Description

The thesis on Avigilon is fairly simple and builds off of my earlier writeup on AMBA. Avigilon is a Canada based manufacturer of security surveillance cameras, trading at 18x NTM consensus earnings, earning a 57% gross margin, with very little R&D spend/IP/invested capital in the business. It is a short due to (1) an overall slowdown in the growth of IP security camera installations and (2) increased competition from Asian manufacturers at significant price discounts.

(1) Overall Slowdown of the IP Security Camera Market

Twelve years ago, the security surveillance market consisted of only analog cameras, that is, a single camera connected directly to a monitor and tape recorder. Several large manufacturers controlled the market through a network of integrators with relationships with the end customer. Over the last 6-8 years, the market has transitioned from analog to IP based cameras integrated with a company's overall technology infrastructure linked with a single hard disk drive recording device and a video management system (VMS). Given the slow moving nature of the entrenched analog companies and the limited technological education of the integrators, the incumbents were slow to change and a host of new IP camera manufacturers, notably AVO and AXIS took share and grew significantly (AVO and AXIS have grown revenue at a 102% and 25% CAGR since 2008) in a large market ripe for an equipment upgrade. 

Given strong growth through 2015, the market and consensus believes AVO can deliver 30%+ earnings growth in 2017. However, AVO primarily serves mid-to-high end customers, the precise market segment where the transition from analog to digital is already largely complete. According to AXIS, the high end of the market is 95% penetrated by IP-based solutions. Therefore, while the overall industry may still grow at a 15% annual rate, most of that growth will occur at the very low end, such as small gas stations and convenience stores, which are extremely price sensitive and generally install only 1-10 cameras. Our research indicates that the mid-high end of the market should grow in the low single digits vs. 30%+ at the low end. These growth rates assume no incremental competition, but this is highly unlikely.

(2) Increased Asian Competition

Further supporting our short thesis, competition from Asian manufacturers is increasing, as industry innovation has hit a standstill at both chip manufacturers and software providers. Historically, the video system-on-chip (SOC) semiconductors for the security camera industry were manufactured in-house at the camera companies and by a few large chip companies. But the market is shifting. Today, new SOC entrants are enabled by an IP ecosystem, as Renesas, Imagination, and Arm are all licensing out their IP to fabless chip manufacturers due to a shift to the H.265 compression standard, which limits any individual SOC manufacturer's compression differentiation. This has spurred a competitive race to the bottom in price, which has, in turn, lowered the costs for new IP camera players to enter the market. Camera manufacturers, such as Samsung, Hikvision, and Dahua, have followed suit by cutting price, thus pressuring profitability for incumbents such as AVO.

Moreover, AVO previously differentiated itself by either offering its own VMS (video management system) or having best in class integration with the VMS ecosystem. New independent third party software companies have begun developing and selling video management software that AVO previously bundled with their own cameras to garner higher ASPs. In addition, Asian manufacturers both the white label Chinese and the branded Samsung, Panasonic, and Sony are increasingly integrating their cameras with a broader swathe of third party VMS operators, thereby eroding the integration benefit that AVO previously enjoyed.

Through conversations with resellers and online price monitoring, we have concluded that the Asian camera manufacturers are selling their products at 20-50% discounts to AVO and capturing significant market share in the process. So far, AVO has not reduced pricing, which we believe will result in revenue growth deceleration. The chart below shows average pricing for AVO vs. Asian competitors for high end cameras (30 frames per second and above, and all resolutions 1080p and above).

 AVO has made two acquisitions in the past 2.5 years.

Intellectual Property: AVO bought patents through Objectvideo.

Quote from the CEO of a SOC vendor to me "In general, Axis has much richer IP than Avigilon.  Just do a patent search.  However, except at the very high end, Asia cameras will be very similar." While a potential risk in an AVO short could be their recently purchased patents, manufacturer/reseller conversations have given me some confidence that few companies are paying licensing revenue given the number of VMS companies that all own their own facial recognition/management software. This however, is the largest unknowable for me in this short. 

VideoIQ Acquisition: AVO bought VideoIQ, a company that combines the VMS, DVR and camera into a single hardware appliance. We think this acquisition is a great example of the decoupling occuring between seperate VMS companies and commodity camera hardware manufacturers, thereby reducing AVO's ability to upsell software for a higher gross margin. 

Valuation:

Like many great shorts, timing is extremely hard to ascertain here but this is a commoditized hardware business with very little invested capital that essentially owns two plants where parts, purchased from just as commoditized suppliers are very simply integrated by hand. Over time, margins will contract as pricing falls, both because demand is shifting to the low end and because the pricing delta on comparable products vs. Asian competitors is incredibly stark.

Assuming they hit the low end of guidance for 2016, $335m (USD) and grow 8% in 2017 (this is aggressive given likely ASP pressure despite mid/high single digit volume growth) and gross margins decline to the high 40s%, at constant S&M as % of revenue (i.e. they can scale back at lower revenue levels, but from previous sales slowdowns here and at other similar companies, we know that, if anything, they need to increase their salesforce to continue to grow/compensate the good salespeople to keep them), constant R&D as an absolute number (they play with the accounting with R&D capitalization), I get to $14.5m in net income (USD) or $0.43 in EPS (CAD). Even adding $2/share (CAD) for their owned building, it’s hard to see how this isn’t a single digit stock in a couple years. 

Catalyst

Continued ASP declines and/or revenue growth slowdown