of a security would be against my investment principles as beta measures price movement.

Many of the questions listed above will be examined in future articles as most are subject to a discussion by themselves. However as I recently picked SodaStream as a favored stock, I must clarify my position on the question “How is management?” because of management's current struggles and earnings misses.

In evaluating management, I mostly look at a few categories which demonstrate their quality: the ability to operate efficiently by cutting costs when needed, meeting their own expectations, growing revenues and earnings, and growing shareholder value by reinvesting effectively, whether through R&D or buybacks among others.

Let’s take a look at SodaStream to see how they passed the test. First off they completely bombed the category of meeting their own expectations for the year 2013 in which they revised their estimates many times downwards. While this may result in a lack of faith in management, I believe their results were a sacrifice in the short-term for the long term good of the company. Meeting expectations can be a category with many variables. One such variable as noted by management was the negative impacting exchange rate where most of their operation costs are held, leading to decreased margins. Margins were also compressed by increased promotional activity by management in the U.S. However the margin decrease is a short term sacrifice to increase households with the product that will lead to stronger margins than before, as a short term effort to increase normalization of the product. Although the company missed their own expectations significantly, some headwinds will come unexpectedly. Short term sacrifices for long term betterment is a solid business practice. Since the company will continue to grow revenue at an exceptional fast pace and margins will grow after short term issues are fixed, I am not so concerned about the company after their recent market correction. See my article for more details.

The example of SodaStream was used to show that not every stock is going to be perfect and there will be some questions. However good stock picking is about realizing whether the market is overemphasizing potential problems and mispricing or is pricing the stock just about right. This can be shown in examples such as Herbalife and Nus Skin, Outerwall or Baidu. Each company faced potential headwinds yet was undervalued with strong growth prospects at times in which I became interested. Such stocks when purchased at the right price offer great returns. Other companies such as IPG Photonics or Cognizant Solutions can be simply mispriced without clear reason, (both trading at PEG below 1 when bought). The art of stock picking boils down to a couple great principles learned through Ben Graham, Warren Buffett and Charlie Munger, take advantage of price fluctuations and buy solid businesses for less than they are worth to the private businessman.

AVG Technologies: A Mispriced Technology Stock With Great Upside

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 Products:

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:

Subscription

(software)

Key Products:

Security Suites

Mobile / Tablet Protection and Optimization

PC Optimization

Identity Protection

Web Protection

Online Backup

Family Safety

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

Platform Derived

(Search and Advertising)

Advertising

Secure Search

Proprietary Threat Data

Other Partnerships

Google

Yahoo

Seznam

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.

Fundamentals:

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

14.8

FY13 Non-GAAP P/E

8.2

FY13 Market Cap/Op. Cash Flow

6

FY13 Market Cap/Unlevered Free Cash Flow

7

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.

Disclosure:

I will most likely initiate a long position in AVG in the next 72 hours.

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