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Avigilon Corp.’s Q2 Earnings Come in Below Expectations; What Should Investors Do?

Sometimes, investing in stocks is not for the faint of heart. Avigilon Corp. (TSX:AVO) is once again proving this point. While the company is well run and its business is experiencing strong growth and strong demand, the stock has been a roller coaster ride. It is a classic case of a stock whose valuation leaves no room for understanding and patience, at least in the short term.

Revenue growth strong …

Avigilon’s second-quarter results showed a business that is showing no signs of slowing. Revenue for the quarter increased a whopping 66%, with revenue coming in at $65.1 million. Growth was evident in all regions, with Asia Pacific being the fastest growing, as revenue increased 122.7%.

While this growth was off of a small base, and this region only represents 7.3% of revenue, it is nevertheless significant. Even more significant, however, are the results posted by the U.S., which saw a 92.7% increase in revenue. Given that this region represents almost 54% of revenue, it is very encouraging that it is still growing at such a fast rate.

… with downward pressure on margins

As we know, Avigilon is in a growth phase where the focus is on market share and revenue growth, and with this focus on growth in sales and market share, the company is ramping up on spending and experiencing downward margin pressure. In fact, general and administrative expense increased to 12% of revenue versus 9% of revenue in the same period last year, R&D expense increased to 6.7% of revenue versus 6% in the same period last year, and sales and marketing expense increased to 28% of revenue from 27% in the same period last year and 22% of revenue last quarter. The goal is to increase awareness, innovation, and to build up the sales force and headcount in order to be able to meet future demand.

While management has broadcast that this margin pressure would happen and it is in line with their longer term growth strategy, investors have nevertheless become squeamish when faced with the numbers. While we will continue to watch closely, we are taking a longer term perspective, and are still comfortable with management’s growth strategy and confident that they can being margins back up in the medium term.

While gross margin increased to 55.3% from 52.9% in the same period last year, operating margins declined almost 19% to 8.9% this quarter. Adjusted EBITDA margins declined to 13.4% in the quarter, versus 13.8% last year and 19.6% last quarter. Management has reiterated that over time SG&A will decrease as a percentage of revenue, and that they expect to return to EBITDA margins of 20%-25% over the medium term.

Delivering on lofty target

At a current annual revenue run rate of $260 million, the company is more than halfway to its target of a revenue run-rate of $500 million by 2016. And this target is only taking into account organic growth. Any acquisition that the company makes will add to this number.

Strong balance sheet

The company’s pristine balance sheet helps to mitigate the risk in the stock, and gives the company much needed flexibility. As of the end of the second quarter, the company had $157 million in cash and negligible debt, so it is still in a good position to take advantage of possible attractive acquisition opportunities, which management is ready and willing to act upon.

Bottom line

The stock trades a P/E ratio of 26.5 times this year’s estimated EPS, and 17 times 2015 estimated EPS (consensus estimates). Given the earnings growth rates that the company has the potential to generate (+57% in 2014 and +55% in 2015, based on consensus expectations), these multiples are reasonable. The question that investors must ask themselves is whether or not the margin pressure will be a temporary phase, as the company says, while it builds up its sales force and makes the necessary investments today for future revenue.

In the short term, Avigilon will continue to expand its sales team and as such, sales and marketing expense will continue to increase as a percentage of revenue. But with all signs pointing to continuing strong growth in revenue, I still see a business model that is sound and an opportunity that is large.

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Fool contributor Karen Thomas owns shares of Avigilon. Avigilon is a recommendation of Stock Advisor Canada.

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