Perion Network: The Enthusiasm Seems Like Too Much

About: Perion Network Ltd. (PERI)
by: Vince Martin

PERI shares have soared of late, gaining 75%+ just since the beginning of July.

Suddenly renewed enthusiasm toward adtech may be a factor, though first-half earnings have been strong as well.

PERI still looks cheap at these levels, particularly with a ~25% pullback in recent sessions.

But there's one key problem with the bull case here: growth is being driven by search, not Undertone. Unless that changes, PERI isn't terribly attractive above $5.

Perion Network (PERI) certainly looks cheap. The stock trades at 4.5x the midpoint of 2019 EBITDA guidance, and ~11x 2019 adjusted EPS backing out net cash.

But PERI for years has been a stock that looked cheap. At one point in 2015, the stock traded at 1.4x trailing twelve-month Adjusted EBITDA and less than two times TTM net income backing out net cash. Investors then were anticipating steep declines in the company's search business, but even after that PERI has on occasion seen sub-4x EBITDA and, quite often, single-digit P/E multiples.

For most of that stretch, investors simply didn't think PERI was cheap enough. But that changed a couple of months ago. PERI entered July around $3 after six months of sideways trading, and then suddenly took off:

PERI stock quote source:

It's not entirely clear what drove the quick, sharp spike upward. Q1 earnings in May were solid, with search posting its first year-over-year revenue increase in five years. But, as seen in the chart, that report did little to move PERI shares.

The most likely scenario is that investors realized there was a laggard in the suddenly hot adtech space:

Chart Data by YCharts

YTD chart

Adtech had been a graveyard for investor capital (Rocket Fuel, Sizmek, YuMe, MaxPoint, etc. etc.) in recent years. A key reason was that Facebook (FB) and Alphabet (GOOG) (GOOGL) simply dominated digital advertising, driving an estimated (and stunning) 99% of the industry's growth in 2016. Smaller publishers were squeezed out, leaving independent adtech firms to fight over a basically stagnant market.

But the two digital giants actually lost market share in 2018. Independent players have managed to adapt their models to the growth in programmatic markets.

As optimism toward the industry grows, Perion seems set to capitalize. It's re-working its go-to-market strategy under what it calls its Synchronized Digital Branding solution. Undertone's higher-quality ads should be attractive for brands focused on engagement, not just quantity. A partnership with Alphonso for 'connected TV' adds to existing competencies in search, social, and display. With the balance sheet cleaned up and expenses under control, Perion seems set for growth - growth which is not priced in at the moment. A surprise year-over-year revenue increase in Q2 may be the first step.

But there's one big problem with the growth thesis. Perion's ad business is cratering. That needs to change in 2020 for PERI to support even current levels, and that's a bet that seems difficult to make at the moment.

The Search Business

Since Perion acquired 'high-impact' ad firm Undertone in late 2015, the plan has been relatively simple. The company's legacy search business was unlikely to post much, if any growth, but it could still throw off impressive amounts of cash. It was Undertone that would drive growth, and eventually generate most, and potentially at one point all, of the company's longer-term profitability.

After all, the search business seemed at significant long-term risk. Perion itself was badly impacted earlier this decade by search changes by Google, which severely limited the use of questionable tactics (including those used by Perion itself) such as home page resets and toolbar installations. Amid pressure on the industry, Blucora (BCOR) sold its formerly namesake InfoSpace business - which had roughly the same share as Perion, per a Perion presentation in 2017 - for just $45 million. Soon after, Perion pivoted to Microsoft's (MSFT) Bing from Google, but search revenue still plunged in 2015 and profits collapsed: Adjusted EBITDA fell 58% from $124 million in 2014.

Even after the reset, search revenues kept heading in the wrong direction, declining 19% in 2017 and 9% last year. But a funny thing happened on the way to irrelevance: search rebounded. Revenue climbed 1% year-over-year in the fourth quarter, then accelerated sharply in the first half of 2019, with an 11% increase in Q1 followed by a 43% rise in the second quarter.

Per management commentary, the growth is coming from new publishers, more searches, and higher rates. (Microsoft itself has called out higher rates for Bing after recent quarters.) Perion is paying up a bit for the growth, as customer acquisition costs and media buy have increased as a percentage of revenue despite the company calling out higher gross margin on the advertiser side. Still, CAC alone doesn't explain the growth: Bing appears to be a strong partner (and vice versa). And that product's exceedingly low share in mobile represents a potential tailwind for search revenue if Bing can increase penetration in mobile (though, given ~flattish desktop usage, a risk if can't).

The growth in search is good news. But, given the option, Perion would be better off if that growth was coming from advertising. Perion still is at the mercy of Microsoft's decisions on algorithms, just as it was with Google at the beginning of this decade. Revenue is less than 40% of what it was in 2015; the long-term trend remains negative even after four straight quarters of sequential growth.

More broadly, trading in PERI over the past five years shows that investors are not going to put much of a multiple on search profits. So does Blucora's sales process with InfoSpace, which took longer than expected and wound up with a price lower than hoped.

Growth in search does help the cause here, and PERI admittedly was quite cheap before taking off in July. Still, investors should be cautious in presuming that search growth continues - and in assuming that PERI is 'cheap' if it does.

Advertising Concerns

The two most logical reasons for the big gains in PERI are adtech optimism and Q2 results. The latter, as noted, was driven by search, which colors the report. The former seems to ignore the fact that Undertone had a very weak first half:

Adtech Revenue Growth, 1H CY19

Company 1H Revenue Growth Y/Y
Perion* -36%
the Rubicon Project +31%
Telaria +45%
The Trade Desk +42%
Cardlytics +24%
Criteo -1%
LiveRamp +31%

* - advertising only

Obviously, peers aren't all running the same business model, but the acceleration in revenue growth across the space clearly hasn't done anything for Undertone so far.

Perion management has framed the first-half weakness as part of the move to the Synchronized Digital Branding offering. On the Q2 call, CFO Maoz Sigron attributed the declines in the quarter to "the transition from selling formats to an integrated solution", echoing language used after Q1.

That transition admittedly should take some time. CEO Doron Gerstel noted in the Q&A of the Q1 conference call that Undertone was retraining salespeople, and that the shift led to "even a change of who you sell to within the [ad] agency; it requires discussion with more senior people." The new offering is a more complex but higher-value proposition, with larger (and more profitable) contracts. A new platform aiming for an early 2020 launch will "break the silos of ad search, social media, and display video" in an SaaS offering, as Gerstel said after Q2.

And Perion does see improvement on the way. The company said it expected ad revenue of at least $57 million in the second half of 2019 against $40 million in the first half. That improvement seems to set the company on a path to growth in 2020 - which combined with search improvements creates big potential for PERI stock at these levels.

But the story isn't quite that simple. The $57 million target still suggests a 10% decline year-over-year in the second half. That seems like a significant disappointment given that Gerstel on the Q4 call appeared to guide for "real growth" that would "definitely come in 2019, towards the second half". And the sequential improvement, as impressive as it sounds, is being aided by seasonality, as Q4 revenue historically has been higher.

That's not the biggest issue, however. The moderating declines on a year-over-year basis - 36% in 1H vs ~10% in 2H - isn't as impressive a jump as it looks. Advertising revenue actually increased in last year's first half (+4.7%), thanks to a 20% jump in Q1. But starting in the second quarter, management began attributing ad revenue declines to a lack of supply of available advertising placements.

That lack of supply had a significant impact. Gerstel estimated the effect in Q4 was between $5 million and $7 million - a sixteen point headwind to ad revenue growth at the midpoint. It's since been fixed, as Gerstel said on the Q1 call. But at least in part due to supply issues, second half 2018 revenue declined 15% year-over-year, against the nearly 5 point growth posted in 1H.

So as far as 2019 goes, Perion is forecasting a 26-point improvement in the year-over-year growth rate in the second half. But the comparison is 20 points easier. And it certainly seems like Q2 results - which saw the same percentage decline on a year-over-year basis - were much worse than those of Q1, given the sharp difference in prior-year results (+20% Q1, -6% Q2).

A closer look at the advertising side of the business suggests that second half guidance is not that impressive on an underlying basis. It also suggests that Q2 was weaker than Q1. That latter issue colors the argument that the primary issue is the transition to selling the new solution; there should be sequential improvement in the growth rate as salespeople adapt and customers are properly educated.

What looks like a potentially disappointing 2019 is a big problem here. Again, it seems highly likely that adtech optimism has helped PERI stock of late - but the company isn't participating in industry growth yet. Meanwhile, 2019 performance comes in the context of a business that has been in steady decline since it was acquired almost four years ago. When Perion acquired Undertone, it guided for full-year 2015 revenue of $143-$145 million and Adjusted EBITDA of $21-$23 million. Four years later, the revenue outlook is ~$97 million - down almost one-third in four years. Consolidated Adjusted EBITDA, after over $20 million in expense reductions last year and with a strong year from search, is guided to $25-$27 million, barely above Undertone's standalone figures in 2015.

A 'Show Me' Story

The big spike since early July seems possibly driven by misunderstandings. A hot adtech space likely is contributing - but industry improvements haven't made their way to Undertone yet. And a huge Q2 beat was driven by third-party search, not advertising, a business which for Perion and on the whole has declined consistently for the past decade.

Again, at $5+, PERI remains reasonably cheap. EV/revenue is likely in the 0.5x range. Only Criteo (CRTO), whose growth has stalled out, is comparable. EV/EBITDA of 4.5x and EV/E in the 10-11x range both imply that any growth can lead PERI sharply higher.

That said, even those multiples leave PERI a 'show me' story. The search business needs to prove that it can drive sustainable growth, particularly with the Bing agreement expiring at the end of next year. The advertising business needs to get to growth, with the obvious risk that what management believes to be sales cycle issues actually are signs of market share loss or other issues.

On both fronts, it does seem like the burden of proof is on the company. First-half advertising results might be explainable in part by the transition to selling solutions, but they also appear to be disappointing relative to expectations. Second-half performance, even if guidance is hit, still requires substantial improvement in 2020 (albeit with easy first-half compares).

And after the past few years, this is a tough company to trust. That might be unfair, and short-sighted. Gerstel, after all, took over for former CEO Josef Mandelbaum, who was responsible for the disastrous merger with Conduit as well as the Undertone acquisition (which, at least for now, looks like a big overpay in retrospect). He's mostly delivered on his promises in fixing the balance sheet and cutting costs.

But those efforts were the easy part: it's much simpler to set the stage for growth than to actually drive that growth, particularly in such a competitive space. The hard work comes now. And as good as Q2 looked from a headline standpoint, the fact is that Perion still has quite a bit left to prove.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.