AVG: A Value Trap Worth Avoiding

Aug.22.14 | About: AVG Technologies (AVG)

Summary

Looks cheap on trailing valuation metrics, but may get cheaper.

Options for the company are becoming limited, with declining sales, rising operating expenses, slowing cash flows and slowing growth rate of new users.

Stock may correct more than 30% as deteriorating growth prospects get reflected in Street estimates.

AVG Technologies N.V. (AVG) is celebrated as an ideal value stock with an almost enviably large number of users, subscription based business model, great margins, decent cash flow, strong brand recall and good valuation based on historical metrics. The thesis has kept a steady stream of Bulls tied up in the stock, which is up almost 30-40% since going public in 2012, but a closer look suggests that the stock is a value trap and getting worse.

The company continues to be a PC centric anti-virus protection service provider, at least looking at the revenue profile, with limited traction among OEM PC makers. Even within the PC space a recent slowing subscription growth rate on the consumer side is worrisome, especially when the revenues from the Platform business are crashing. The company has failed to monetize its large user base so far and with high valuations of private companies, AVG's balance sheet does not look strong enough to make strategically important acquisitions. The tech sector is littered with a long list of great brands that barely stay alive, but with little value addition for shareholders AVG may soon join the ranks, unless the company delivers fast.

The stock, which has benefited from buybacks, looks vulnerable with Street expectations of 6-10% revenue growth for next year. There are high expectations for AVG Zen, the new security tool for multiple devices, and consistent growth from the SMB segment, but worsening fundamentals may push the stock down and close the valuation gap with its better-positioned peers.

Valuation argument may not stay as strong

The strongest argument in favor of the company is usually the value it offers, but take a closer look and the argument holds much less appeal, whether one looks at the company relative to much established peers, as the sheet below shows, or in isolation.

Est. Rev. growth 2014

EV/EBITDA (TTM.)

EV/ Sales (TTM.)

P/ Book

AVG

-10%

6.9

2.3

30.9

SYMC

0%

7.6

2.2

2.9

OTCPK:TMICF

4%

10.3

3.6

3.8

Click to enlarge

Even though revenue and other important financial indicators like cash flows are decelerating, the company is comfortably profitable, but not for long if the trend stays the way it is right now.

Margin Available

Research & Dev.

$15,823

Sales & mkt.

$22,550

Gen. & Admin.

$16,757

Total OPEX

$55,130

Gross Margin

86%

Revenue BE (Approx.)

$64,230

Revenue last quarter

$88,009

Rev. upside available

$23,779

Rev. upside available %

27%

* Keeping Q2 2014 costs

Click to enlarge

As the calculation above shows, at the current operating expense structure breakeven revenue for AVG is at approximately $64 million, which may look far, but looking at the double digit revenue declines of the last few quarters and rising operating costs, investors may be well served to start baking the scenario into their calculations.

Overall, operating expenses are transitioning from that of a PC based single product company to one offering multiple products for multiple devices, while revenues are shrinking.

Amid worsening data, estimates seem overly optimistic

Even after revenue declines and guidance reductions, Street estimates are still calling for high single to low double-digit revenue growth for next year, which seems overly optimistic.

Growth

2012

2013

Q1 2014

Q2 2014

Subscription

12%

27%

19%

12%

Platform

64%

-2%

-45%

-50%

Total revenue

31%

14%

-11%

-12%

Click to enlarge

While the estimates are based on stabilizing Platform revenues and growth of the Subscription business, looking at the recent revenue trend, the deceleration is just gaining pace.

Within the subscription business, growth of the consumer market, which is almost 80% of the subscription business, has slowed down to 8% in the most recent quarter and SMB market seems to be the only growth pocket left with almost 30% yearly growth rate, which is being helped with the transition toward Cloud offering. Platform revenues are depleting fast, especially after Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) guideline changes, and the company has already decided to not go for new contracts.

Worsening indicators

Deferred revenue

$181,156

$197,186

$197,047

$196,060

Book value/ share

$(0.4)

$0.2

$0.4

$0.6

Tangible book/ share

$(2.7)

$(2.5)

$(2.2)

$(2.0)

Active users

35%

21%

25%

17%

Average active user

23%

27%

28%

19%

Rev./ avg. active user (Y/Y)

6%

-10%

-18%

-26%

Click to enlarge

Even looking at the deferred revenue, which is a good leading indicator for subscription revenues, there is less hope for major growth coming back. Another indicator that is concerning is the revenue per average active user, which is now declining faster than the growth in average active user for the first time in a while as the sheet above shows. Exiting from the distribution business and transitioning toward the Zen platform is driving a part of this deceleration of active users and the growth rate, both of which may stay for a while.

In the face of such challenges, one has to be pretty optimistic to expect a double-digit revenue growth rate environment for the company.

Rising operating expenses and limited cash to restrict options

As part of a diversification effort toward new offerings like Zen and Mobile, the company has maintained high operating expense structure, even in the face of revenue declines.

2012

2013

Q1 2014

Q2 2014

Gross Profit

85%

83%

86%

86%

Research & Dev.

16%

15%

18%

18%

Sales & Marketing

26%

24%

24%

26%

General & Admin expense

21%

17%

18%

19%

Operating Margins

23%

27%

26%

23%

Click to enlarge

Size of profitability and cash flows are important because a big part of a Long thesis rests upon the strategic options available to the company, including acquiring emerging business and buybacks, which the company has used in the past, and therein lay one more reason to get worried.

2012

2013

Q1 2014

Q2 2014

Net Cash ($M)

$(45)

$12

$31

$45

Free cash flow ($M)

$101

$128

$30

$19

Cash flow/ revenue

33%

34%

32%

22%

Share dilution

1%

-3%

-4%

EPS growth

35%

55%

-27%

-16%

Click to enlarge

Decelerating margins and cash flows are not just closing the buyback window, but amid a high valuation for venture funded companies, AVG's $50-100 million may not go far.

Early reports on AVG Zen offering are nothing extraordinary

For AVG to make a comeback, a lot depends upon the new Zen offering, but McAfee (owned by INTC), Norton and Kaspersky Lab already offer similar services, including coverage for the Mac, which AVG lacks right now. Overall, offering small additional features may not make a dent, at least not big enough needed to move the growth curve.

Conclusion

"Cheap about to get cheaper" is the message one gets after taking a closer look at the fundamentals. It will be difficult for the company to arrest declining top line growth rate, especially with the recent deceleration of the growth rate in the all important subscription business, while the platform business is getting crushed. Indicators all around are worsening, be it slowing growth of deferred revenue, cash flows, revenue per average user and even the growth rate of the average active user. Strategic options to acquire growth are getting limited with low cash, while the rise of Cloud based backup, storage and security companies is making AVG less attractive as an acquisition target. A target of $12 is based on 1.6 - 1.8 times EV/ this year's estimated revenue, which is more in line with the peers considering the poor growth profile and weak balance sheet of the company.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.