Description

Perion Networks (PERI) is an Israeli technology company with two businesses:  a search-based monetization solution for publishers called CodeFuel which is partnered with Microsoft’s Bing and  a digital advertising business which goes by Undertone. CodeFuel drives traffic to Bing and generates solid cash flow through a revenue share model. Undertone is a  niche digital branding solution going through a turnaround and is break even to slightly negative at current levels. Due to an overhang created by two legacy shareholders who are looking to exit their position (together they own 12% of the company) and the decline in Undertone, Perion is trading at a >20% FCF / EV. At the current valuation you are getting  CodeFuel at a discount and a free option on an Undertone turnaround. On a sum of the parts basis we think the shares are worth $12. With a 3:1 skew to the upside, the shares represent a very favorable risk/ reward.

CodeFuel. 

CodeFuel manages a network of hundreds of  publishers and software developers that monetize their properties by driving search queries to Microsoft Bing. CodeFuel focuses on the “big tail” of these very small publishers and application developers that are too numerous to warrant the attention of Microsoft but in aggregate can drive substantial search volumes. Perion has contracted with Microsoft to share the code that redirects search inquiries from these small sites to Bing. Perion is one of the largest redistributors  of search monetization in the US and they earn revenue as a result of the searches conducted by end users who utilize the search engine that appear in Perion’s products, publishers products, and various websites. 

The competitive landscape among redistributors  is relatively stable for two primary reasons. First, Microsoft is very concerned with the quality of the traffic that its partners bring.  As much as they want to drive traffic to Bing, they need to insure first that the search queries are real (not coming from Bots), don’t infringe on copyrights,  and are coming from non offensive sources. Any new entrant would need to first convince Microsoft that they could be trusted and have the ability to monitor their traffic and walk away from non compliant traffic to their own financial detriment. Second, there is a natural network effect to this business and that is why it exists in the first place: Microsoft needs the traffic but  wants to limit its distribution partners to a select few. In order to get Microsofts’ attention you first need to have a critical mass to make it worthwhile.

Perion has been in this business for 15 years and serves 13mm daily searches which equates to a run rate of $135mm in revenue for Perion and a revenue number that is close to ~$500mm for Microsoft (management's estimate). While this might seem irrelevant given the size of Bing, the traffic has strategic importance given the dominance of Google. Incidentally, BIng still enjoys 35% of non mobile searches in the US so there is still a vibrant ecosystem around desktop search. The obvious downside to this partnership is that Microsoft can terminate the relationship at the end of the contract which are  all three years in length (the next renewal is at the end of 2020 so we’ll learn by the middle of next year if there has been an extension). Without speaking to Microsoft directly our ability to handicap the likelihood of a renewal is clearly limited and we can only read the tea leaves. Perion management will point you to the last three quarters of sequential improvement in search revenue. They have also made public reference to working on new projects with Microsoft to develop a secure browser.  

In the worse case scenario that Microsoft does not renew, Perion would still be left with a stream of high margin search revenue that would decay over time as users move away from the network.  At a current run rate of ~$135mm in revenue presumably there would be several years of revenue but eventually it would go to zero . Perion doesn't break out the profitability of the two divisions on a stand alone basis, but for illustrative purposes if you allocate half of the customer acquisition costs and media buy to CodeFuel, you get to over $70mm in pre tax earnings. The big question in this scenario would then revolve around the prospects for Undertone and whether the cash will be reinvested in that business or returned to shareholders.  

Undertone

In 2015 Perion purchased an Adtech company called Undertone for $180mm. Due to technological disruptions in digital advertising and the move towards programmatic advertising, Undertone has been forced to reinvent itself and it is now focused on a new offering called  Synchronized Digital Branding. The idea behind the strategy is to move from selling a format to a full solution. To appreciate what Undertone is doing, it’s necessary to understand the drivers behind the commoditization of display advertising. It began with the General Data Protection Regulation (GDPR) in the EU and the Coalition of Better Ads that imposed numerous constraints  on certain formats that were Undertone’s highest margin offerings. So instead of going after the commoditized offerings, Undertone has invested in technology that creates a sequential offering of ad units that follow the consumer from awareness, intent, and all the way to the actual buying decision. The new offering will be more SAAS-like and Undertone will be able to leverage its previous relationships with Fortune 500 companies. Given the higher margin profile and the existing customer relationships there is a credible growth  story here but it is still early.

Although Perion has indicated that they are increasing their R&D spend in Undertone this year by $5mm, the current CEO Doron Gerstel was brought in two years ago to cut costs, turnaround the company, and eliminate all the debt from the balance sheet. Since he came  to Perion in 2016 he has reduced G&A by 34% and reduced debt from $65mm to $23mm so he has done exactly what he said he would do. On top of this, his cash bonus is tied to meeting EBITDA and revenue targets so we’re confident he’ll have the discipline to make the right capital allocation decisions if Undertone’s new offering doesn't’ get traction.

Valuation

At the current price of $4.00  with 26mm shares outstanding Perion has a $104mm market cap. Pro forma for the $8mm redemption of the Series L Convertible Bonds Perion has $37mm in cash and $23mm in debt so the EV is $90mm.  Assuming the current run rate of $25mm in EBITDA, ~$2mm in Capx, and $2mm in cash taxes Perion will generate no less than $20mm in fcf per year at current revenue levels which it will use to deleverage.  Perion will be debt free by the end of 2020 and cash will build thereafter.

On a sum of the parts basis we value Undertone at 1x revenue and CodeFuel at 3x pretax earnings which is low for a high margin, growing business but understandable given the renewal risk with Microsoft. Adding it all together gets you to a value in excess of $300mm or $12/ share. We concede that the margin of safety in this investment relies upon the company limiting their exposure to Undertone if the investment in the new offering doesn’t pan out. There is also always the risk that they lever up and do another big acquisition.   On the other hand, there is evidence that this is a shareholder friendly management team that is not interested in building an empire. With the upside/ downside skew of 3:1 we think Perion is asymmetric and presents a compelling opportunity at current levels.

Catalyst

- roll out of new Undertone offering in 2H19

-continued strength at CodeFuel

-debt paydown