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AVG Technologies NV (NYSE:AVG)

Q1 2014 Results Conference Call

May 07, 2014 / 05:00 P.M. E.T.

Executives

Erica Abrams – IR, The Blueshirt Group

Gary Kovacs – CEO

John Little – CFO

Analysts

Gregg Moskowitz – Cowen and Company

Melissa Gorham – Morgan Stanley

Pat Walravens – JMP Securities

Hamed Khorsand – BWS Financial

Mark Grant – Goldman Sachs

Fred Grieb – Nomura Securities Intl

Operator

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the AVG first-quarter 2014 financial results conference call.

(Operator Instructions)

This conference is being recorded today, May 7th, 2014. I would now like to turn the conference over to Ms. Erica Abrams. Please go ahead.

Erica Abrams

Thank you, Camille. Thank you all for joining us for AVG's first quarter of fiscal 2014 financial results conference call. Joining me on the call today are Gary Kovacs, CEO; and John Little, CFO of AVG.

Before we get started today, I would like to remind you that this call is being webcast and recorded. The webcast can be accessed live on the Investor Relations section of our website and via replay on our website shortly after the conclusion of the call. The website can be accessed at investors. AVG.com.

On this call today we will provide you with details about our performance in Q1 of fiscal 2014. Some of our comments may include forward-looking statements such as statements regarding our outlook for fiscal 2014.

These forward-looking statements are based on certain assumptions and are subject to a number of risks and uncertainties. Actual results may vary materially. Please refer to the section entitled forward-looking statements in our earnings release and read the risk factors included in our filings with the SEC, most recently our 20-F filed on March 25th.

I would also like to point out that the results reported today include certain non-GAAP financial measures, and that the numbers discussed on this call will be non-GAAP unless stated otherwise. We provide non-GAAP financial measures because we believe that they are the most valuable way to review our core operating results. We have provided a reconciliation of non-GAAP measures to their comparable GAAP measures in our earnings release, which is available on our website and has also been filed on form 6-K.

The forward-looking statements and risks stated on this conference call are based on current expectations as of today, and AVG assumes no obligation to update or revise them, whether as a result of new developments or otherwise. Now I'll turn the call over to Gary Kovacs for his remarks.

Gary Kovacs

Thank you, Erica. Hello, everybody, and thank you all for joining us today as we report our first-quarter 2014 results. On the call today I will give you a high-level summary of the business overall, as well as walk you through each of the business areas. And will then turn the call over to John Little, our Chief Financial Officer, who will provide a deeper review of our overall business.

We are pleased with our performance in the quarter, where we're reporting total revenue of $93.5 million and earnings per share of $0.56. And at the same time that we reported these good financial results, we also continued to manage cash flow, our balance sheet, and our overall costs, and we took a significant step forward in the delivery of our vision with the launch of AVG Zen.

During the quarter active users reached 187 million at the end of the quarter, including 81 million mobile users, up nicely over the prior quarter. The first quarter was well in line with our expectations as we move AVG forward as the on-line security company. We executed well on our key strategic initiatives focusing on devices, data, and people as we discussed in the last earnings call and as we reviewed in detail at our Analyst Day in New York in early March.

Let me start the deeper review with our consumer business. Sales of our premium security and PC optimization products continued to be the main contributors to top-line and subscription growth overall.

Importantly as we committed last quarter. we launched AVG Zen in the first quarter. This is a new interface on top of our existing applications that provide an easy approach for the discovery and deployment of all of our products and services across all of our users connected devices.

This is the market opportunity we are addressing, and we are currently evaluating different offerings to monetize. We believe that searching these – pardon me, securing these multiple connections will deliver an outcome that drives higher customer engagement and greater lifetime value over time. By simplifying and securing a customer's connected world, we believe AVG Zen will be at the forefront of what needs to be an industry redefinition, making security much, much simpler.

The initial results of AVG Zen are positive, and the consumer uptake is encouraging. Following a limited rollout to selected geographies, we are seeing initial conversion rates that are higher than historical rates for AVG's other products. We are excited about the opportunity this new application offers AVG to monetize our mobile users.

The first step was the launch of AVG Zen, and that was successfully achieved in Quarter 1. In the coming months we plan to gradually release this application with increased functionality and for other platforms to new users as they sign up for AVG's services.

Our target is to offer AVG Zen to 100% of our new traffic by mid-September of this year and following this milestone, we also plan to convert existing users to AVG Zen with a target of having the majority of those users converted by the end of the year. We are on track for this rollout and will keep you updated during the year about our progress.

Further, in the area of mobile, we continue to see an expansion outside of our anti-virus products. We are now recording a total of 1.07 apps per device, up from 1.05 last quarter.

Now, in overall numbers this means 81 million devices are protected and are using 87 million applications overall. 16 million of these applications are outside of our traditional security products, all of which we believe will drive long-term stickiness and are important as we seek to diversify and expand our overall product offerings. In addition, AVG remains the most downloaded security application on the Google play store today.

On the mobile partner front, and as a result of our Qualcomm reference design program that I talked about last quarter, our security software app is now available preloaded on the NTN Step Out smartphone, which is priced competitively and offering a custom selection of built-in apps for consumers in South Africa. This is part of our overall strategy to go direct to the mobile user in geographies where desktops are not as commonplace.

Now turning to our small and medium business, we are beginning to see results from our strategic investments with both managed workplace and cloud care contributing to revenue growth in the quarter. Annual monthly recurring revenue from our software-as-a-service products increased 15% sequentially and reached nearly $15 million in total. We continue to build out of our North American sales and channel teams, and have also laid the groundwork for further rollout into Europe, Middle East, and Africa in the second quarter and beyond. We believe our SMB business is set to continue to contribute nicely to the top line in the second half of 2014.

In our platform business, we are seeing the expected decline in search revenues consistent with the technology and policy changes that our industry partners are making, as well as our decision to exit from the third-party search distribution business that I talked to you about last quarter. Consistent with this, we expect further search revenue declines in the second quarter and believe that we will establish a new baseline in the platform business by the second half of the year.

The platform business is strategically important, even as the search business declines, and we continue to explore various indirect monetization streams, such as web tuneup and mobile advertising. We will report more to you about these initiatives in the coming quarters.

At our last conference call I also emphasized the importance of innovation. And I am pleased with the early outputs of this investment.

In addition to introducing AVG Zen at Mobile World Congress in first quarter, we launched our latest mobile application, AVG Vault, which is a free application introducing users to advanced encryption methods that help protect their private information and personal data. We expect to monetize this over time.

We also implemented a shortened form privacy notice which demonstrates our thought leadership in the area of privacy. As I have stated previously, this kind of innovation puts us at the forefront of the industry by establishing new best practices in the mobile world. And we will continue these initiatives.

In summary, the first quarter was a very encouraging start to 2014. The team executed very well, and we made solid progress towards our strategic growth initiatives.

As a result, we are maintaining our financial outlook for the remainder of 2014. We believe that AVG is positioned for strong and sustainable future in a very important and growing market. With that, now let me turn the call to John Little.

John Little

Hello, everybody. As Gary has already said, we had a strong first quarter with total revenue of $93.5 million and earnings per share of $0.56.

Our subscription business contributed $67.3 million, 72% of total revenues. Our platform business contributed $26.3 million. Free cash flow was $30 million, or $0.56 a share, and cash conversion was 32%.

Turning to more detail of our first quarter performance, subscription revenue increased 19% over the prior year to $67.3 million, with a gross margin of 90%. And our subscription revenues both consumer and SMB grew meaningfully year over year in the first quarter. Consumer subscription revenue by 17% to $53.2 million, and SMB by 27% to $14.1 million.

This quarter we're beginning to provide additional visibility into our business by reporting consumer and SMB segments. Today consumer includes the majority of our subscription and all of our platform business. SMB includes the remaining piece of our subscription business. The SMB business is evolving into a SaaS model where consequently we are increasingly viewing that as differentiated from our consumer business.

In our platform business, revenue is $26.3 million, down sequentially as expected. Yahoo represented approximately 49% of platform revenue up from 42% in the prior quarter.

Organic search revenues were $17.4 million in Q1, down year over year as compared to Q1 2013 when we had a very strong quarter prior to the Google guideline changes. Overall we saw the number of searches decline to approximately 900 million in the first quarter of 2014 as compared to 1.2 billion in the prior quarter.

On a dollar basis, we expect approximately the same rate of sequential revenue decline in the search business in total in the second quarter as compared to the first. We plan to establish a new baseline in the platform business in the second half with contributions from initiatives such as mobile advertising as Gary mentioned. Platform business posted 83% gross margin in the first quarter of 2014.

Turning to more details around revenue drivers. (inaudible) held steady at approximately 16 million. In addition, total active users were 187 million, and mobile users reached 81 million as Gary discussed.

We continue to improve our accounting methodology and made a number of changes to our method of counting this quarter, as described in greater detail in the notes to our quarterly financial statement. This resulted in the mobile free user count increasing by 2.4 million. As AVG Zen continues to gain traction, we may further evolve our accounting methodology.

Operating income was $34.4 million, and operating margin 37%, significantly exceeding our expectations. As we continued our exit from the third-party search distribution, we removed resources and reallocated resources to mobile and Saas initiatives as the future growth areas of our business.

As we look across our segment analysis, from an operating income basis, the consumer business contributed $39.9 million or a 50% margin, and our SMB business $3.2 million or a 23% margin. We have $8.7 million of unallocated costs representing approximately 18% of OpEx.

As we transition the SMB business to a SaaS model, we are spending more to drive growth, but it's still nicely profitable. Margins in the consumer business expanded by more than 100 basis points year over year.

Interest and other expense in the quarter was less than $100,000, as compared to $2.1 million a year ago. As a result, net income was $30 million at a margin of 33%.

Turning to the balance sheet, deferred revenue at March 31st was $197 million, unchanged from the prior quarter, and up 5% compared to the prior year first quarter. Cash and cash equivalents totaled $36.4 million at March 31st, and net cash was $31.4 million, as we continue to generate significant cash flow and apply $25 million to paying down a proportion of our revolving debt, leaving $5 million of total outstanding debt.

Turning to cash flow, we generated approximately $30 million of free cash flow in the quarter. As our debt approaches zero, we have changed our reporting free cash flow this quarter and will continue to do so from now object. We repurchased an additional 501,000 shares in the quarter at a cost of $8.3 million under our anti-dilutive share repurchase program.

We paid $2.3 million in taxes for the quarter. Interest paid was $300,000 compared to the prior year of $2 million, primarily due to the lower debt level.

Turning to our outlook for the remainder of 2014. With AVG Zen we've see long-term benefits related to the cross-platform opportunity and ability to deliver additional product as we roll out this application to additional users over time. As we've stated in the past we expect meaningful revenue from this initiative in 2015. Our SMB business is expected to deliver more revenue in the second half of 2014 as we continue the transition to the SaaS model.

With the first quarter behind us, we are maintaining our revenue and EPS outlook for the year. As we discussed with you last quarter, we believe the second half of the year will represent a proportionally larger share of annual revenue.

Finally, thanks to all of you who made it to our Analyst Day, whether in person or on the webcast, and we look forward to talking to you all again soon. Now back to Gary for closing remarks.

Gary Kovacs

Thank you, John. Well, just a quick wrap-up from me.

We executed well in the first quarter, delivered good financial results, and made major engineering improvements to support the introduction of AVG Zen to the market. The opportunity with AVG Zen is to increase customer engagement and make it easier to deploy and discover all of AVG's technology through this new user interface.

As well, AVG Zen gives us the opportunity to drive subscription revenue as users sign up to new accounts and to deliver security across platforms much, much more easily. We have now pivoted our business, and the opportunity lies ahead.

Over the next several quarters you should expect continued innovation, new partner relationships and inorganic growth opportunities while we also stay focused on delivering leading technologies and services to protect people, their data, and devices. Becoming the on-line security company will take a few more quarters but we are uniquely positioned to succeed.

I would also like to take a moment and welcome our newest board member, Ronan Dunne, who we announced earlier this week. His deep and distinguished career in mobile will help us navigate into these new areas, and I look forward to working with him and the rest of the Board going forward.

Thank you again for joining us, and I will now close the formal part of the call and turn it over to the operator for any questions. Operator, please go ahead.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question is from the line of Gregg Moskowitz with Cowen and Company.

Gregg Moskowitz – Cowen and Company

Thank you very much. Hi, Gary. Hi, John.

First question, can you talk about the search revenue declining again essentially in Q2, then establishing a new baseline in the second half? Just wondering in terms of the number of searches, because that did decline by a fair amount this quarter, do you expect the total number of searches to stabilize in the second half as well?

John Little

I think as we said in the past, Gregg, what we're looking at there is an expectation of maintained RPM. So to muddle the RPM. So as that moves, then you're quite right that the search number that we would expect to potentially go down in the RPM to remain solid.

Gregg Moskowitz – Cowen and Company

Okay. Perfect. And John, your operating margins this quarter were much stronger than expected. Could you walk through why the EPS guidance for the year wasn't raised and just kind of why operating margins are likely to fall fairly significantly over the balance of the year?

John Little

It's the same point that we've made and I guess I've made over a number of quarters, Gregg. We have taken a significant amount of costs out of our more mature businesses again this quarter. And the investment in the new businesses of SaaS and mobile hasn't caught up with that Q1. As we continue that transition of investment I think it prudent, particularly with it just being Q1, to continue the guidance that we've given for the full year at this point.

Gregg Moskowitz – Cowen and Company

Okay, great. And then, John, historically in Q1 periods, your deferred revenue has grown by a few percentage points on a sequential basis. This quarter it was flat, and I was just wondering if there was anything that would you point to there.

John Little

No, not – I think not really, Gregg. We saw – I think we talked to you all about the sort of atypical release this quarter. As you saw that came to fruition, and the balance sheet was similar to that.

I think we were, as quite rightly say, looking at a very tough quarter compared to last year. We would expect deferred revenue to continue to increase from Q2. So back to the normal. So that's why we didn't talk about it on the call. We were expecting that to continue to grow from next quarter onward.

Gregg Moskowitz – Cowen and Company

That's helpful. One last one for Gary. And by the way, nice to hear some of the early positive feedback on Zen.

Certainly the Company had a lot of internal initiatives that are important. Just wonder if you could update us on how you're thinking about potential M&A.

Gary Kovacs

Thanks for the question, Gregg. M&A continues to be an important part of how we're charting our growth. At the Analyst Day I talked about three specific areas. We're basically holding to those.

The first is, the strategic tuck-ins as we have done in the past, and we've done a great job of integrating those, and we're active in continuing to search for those. On the other side of the spectrum are some fairly strategic deals that are more sizable in nature that will accelerate us into these new areas of mobile and cloud. I think those are of a very strategic nature and quite helpful and we're active in those.

Of course the middle ones are sort of a combination of the two where there are companies that have reached some limit as to how much they can generate in terms of revenue and market share because they don't have scale. Going to the capital market sometimes now for private companies is a little difficult for that purpose, and we have scale. We have a channel, we need to fill it. So those are the three areas, and I say nothing to report now but we're still very active in driving those forward.

Gregg Moskowitz – Cowen and Company

Great. Thanks very much.

Gary Kovacs

Thank you.

John Little

Thanks.

Operator

Our next question is from the line of Melissa Gorham with Morgan Stanley. Please go ahead.

Melissa Gorham – Morgan Stanley

Thank you for taking my question. So I just have a question on the subscription business. It was definitely a solid quarter but growth did decelerate a little bit. I think originally you talked about maybe mid to high teens growth in the subscription business over the course of the year. Is that still how we should think about it? Maybe just any additional color on how we should think about the relative growth rate of subscription versus platform in your full-year guide.

John Little

I think that's exactly how you should still think about it, yes. So no changes at all for the overall guidance, and so I think that gives you the idea of where we were – where we're coming at, Melissa. And of course, it's significant growth in subscription, then I think we called platform of being $80 million to $100 million, and we haven't moved away from those numbers. Everything as you were on those points.

Melissa Gorham – Morgan Stanley

Okay. Great. Then just one sort of high level question for Gary.

So recently we saw on the news someone from Symantec saying that anti virus is dead, and maybe he was talking about a little more from the perspective of the enterprise but definitely still applicable. I think he was also talking about the consumer business there as well. Just wondering how would you respond to that if you have noticed potentially any changes in the competitive dynamic with someone like Symantec perhaps de-emphasizing their consumer business.

Gary Kovacs

It's a great question. I hadn't noticed the article. Of course, we've seen the article. From an AVG perspective we definitely do not see the same thing. Do not.

In fact, the number of research reports, including fed companies own report shows an increase, quite a dramatic increase in the number of viruses detected both on desktop and mobile. We also see from the same company's research report a decrease which means more risk of viruses coming in from e-mail. So the data and the research doesn't support the fact that viruses are not still a threat.

What we do see, which is what we talked about last quarter and at our Analyst Day, certainly how we're building our strategy, is the definition of security has broadened quite substantially. Virus detection and eradication are just one aspect of the entire security portfolio that consumers everywhere are expecting. And it's at the core of how we're looking at security across devices, data, people, and there's also many different levels of how we now detect viruses and eradicate them.

So it's quite a complex area. I can't speak with any level of intelligence to what specifically they were referring to, but we certainly don't see the same pattern here.

Melissa Gorham – Morgan Stanley

Great. Thank you.

Operator

Our next question is from the line of Pat Walravens with JMP Securities.

Pat Walravens – JMP Securities

Gary, can you tell us when Zen is going to cover Apple products, and then just how are you going to start saving and charging for Zen?

Gary Kovacs

Hey, Pat, thanks for the question. What we said at the Analyst Day is we will cover Apple products that will be part of our first set of releases in the second half of the year. We're still on track for those.

And along with a measured rollout of Zen across our portfolio of products and the increase in functionality. So that kind of gives you the dynamic. What I – to the question specifically of how we monetize Zen and obviously the incumbent question there is how do we monetize mobile?

What Zen does is increases the engagement with our users. The biggest challenge that our users have indicated and – new and existing users have indicated, there's a lot of insecurity. It's confusing, it's not easy. It all looks different, which is exactly the value proposition that Zen is aimed at.

So as we broaden and deepen the relationship with our users, there is an understanding that we can now start to charge, either on a subscription or on a in-app purchase to other products or other platforms from our users, because there's just much more value that we're providing, some of which they've come accustomed to paying for. So those are where our experiments are aimed at today.

What we did talk about at our Analyst Day, and on our last conference call is we want to be very measured as to how those experiments go. Because the first stage of mobile is we have to get our user base, and introducing Zen, making sure they adopt it, and of course with Zen, making sure they sign up for an AVG account gives us the opportunity then to have a relationship directly with them rather than through a specific store.

It is through that relationship that we can then work with them and experiment on different monetization schemes where they see value and certainly we get compensated so we don't want to do that too quickly. If you do it too quickly, the world is littered with companies that tried to push too quickly and users just fled.

So I would say those results, as I mentioned during the prepared remarks, are very encouraging. We will continue to be very measured and thoughtful.

But we see kind of two steps to the monetization scheme just in summary. Number one is from a subscription point of view as we start to add more products and more platforms to Zen, we're asking the user to subscribe. The second, if they just want to buy on an a la carte basis, these updates, just sort of the more enhanced versions will become an in-app purchase opportunity for us.

Pat Walravens – JMP Securities

Thank you.

Gary Kovacs

Thank you, Pat.

Operator

Our next question is from the line of Hamed Khorsand with BWS Financial.

Hamed Khorsand – BWS Financial

Hi. First question I had was, is it too early for you guys to see any kind of trending data from subscribers downloading Zen and what the app attach rate is? Is it improving?

Gary Kovacs

You know, it's not too early. We're not reporting that just yet. We're seeing very early results.

We've done a very measured rollout, I think for all the right reasons. What we want to make sure is that we grow the user database.

The measured rollout, as I said during the prepared remarks and John gave a little more detail, is showing encouragement. Meaning, specifically a couple of things. The engagement is increasing in terms of the number of apps used by those customers; the conversion rate specifically.

So those are positive as we now move to the next phase of rollout in terms of percentage. We're going look for that same pattern and once we get that same pattern confirmed, then we're going to open up the rollout to much broader. We're not breaking it out, but generally speaking, we're seeing a positive – in fact, quite a positive result.

Hamed Khorsand – BWS Financial

Okay. Then my other question was going to be, what's causing that rolling per subscriber number to be at 235 if you're not really providing that Zen figure? What are people buying other than just the antivirus software that you're getting at 235 per subscriber?

John Little

It's the same three things that we've looked at historically, Hamed, meaning that the PC optimization and the consumer security renewals are the two big drivers for growth. We've also seen the SMB business continuing to do that and, of course, as the organic search business continues on its way, that also contributes. So you've got those four things.

And I think the thing to take care of as well is first consider, as Gary is saying, the mobile users right now aren't monetizing. So if you take that $81 million there that also gives you another trend to consider.

But the four main things remain on the PC side; organic search, consumer security renewal, PC optimization for purchases, and the growth in the SMB business.

Hamed Khorsand – BWS Financial

My last question is, one of your main competitors just released a secure search browser for mobile, and I guess they're going mobile that path. Do you think that will impact your strategy into mobile?

Gary Kovacs

Good question. No, it doesn't impact our strategy.

Secure search in a browser is something that we have actually been offering through both our core products, as well as our tool bar. And the distribution of that organic tool bar. I think there's different ways to look at security.

We have also – and we've been public about this in the past, evaluated whether we partner with a browser company, which we do today, all of the major ones, or we build something ourselves. We didn't want to take the path to do that because then we're in competition with a main distribution for part of our business.

And we think with the – frankly with the plug-in mechanisms and the way that they're technically designed today, most browsers offer us a very simple way to plug a very meaningful set of security product into the browsers. So that's our current strategy and what we're going to continue to push.

Hamed Khorsand – BWS Financial

Thank you.

Operator

(Operator Instructions) Our next question is from the line of Mark Grant with Goldman Sachs. Please go ahead.

Mark Grant – Goldman Sachs

Thanks for taking the question. Quick one from me. We have heard a couple of other companies come out this quarter and mention that their automatic billing and automatic renewals were impacted somewhat following the Target breach as a lot of customers have changed account numbers, credit card numbers, those things. Have you seen any impact from that, from the PC tune-up or any other subscription products, and do you have a plan to proactively reach out to the customer base and update billing info going forward?

John Little

Yes, we did see some impact from the quarter. I think as we looked at the quarter, it was probably, while still not material, was probably our biggest variation from our expectation against our subscription business.

So consequently from that we have taken a number of initiatives to ensure that to make sure that that does get back on track. But again, it was an impact. I would not describe it as a material impact, but certainly it was something that did come into consideration.

Mark Grant – Goldman Sachs

Great. Thank you very much.

Operator

Our next question is from the line of Fred Grieb with Nomura Securities.

Fred Grieb – Nomura Securities International

Two from me. First, can you give us a bit more detail around the acceleration and revenue growth we're seeing in the SMB business? Maybe just dig into what the key drivers are there?

John Little

Yes, I think the main drivers that we're looking at there is the transition to the SaaS model. And also the fact the big driver for that has been our cloud carrier, our organic product there and the acceleration of the revenue from the acquisition of what has now become AVG managed workplace.

So those two things together are giving us nice traction into the market, and I think that as we've given the guidance for the year, we've said that we expect approximately 20% growth in that SMB market. It's nice to see that we're on track for that, plus, the most pleasing thing about that all is the – not just the SMB business overall, but within that SaaS model and the annualized monthly recurring revenue, the sequential growth in that of 15% I think is exceptionally pleasing, and probably one of the highlights of the first quarter coming out.

Fred Grieb – Nomura Securities International

Got it. And then second question, have you guys begun having conversations with third-party software vendors about selling their software through the AVG Zen platform?

Gary Kovacs

Yes, we have. AVG Zen, just to reiterate what we talked about at Analyst Day, was stage 1 is getting the product level out with a base level of function, then upgrading both function as well as distribution reach from there. So we are a couple of quarters away from having the actual interface to the point where it's easy to plug those software vendors' product into the degree that they apply.

But that means that we're starting some of the conversations in advance of that. So obviously not talking about anything specifically, those discussions are ongoing, and we have a group formed to do that.

Fred Grieb – Nomura Securities International

Great. Thanks a lot.

Gary Kovacs

Thank you.

Operator

There are no further questions at this time. Ladies and gentlemen, this does conclude the AVG first-quarter 2014 financial results conference call.

If you would like to listen to a replay of today's conference, please dial 1-800-406-7325, or 303-590-3030 with the access code of 4677906. We'd like to thank you for your participation. You may now disconnect.

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