Perion Network: It Can't Be This Bad
http://seekingalpha.com/article/3985222-perion-network-bad
Summary
It does look like continued pressure from a massive lock-up expiration is artificially depressing PERI shares.
At the same time, there are some concerns about the Search business and early performance from Undertone.
Still, a share price near $1 doesn't make sense, given the price paid for Undertone (an acquisition the market loved) and increasing bond prices.
This remains a risky play, but PERI simply looks too cheap.
After years of being a bear on the stock, I turned bullish on Perion Network (NASDAQ:PERI) after its $180 million acquisition of Undertone in December. Shares were at $2.68 at the time; it would be an understatement to say the call hasn't worked out:
source: finviz.com
Honestly, I've been stunned by the magnitude of the decline. Perion management has pointed to the expiration of a lock-up on shares granted in the company's reverse merger with Conduit as providing pressure, but in a call earlier this year (with shares above $2), CFO Yacov Kaufman told me that six core shareholders would hold their ground and hopefully stem the bleeding.
Clearly, that hasn't happened, but there's still reason to think that the continued declines are not necessarily being driven solely by fundamental revaluation. Indeed, there's a bit of a disconnect at Tuesday's close of $1.12 for a number of reasons. I can see some cause for concern, and I'm somewhat regretting trusting Perion after years of questioning management. But I went long at $1.30, since this stock looks just too cheap, and I still see reason to believe the pressure on the stock isn't related solely to Perion's business.
A Disconnect
The recent trading in PERI shares is a bit illogical, in my opinion, for several reasons. First, Perion's enterprise value (including outstanding consideration due to Undertone's former owners) is at $174 million. The company paid $180 million for Undertone barely six months ago. And the market loved the deal: shares rose 80% in a matter of sessions before beginning their long decline just before the lockup expired January 1st. There was some reason for potential concern in the Q1 report, with Perion already projecting lower-than-expected growth from Undertone in Q2. But the stock gained almost 7% on the day of the Q1 earnings release, and it had already hit $1.50 the day before.
There really hasn't been any fundamental news over the past six months to change the implied valuation of Undertone all that much. To be sure, some of the December gains may not have come solely from the value seen in Undertone; there likely was some relief by investors that Perion had put its cash into a profitable business after some questionable purchases in the past. But early performance appears reasonable, and sector valuations in adtech haven't fallen all that much:
RUBI Chart
RUBI data by YCharts
I can see some reason for bringing Undertone's valuation down; I was a bit concerned after the company pulled down directional guidance for 2016 after Q4. But the magnitude of the decline in PERI shares seems to far outweigh any news over the seven months since the transaction was announced, and the current valuation implies either that Perion overpaid (likely by close to 100%) or that the rest of the business is basically worthless.
Perhaps that's the case. But there's one group of investors that don't appear to think so:
source: Tel Aviv Stock Exchange
That's the chart of Perion's convertible bonds. The conversion feature is of little value, with the conversion price at about $8.61, and the bonds appear subordinated to an Undertone credit facility and another secured by legacy Conduit assets, per the 20-F. While the equity seems to be pricing in some risk of Perion's strategy leading to bankruptcy, the bond market - in Israel, at least - seems much more confident.
There simply doesn't seem to be a fundamental reason for such a steep decline, and recent trading certainly seems to imply that a large stake (or stakes) are being liquidated of late after similar sales at the beginning of the year:
PERI 30-Day Average Daily Volume Chart
PERI 30-Day Average Daily Volume data by YCharts
And Perion itself can't do anything to support its stock: per the Q1 conference call, it is prohibited by Israeli law from buying back shares as long as retained earnings are negative. All told, there appears to be a bit of a "perfect storm" relative to trading that might explain some of the unrelenting pressure on PERI's stock price, and might imply that there's a buying opportunity for investors patient enough to wait out this turmoil.
Real Concerns
I do think the sell-off is overdone, and likely magnified by the lock-up expiration and the inability of Perion to repurchase shares (with the market cap at $86 million, even a $5-$10 million authorization could have a significant impact on demand). But there were some concerns in the Q1 report as well, even if the initial response was bullish. To be sure, Perion did beat analyst estimates and its own guidance rather handily. But it's starting to look like Perion sandbags its guidance somewhat, and the bottom-line beat relative to consensus comes from Perion deciding to shut down part of its Grow Mobile business, moving a loss to discontinued operations (on a GAAP basis, that $0.05 shift exactly matched the delta against the two-estimate EPS number).
In Search, revenue fell 6% sequentially, with Perion guiding on the Q1 call for that figure to stabilize. That number looks a bit of a disappointment, with the company having said on the Q4 call that Q4 levels would be the bottom, plus or minus 5%. Margins fell dramatically, as Search revenue fell 5.6% year-over-year but customer acquisition costs nearly doubled. Some of the CAC gains comes from Undertone media buys, but even excluding that spend, CAC was up over 80%, moving from 36.5% of Search revenue in Q1 2015 to 78% in Q1 2016. And it appears Perion was a bit more aggressive in Search than expected, which drove revenue above expectations - enough to more than offset the top-line loss from Grow Mobile - but also means the company continues to be exposed to what looks like a declining business. Perion's revenue is now concentrated in Microsoft's (NASDAQ:MSFT) Bing, and there's still a fear that changes relating to Windows 10 and Edge - or simple policy changes similar to those from Google (NASDAQ:GOOGL) (NASDAQ:GOOG) that decimated the third-party search business two years ago - could further pressure Search profits. The two other major players in the space - AVG Technologies (NYSE:AVG) and Blucora (NASDAQ:BCOR) - have essentially exited, with Blucora looking to sell its InfoSpace division and AVG's Search business limited basically to its desktop anti-virus programs. The continued declines - even if Q1 may have had some seasonality - raises some worry for what is still a reasonably big part of Perion's business.
In terms of the mobile business, the decision to shut down Grow Mobile had been tipped somewhat on Q4, when Perion fully impaired the intangible assets acquired in 2014. But it's still not entirely clear what went wrong there; Perion is focusing on the "high impact" space with Undertone, trying to avoid the "race to the bottom" in the increasingly commoditized adtech space. But on the Q1 call, CEO Josef Mandelbaum said the drivers of a lower-than-anticipated growth for Undertone in Q2 were "a more pronounced shift of advertising budgets to social and in-app". Perion was supposed to have added those capabilities through the purchases of MakeMeReach (social) and Grow Mobile (in-app), both of which were supposed to complement Undertone's more advanced mobile offerings. Grow Mobile's in-app engineers appear to be staying on, and Mandelbaum cited the revenue synergies of Undertone's high-impact portfolio with MakeMeReach's social offerings, but it appears that the integration is a bit slower than hoped. The fact that the businesses acquired by Perion before Undertone aren't benefiting from this shift in the space (and that Grow Mobile has been a bust) also casts a shadow on Undertone: is Perion once again behind the curve in trying to enter a space in which it doesn't have any real competitive edge?
Valuation
Still, the current price seems just too low, even considering those concerns. Full-year guidance was roughly maintained, with Perion now pointing to the high end of EBITDA guidance, based on previous expectations of 50%+ revenue growth and 10-12% margins. That hike doesn't necessarily imply an improved business outlook; rather, it simply seems to incorporate the benefit of shifting Grow Mobile into discontinued operations.
But full-year projections still imply about $39 million in Adjusted EBITDA, a EV/EBITDA multiple of just 4.5x. Interest expense should be about $13 million, capex ~$3 million (adjusted up from the pre-Undertone baseline of ~$2 million), and normalized tax rates should be low, thanks to high amortization and a low Israeli tax rate (25% is the corporate rate, but as a "preferred enterprise" the rate can drop as low as 9%). The free cash flow multiple looks to be in the 4-5x range - which implies outright failure in Search and declines in Undertone, both assumptions which seem far too pessimistic. Even a ~3x EBITDA multiple on Search profits (about $15 million, based on previous guidance relative to Undertone, at a multiple where depressed PERI shares traded before the attempted 'pivot') plus a 6x multiple on Undertone supports the current price, below profitable adtech plays (see the Rubicon Project (NYSE:RUBI) at ~8x 2016 guidance and Criteo (NASDAQ:CRTO) in the mid-teens).
There's risk here: if Undertone gets left behind in mobile and Perion can't develop its 'in-app' capabilities quickly enough, PERI's equity can get to zero down the line. (The outstanding consideration for Undertone isn't based on targets, so there won't be any help there if the acquired company's results turn south.) Perion appears to building in some benefit from political spend, particularly in Q3, which might make 2017 comparisons a bit more difficult by inflating 2016 numbers.
But even with a modestly disappointing performance since the acquisition, a price above $1.50 still seems reasonable (~6x EBITDA, 5-6x free cash flow) and Undertone is still growing, if not at the rate Perion was hoping for in Q2. It does seem likely that a bottom in the stock will come at some point (though I've thought that for some time), and solvency isn't a near-term threat, giving the company some time. And it does seem that the sell-off has been driven at least in part by the lock-up expiration and the inability of Perion, and the lack of interest from other large buyers, to step up in response. The equity market is showing a company with a reasonable chance of imploding; the bond markets aren't. For now, I still think it's equity investors who have the story wrong.
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... and hopefully earnings report in a month will take it up well above that to a return to bullishness for 2018! 
