AVG: Stale Short Interest, Great Opportunity

For reasons I will explain below, I think there is a good short term long opportunity in this stock as its very high short interest is likely to come down meaningfully and relatively quickly. Even if I put in very conservative assumptions into a DCF, I cannot generate a valuation that is not AT LEAST 100% upside from here (assumptions for DCF highlighted in the paragraph below).

AVG Technologies (AVG) is a consumer and enterprise software company that operates using a “freemium” model. In 2012, the company grew Adjusted EPS 37% on 18% sales growth. Despite this growth and consistently beating expectations (the average EPS beat vs Street over the last 5 quarters has been close to 50%), the stock currently trades at less than 10x NTM Street Adjusted EPS. Free cash flow per share has historically been higher than EPS primarily because of the company’s growing deferred revenue balance (subscribers generally pay ahead of revenue recognition). As of the middle of June, the short interest as a % of the float stood at 33%.

The company’s main product offering is free antivirus for desktop computing. AVG primarily monetizes its user base by upselling subscriptions to a portion of its users and through a product called “secure search.” Users of the antivirus software can download a toolbar so that AVG becomes the default search provider. As users click on advertisements, AVG gets a revenue share with the search engine company that is providing the search results. The bear thesis largely revolves around this search business.

Immediately after this article came out, AVG’s short interest jumped from just 751k shares at the end of January to over 8.5m shares in mid-April. The Company significantly beat Q1 expectations when it reported results on April 24th and as I will argue below, the short thesis seemed to have largely played out but the short interest remains very high at 7.9m shares.

In q4 2012, almost all of AVG’s search revenue came from its Google partnership. In February, Google made a policy change so that all new downloaded toolbars needed to be “opted in.” Bears were correct in concluding that this change would force AVG to move all new users to Yahoo, which still has an “opt-out” policy. However, they were incorrect in the financial impact this would have. Bears argued that since Yahoo monetizes search significantly (up to 50%) lower than Google, AVG’s search related revenue would have a sharp fall. This argument made sense at the time, but the evidence does not support the bear case. In Q1, the company reported that Yahoo represented 9% of search related revenue.

Moreover, AVG said that Revenue per Thousand Searches (RPM) stayed flattish sequentially and guided for this to be the case for Q2. The bears are failing to recognize the fact that while Yahoo likely monetizes less, Yahoo’s new management views getting increased scale in search as strategic and is very likely giving up more in revenue share than Google was. I estimate that AVG’s revenue per search is only about 15% less than what it was getting with Google. If it is much lower than that, then RPM would not have stayed relatively flattish sequentially. This estimate has also been confirmed by talking to other toolbar companies.

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Moreover, if one looks back to the 1st half of 2010 when almost all of AVG’s search business was with Yahoo, the RPM was in the $16-17 range vs the $21 RPM it had with Google in q4 2012. Based on conversations with several people in the industry, I think it is highly likely that AVG’s current RPM with Yahoo is much better than it was in the first half of 2010. First, Yahoo has improved monetization since then. Second, AVG has much more leverage since it has many more users. Third, Yahoo has new management who wants to take share from Google and who views increased scale in search as strategic. While it is true that AVG would have been economically better off if Google did not do the policy change, it does not appear that the lower monetization with Yahoo is enough for the company to miss estimates and at sub 10x FCF, the company needs to miss estimates significantly for the shorts to make money. When the company beat EPS expectations in q1 by over 50%, AVG left full year guidance largely unchanged. This effectively brought down search revenue expectations for the rest of the year and was the impact of the Google policy change. This should become even clearer when the company reports results for Q2 which will be the first full quarter following the Google policy change. Perion Network (PERI) and InteractiveCorp (IACI) are impacted by the same Google policy change and both also still guided for growth.

While the new Google policy has already impacted Street numbers, there are several sources of large upside optionality that will also become clearer to bears as we progress through the year.

1) AVG has 36m mobile users as of q1. These mobile users grew 100% y/y (83% organically if you adjust for an acquisition). The company is currently not monetizing these users and the Street does not seem to be incorporating any revenue from mobile even for next year. AVG has said that it will start to monetize these users in q4. AVG’s mobile products have gotten great reviews for products such as Disclaimer associated with this blog. The author and/or others he advises hold shares in AVG at the time of publishing this article. The author may make trades in securities mentioned without notification. The information contained in this article is impersonal and not tailored to the investment needs of any specific person. You should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

Written By: Ravee Mehta