BLUE COAT SYSTEMS INC BCSI
July 25, 2011 - 1:17pm EST by
bank999
2011 2012
Price: 21.50 EPS $1.27 $1.57
Shares Out. (in M): 49 P/E 17.0x 13.7x
Market Cap (in $M): 1,053 P/FCF 10.8x 9.2x
Net Debt (in $M): -298 EBIT 52 74
TEV ($): 756 TEV/EBIT 13.2x 8.0x

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Description

Synopsis

Blue Coat Systems, herein referred to as "BCSI" or the "Company", trades at a significant discount to intrinsic value which we estimate at $32/ share under our base case.  We believe the Company is a classic example of a turnaround story that is underappreciated as a result of Wall Street's focus on short term results.  There are many aspects of the story that we like: strong cash flow, a new and experienced CEO, expanding TAMs, a replenished salesforce, sticky customers, options on accelerating growth, and an active board.  At $6.08 net cash / share and 6.4x FCF to the enterprise, we believe current prices make a compelling entry point.

There are 4 key aspects to this story that we believe investors should focus on:

1.       The Company's FCF is significant and will substantially exceed earnings for the foreseeable future due to a favorable international tax structure, $259M of NOLs, and depreciation in excess of capex

2.       The cloud security business is not understood/discussed but it is a game changer; cloud is gaining substantial traction and can leapfrog WBSN, FTNT, and disintermediate firewall providers such as CHKP.  This business is based on a SaaS model and should be valued on bookings.

3.       The WAN optimization business has the potential to be $100M in a few years.  The product is finally competitive and is gaining momentum in a market that is still greenfield.

4.       The turnaround is progressing well, and at 9 months in, we are still early in the re-alignment.  In our experience, these turnarounds take time but the street has priced in an expectation that it has already failed.

Business Description

Historical Product Snapshot          
    FYE FYE FYE FYE FYE   FYE FYE FYE FYE
$mm's   Apr-07 Apr-08 Apr-09 Apr-10 Apr-11   Apr-08 Apr-09 Apr-10 Apr-11
ProxySG          115.4        184.4        198.6        221.9        194.8   59.9% 7.7% 11.8% -12.2%
Mach5              8.2          14.0          18.3          14.7          27.0   71.0% 30.7% -19.8% 84.0%
Webfiltering          13.2          35.4          29.8          26.5          21.0   168.2% -15.8% -11.1% -20.8%
Packeteer          -         -            58.9          59.0          49.0   NM NM 0.2% -16.9%
Total Products       136.8      233.9      305.6      322.1      291.8   71.0% 30.7% 5.4% -9.4%
                       
Total Services          40.9          71.6        139.1        174.0        195.3   74.9% 94.4% 25.1% 12.2%
Total Revenue       177.7      305.4      444.7      496.1      487.1   71.9% 45.6% 11.6% -1.8%
                       
Note: Aside from FY 2010 and 2011, historical product splits are estimated          
Note: Sales of CacheFlow and ProxyOne are small and not included            

BCSI operates in 3 business segments: security, WAN optimization, and cloud.  The security division sells webfiltering, malware, SSL analysis, and data loss prevention tools through its ProxySG, ProxyAV, and webfilter product lines.  This business generated $216M of product revenue in the LTM period and sells to Fortune 500, federal, and mid/large enterprise customers though a combination of direct sales and a VAR/reseller channel.  Ex-federal and strategic accounts, 30-35% of sales are to the mid/large enterprise customer segment. 

The WAN optimization business provides enterprises the ability to accelerate applications over a WAN by eliminating redundant transmissions, staging data in local caches, compressing data, and streamlining chatty protocols.  BCSI's Packetshaper, which shapes and prioritizes applications, and Mach 5, which is similar to RVBD's steelhead product line, generated $76M of product revenue in the LTM period; in addition, WAN optimization can also be sold in the ProxySG appliance.  BCSI's customers range from mid-market to large enterprises and distribution channels include resellers, VARs, and direct.  Unlike RVBD which targets both branch and datacenter to datacenter markets, BCSI specifically targets branch customers.

Cloud security is based on a subscription SaaS model that brings Blue Coat's high end security to public and private clouds to help secure branches and mobile end-points.  The feature set includes real-time protection, location aware protection, and application level filtering.  BCSI's focus is on small and large businesses and products are sold through a combination of white label OEMs, security VARs, and a direct sales.  Launched last April, BCSI already has 100 trials underway that encompass over 70,000 seats.  By comparison, BCSI's security appliance user base is currently 60 million.  This product is complimentary to the ProxySG for the large enterprise who need hybrid solutions and greenfield for smaller customers that launch directly into the cloud.  

Greater than 50% of sales are through 3 major resellers: Computerlinks, Westcon, and Arrow.  Several large customer accounts are deemed strategic and are touched by a direct salesforce but over 90% of sales are indirect.  The recent reorganization of the salesforce further streamlined teams under security, WAN, and cloud.

      FYE FYE FYE FYE
$mm's     Apr-08 Apr-09 Apr-10 Apr-11
Total Revenues      305.4  444.7 496.1   487.1
% YoY Total Revenue 71.9% 45.6% 11.6% -1.8%
             
Total Gross Profit   237.0 336.8 380.5 386.9
% GP Total   77.6% 75.7% 76.7% 79.4%
             
Research and Development    46.5    71.4    79.5    75.1
% of Sales   15.2% 16.0% 16.0% 15.4%
SG&A       143.5    212.0    214.8    217.3
% of Sales   47.0% 47.7% 43.3% 44.6%
Operating Income       47.0     53.4     86.1     94.1
% of Sales   15.4% 12.0% 17.4% 19.3%
             
Adjusted EBITDA       53.0     54.3    106.6    116.7
% of Sales   17.4% 12.2% 21.5% 24.0%
             
Net Income       49.2     36.0     59.1     68.5
% of Sales   16.1% 8.1% 11.9% 14.1%
             
Diluted EPS, Non GAAP         1.24         0.94         1.29         1.42
             
Shares Outstanding            39.7          38.5          46.0          48.3
 
 
History and Turnaround Effort
 
After experiencing consistent top-line product growth from FY 2007 through FY 2010, BCSI's revenue began to slow while the security and WAN markets continued to be robust.  The primary culprit was the security business.  BCSI is 90% penetrated into fortune 500 accounts and this market is not expanding quickly; incremental growth in Fortune 500 accounts is tied to customer expansion.  The growth in the security market is being driven by the mid-enterprise customers where WBSN and various unified threat management companies have started to gain a foothold.  Second, BCSI never had a truly competitive WAN optimization product until recently and even then, the product was not well marketed.  Recent Mach 5 growth of 84% is coming off of a small revenue base that was not enough to offset declines in security. 

Additional issues also plagued the company.  Our research has uncovered that a lethargic salesforce, poor customer support, and increased competitiveness from WBSN and FTNT were critical factors that eroded BCSI presence in the channel.

To address these challenges, BCSI embarked on a turnaround beginning with the appointment of Mike Borman as CEO in September 2010. Following the announcement and Mr. Borman's promise to demonstrate results after 9 months, BCSI's stock began to move off its $18 lows and touched year highs at $32/share. 

The restructuring over this period has been significant.  The salesforce has been replenished after massive turnover and has been recently stabilized. Many of the sales representatives that customers deal with are new, and they are still ramping on the productivity curve.  The organization was also split into 3 business units: security, wan optimization, and cloud.  New division heads were assigned to each of these units to create better P&L accountability and clearer go-to-market messages.  Heads of sales were replaced geographically in North America, Europe and APAC and a new CMO was brought onboard.  In addition, stronger sales incentives, including better margins for the channel versus Riverbed, were put in place to help focus on WAN optimization.      

Concurrent with the restructuring, the Company began to release both new and upgraded products.  All appliances were refreshed with 64-bit operating systems, bringing densities in line with the market.  The Mach 5 WAN appliance was simplified for easier installation (previously a major complaint), and it now boasts leading technology over RVBD in video acceleration and file sharing.  The new mid-market ProxyOne appliance was launched last quarter and in April, the cloud based security product was introduced. 

Despite these changes, it became clear at the end of FY Q4 that the restructuring efforts would take longer than anticipated.  The company pre-announced unfavorable results for the April quarter - 9 months into the CEO's promise to demonstrate results - and the stock traded down on the news.  Further, BCSI guided down during its earnings call citing greater competition in the mid/large enterprise security business.

The Opportunity

We believe current valuations support a worst case scenario for the Company and provide a high margin of safety for long-term investors.  Under a worst case scenario, the company will generate over $2.00 / share in FCF with current cash on hand of $6.08 / share.  However, we believe the turnaround has a high probability of success and there are options for sustained long-term growth from cloud security and WAN optimization.  These options to the upside could significantly move the price / share to the $40 range over the next couple of years.  Probability adjusted, we are setting a base case target price of $32 / share.
 
Strong New Management
 
In September of 2010, Brian NeSmith, who served as CEO since 1999, was replaced by Mike Borman.  While Brian came from an engineering and product development background, Mike came with much needed sales and turnaround experience.   Prior to his current role, Mike was the CEO of Avocent where he was credited with successfully restructuring and selling the business to Emerson Electric.  In addition, Mike spent nearly 30 years at IBM in senior sales positions and built a reputation as a strong channel executive.  Given that BCSI needed greater sales focus, channel presence, and organizational changes, we view the sum of Mr. Borman's experiences favorably.     There are other things to like about Mr. Borman.  Channel partners have re-iterated their belief that Mike is very "capable" and that he is the "right person for the job".  And our conversations with Mike have given us comfort that he is addressing the turnaround methodically and in the right steps.  Specifically, he is re-organizing around key initiatives rather than a scattering of products (as was previously done) and is aligning interests across the organization.  Critically important, he understands that cloud security is necessary to penetrate mid-market security and move BCSI's fortune 500 accounts into the next stage of growth.  If there is anything to fault, we believe it is his communication to the street.  In our experience, turnarounds take time, especially when there is a major re-organization.  Consequently, we are not sure why Mike only gave himself 9 months to fix the business or why he continued to keep guidance at existing levels while the salesforce churned.  We believe he was correct in focusing on better sales efforts for WAN optimization, but it is likely that the organization took its eyes off the mid-enterprise security customers as a result.  However, we believe the vast majority of the "bad news" is now behind us and are comfortable that BCSI is re-focusing to ensure these issues do not recur.
The vast majority of Mr. Borman's compensation resides in 225K options and 75K RSUs that vest over 4 years. In addition, a recent restructuring of the bonus calculation effectively dropped his target bonus to $0.

Security Products Are Not Dead

Our sense is that BCSI's security franchise is a key risk in the minds of investors today, and to better understand this risk, it is important to understand the differences between the large and mid-enterprise customers.  65-70% of BCSI's customers are large, Fortune 500 customers who, for the most part, buy best-of-breed for their security solutions and will continue to do so in the future.  Our calls to this segment have revealed that the Proxy SG is preferred over its peers in the labs and in practice because it is multiples more robust.  Many customers test the competitive products by attempting forced breaks to reveal weaknesses for each type of security feature (firewall, proxy, filtering) and then assemble the best pieces. Unlike the Fortune 500 market, the mid-enterprise is highly competitive.  Two key points came through in our research: customers want to buy 1 appliance with multiple features rather than multiple appliances with 1 feature and "good enough" proxy functionality may suffice for some businesses.  Consequently, WBSN has been moving from the low-end into the mid-enterprise market with their Triton appliance and Fortinet has been selling UTM (unified threat management) architecture with "good enough" proxy features.  It is likely that some of the losses BCSI had in the last quarter were self-inflicted; they have the right feature set but not all are within the same appliance.  For example, WBSN's sales of Triton products may have been boosted with their integration of DLP features and recently attributed growth to a combination of feature integration and competitors losing focus on the market.  BCSI has also conceded that some functionality it sold to the mid-enterprise was too rich in functionality, and thus in price as well.  Management is now refocusing maintaining existing accounts and reconfiguring the product to be more mid-market appropriate. The mid-enterprise segment, which comprises 30-35% of Proxy SG revenue, is roughly $69M or $17M / quarter.  Sales of Proxy SG were $45M in Q4 2011 which implies that mid-enterprise sales dropped from $17M to $9M in the quarter.  As such, we believe the maximum residual risk to the security business is ~$36M on an annualized basis.  Our base case assumes a loss of $25M in the mid-market from Q4 2011 to FYE 4/2012.   
 
 
  Downside Base Case Upside
Assumptions      
 Proxy SG    -9% 2012, -2% 2013,   -9% 2012, 0% 2013,   -9% 2012, 0% 2013,
    -2% 2014    0% 2014    0% 2014 
 Cloud Security     No SaaS revenue   433K users at EY   675K users at EY 
       
2013 Revenue      
 Proxy SG  173.7 177.9 177.9
 Webfilter  14.6 14.6 14.6
 SaaS  0.0 12.6 19.8
 Total Security  188.3 205.1 212.3
 
 
WAN Optimization Markets Provide Upside

Similar to the security business, we believe the WAN optimization business is of higher quality than most analysts believe.  Although the Company has provided the Mach 5 product for some time, the first iteration was admittedly sub-par relative to RVBD.  As a result, RVBD grew to become the dominant WAN player in the first installation cycle.  In 2008, the Company bought Packeteer for $268M which provided application performance visibility, application shaping, and more importantly, a sales channel.  However, Packeteer was never fully integrated and the basic Mach5 was still marred with issues including difficult installation and management.    

Today, the new WAN optimization product appears to be solid.  It is perceived as being just as capable as Riverbed's and even better in some aspects including video acceleration through object caching (RVBD is byte level caching), consolidation of SSL acceleration into the same appliance, and asymmetrical acceleration into the cloud.  An independent organization, Broadband Testing, confirmed these results and channel checks confirmed that the new products are highly regarded and more competitive on price. 

The issue for BCSI is that they face the reverse problem from high end security; it is difficult to unseat the incumbent, especially when they are already installed within a customer's premise.  However, unlike the security market, we believe there is a strong path to growth.  Management has taken a strategic angle by focusing specifically on branch offices - rather than the datacenter to datacenter market which is dominated by RVBD and SilverPeak - and is targeting customers to which video and cloud are key decision factors.  Moreover, BCSI has significantly increased its marketing spend, focused on providing more test/demo models quickly into customer labs, and began providing the channel with better incentives to push sales.  Our checks have commented that the BCSI salesforce now seems refreshed, focused, and aggressive.

There are two macro tailwinds that should also help the Company.  First, the WAN market is healthy and growing at a 14% CAGR through 2014.  Moreover, RVBD's consensus growth for 2011 and 2012 are 32% and 23% respectively.  Driving this growth is a combination of datacenter consolidation and network intensive application upgrades such as Sharepoint and Exchange.  Bandwidth is also expensive, so as consolidation occurs, WAN optimization has become a more efficient path for companies to upgrade their networks.  Second, we are now approaching the next upgrade cycle for initial WAN optimization installs.  Many companies initially bought RVBD appliances for moderate deployments 4-5 years ago and are now architecting for larger build-outs.  Our checks have indicated that BCSI has already started displacing RVBD in major accounts like Citibank Retail.  There is also a large greenfield opportunity in WAN, especially with mid-enterprise companies who are now adopting the technology as it has matured.  VARs, and even RVBD's management, have indicated that a significant portion of the market is still greenfield.

We believe that breaking out the WAN organization will help the company focus on delivering a cleaner message to the market and create much greater accountability in terms of sales performance.  Already, the results are beginning to show with sales increasing 82% YoY to $27M.  Although these are smaller numbers, we believe BCSI should be able to grow this business in excess of market rates and that it could potentially be a $100M business over several years.  Management believes it can get the business to at least double in the short term.

 
 
 
  Downside Base Case Upside
Assumptions      
 Mach 5  45% 2012, 32% 2013,  50% 2012, 37% 2013  54% 2012, 38% 2013
    19% 2014   23% 2014   25% 2014 
 Packeteer   No growth   No growth   No growth 
       
2013 Revenue      
 Mach 5  51.8 55.6 57.6
 Packeteer  44.2 44.2 44.2
 Virtual WOC  0.0 0.0 0.0
 Total WAN  96.1 99.9 101.8
 
 

Cloud Security is the Next Growth Wave

As businesses move to public and private clouds, protecting the cloud and mobile endpoints is becoming a greater priority for CIOs.  Currently, only zScaler (~$65M in sales) and CSCO's Scansafe have options on the market, but neither are as robust as Blue Coat's offering.  In addition, zScaler's products are not appropriate for large enterprises.  The cloud product also bakes in firewall functionality which allows it to be very competitive against players like Checkpoint and UTM players like Fortinet.  According to 1 super regional bank, the migration to BCSI's cloud security platform will allow them to "tear down 15 Checkpoint implementations". 

Gartner is forecasting that 40% of secure web gateways will be delivered through the cloud by 2015 from 5% today, and Blue Coat's initial uptake seems to support this trend.  Since the launch in April, BCSI began 100 trials encompassing over 70,000 seats.  At an average price per user of $12 / year and a total security install base of 60M users, the TAM on BCSI's install base alone can be $840M.  It is important to note that this TAM does not eliminate the need for the ProxySG appliance but rather compliments existing implementations. 

Moveover, because this business is based on a "software as a service" (SaaS) model, the valuation of cloud security should be based on bookings and cash flow.  SaaS companies such as SFSF, LOGM, and CSOD trade at forward multiples of 7x bookings.  Based on the above install base, we believe at least $50M in bookings should be easily achievable within the next couple years which would add ~$350M of additional market capitalization.

BCSI is committed to growing this business and has invested over 70 engineers to cloud security to date.  The existing trials are evenly split 50/50 between large and small enterprise customer segments and while smaller customers will be early adopters, large customers will comprise the majority of the market in the future.
 
Government Channel Could Add Near Term Growth
 
The federal business, which was 10% and 9% in FY 2010 and 2011 respectively, could potentially add additional upside.  BCSI has a large installed base with the federal government because they were one of the first companies architected into security designs.  Today, FTNT, RVBD, and others are now qualified vendors as well, and while they may win business on the margin, it is likely that existing government installs will continue to upgrade with the Proxy SG product.  Unlike the mid-enterprise segment, we believe federal spending will be at worst flat and at best, substantially up. 

After the end of the Continuing Resolution, government VARs raised federal spend targets; while the DoD budget remains flat, there appears to be a shift in spend away from military equipment towards IT. One large government reseller believes that security based spend will increase this year and another believes that BCSI is the default vendor because it is easier to upgrade rather than re-architect.  However, government preference for security vendor depends on the department and some, like education, have historically placed large purchase orders and only fulfilled a fraction of them.

Westcon and Arrow, BCSI's largest government channel partners, are both forecasting YoY growth for this fiscal year.  Our base case does not assume any impact from the government channel.
 
Management is Better Aligned with Shareholder Interests
 
At the end of FY 2011, the Company made its first major change to the bonus plan since 2007.  The prior plan was based on an easily achievable operating margin calculated after multiple add-backs.  The plan called for an award of 10% for every 1% operating margin above 15% such that at 25% operating margin, employees received 100% of their bonus.  The plan was calculated on a quarterly basis.  Under the new plan, the compensation is set bi-annually and is based on both topline and margin targets.  The hurdles are now set higher.  At 90% of revenue targets and 70-80% of operating margin targets, the company can pay a bonus of up to 25%.  Management bonuses, which were close to 100% payout went to $0 based on current results.

Also of significant importance for shareholders is the magnitude and speed of the recent $50M stock buyback.  The repurchase was the first buyback authorized by the Company based on trading levels rather than as an offset for option dilution.  This buyback was announced after Q1 2011 earnings and will be completed prior to Q2 2011.  At an estimated average cost of $23/share, share count will now be reduced by 5%. 

Activism and a Takeover Candidate
 
One of the most interesting aspects of BCSI is its relationship with Elliot Associates.  In 2008, Elliot attempted to buy the Packeteer asset but was outbid by BCSI.  As part of the transaction, Elliot and Francisco Partners financed the transaction with an $80M, 0 coupon convertible note due in 2013 at a conversion price of $20.76.  BCSI also issued warrants to Elliot and Francisco to acquire 385K shares at the initial conversion price of the convertible notes.  Today, Keith Geeslin, a partner at Francisco Partners, sits on the board.  In addition, Elliot increased its stake in 4 of the last 5 quarters with the largest % increase occurring after the appointment of Mike Borman.  The activist now owns 9.9% of the equity and an additional 2.7% in derivatives convertible into equity. 
Given Elliot's history in technology, including the recent Novell transaction, we view their presence as a positive for the stock.  We take comfort that Elliot will be involved in key decisions, help minimize poor uses of cash, and keep management focused on the turnaround.
Moreover, we believe BCSI is a strong takeover candidate.  Elliot has been known to bid for companies themselves, and based on the Company's cash flow, an LBO is easily achievable.  Even assuming that 50% of the transaction is in equity, a 20% IRR can be achieved at a $50 acquisition price.  If strategic investors get involved, the purchase price could be even higher.  Moreover, Blue Coat does have strong products and leading technologies; we believe the company could be a strategic asset for companies such as Cisco, Dell, and HP.
 

Valuation

  FY FY FY FY FY FY-Est FY-Est FY-Est
  Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
ProxySG          115.4        184.4        198.6        221.9        194.8        177.9        177.9        177.9
Mach5              8.2          14.0          18.3          14.7          27.0          40.6          55.6          68.7
Webfiltering            13.2          35.4          29.8          26.5          21.0          16.3          14.6          13.2
Packeteer                -                -            58.9          59.0          49.0          46.6          44.2          42.0
Cloud Security                -                -                -                -                -              1.2          12.6          39.5
Total Products         136.8       233.9       305.6       322.1       291.8       282.5       304.9       341.3
                 
Total Services            40.9          71.6        139.1        174.0        195.3        211.5        228.1        247.6
Total Revenue         177.7       305.4       444.7       496.1       487.1       494.0       533.0       588.9
% YoY   71.9% 45.6% 11.6% -1.8% 1.4% 7.9% 10.5%
                 
Gross Margin          134.1        237.0        336.8        380.5        386.9        387.1        417.9        464.2
% of Sales 75.5% 77.6% 75.7% 76.7% 79.4% 78.4% 78.4% 78.8%
                 
Research and Development            35.0          46.5          71.4          79.5          75.1          74.0          75.2          84.2
% of Sales 19.7% 15.2% 16.0% 16.0% 15.4% 15.0% 14.1% 14.3%
SG&A            82.9        143.5        212.0        214.8        217.3        229.7        237.2        246.2
% of Sales 46.7% 47.0% 47.7% 43.3% 44.6% 46.5% 44.5% 41.8%
Operating Income            16.1          47.0          53.4          86.1          94.1          83.5        105.4        133.9
% of Sales 9.1% 15.4% 12.0% 17.4% 19.3% 16.9% 19.8% 22.7%
                 
Adjusted EBITDA           20.9         53.0         54.3       106.6       116.7       103.7       125.4       147.5
% of Sales 11.7% 17.4% 12.2% 21.5% 24.0% 21.0% 23.5% 25.0%
                 
Net Income            18.8          49.2          36.0          59.1          68.5          60.0          76.0          96.9
% of Sales 10.6% 16.1% 8.1% 11.9% 14.1% 12.1% 14.3% 16.4%
                 
Diluted EPS, Non GAAP           0.64         1.24         0.94         1.29         1.42         1.27         1.57         1.97
                 
Shares Outstanding            29.2          39.7          38.5          46.0          48.3          47.4          48.3          49.1
 

Cash Flow

Under our base case scenario, we believe BCSI is worth $33/share.  The Company closed FY 2011 with $6.08 net cash / share and $2.40 FCF / share and is trading at 6.4x FCF to the enterprise.  By contrast, WBSN is trading at 12.3x, RVBD at 45.2x, FTNT at 29.1x, and SYMC at 8.5x.

  FY FY FY FY FY FY-Est FY-Est FY-Est
  Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
Net Cash            52.0        162.2          37.8        159.1        297.8        342.7        456.4        604.6
Shares Outstanding            37.2          39.6          43.6          47.8          49.0          47.7          48.6          49.4
Net Cash / Share           1.40         4.10         0.87         3.33         6.08         7.19         9.40       12.23
                 
FCF / Share            0.61          1.15          0.73          1.92          2.40          1.99          2.34          3.00
Multiple 10.0x 10.0x 10.0x 10.0x 10.0x 10.0x 10.0x 10.0x
Value of FCF              6.1         11.5           7.3         19.2         24.0         19.9         23.4         30.0
                 
Value of FCF + Net Cash             7.5         15.6           8.2         22.5         30.0         27.1         32.8         42.2
 
 

Despite a decrease in absolute dollars in cash flow for the next fiscal year (we are assuming the mid-market Proxy SG customers churn), BCSI's FCF yield will remain above 9% and likely climb to 14% by 4/2014 under our base case.  There are several structural reasons for this.  First, The Company has $259M of NOLs and a favorable tax structure that burdens the US with much of the R&D expense.  In FY 2011, BCSI had a 3-5% cash tax rate which will continue into the foreseeable future with NOLs likely to expire sometime in FY 2015. The cash tax rate will be in the 10-15% range after the expiration of NOLs.

Second, the services business is much stronger than most analysts realize.  Services and support are tied to each net new product sale with terms of 1.0-1.5 years on average.  With 90% retention on service contracts after expiry, each incremental net new product sold increases the deferred revenue stream.  Over the past 3 years, deferred revenue has increased from $90M to 178M or 23% to 40% of sales respectively.  While this portion of the business is mostly ignored, once cloud security begins to gain momentum, the sell side will have to focus on deferred revenue and backlog.

Finally, capex will continue to be low as a % of sales.  The spike in capex to $18M in FY 2010 relates to a facility buildout, and much of the current capex relates to the cloud business.  Management expects current run-rates to continue for the foreseeable future at around $3M / quarter. In addition, the Company is amortizing past acquisitions and cloud security investments which will keep D&A greater than capex.

 

Comparables

BCSI trades at a discount to its peers in both security and WAN optimization despite superior cash flow characteristics.  Based on comparables, we believe the Company is worth $34 / share using separate valuations for security, WAN, and cloud.  Security company multiples for WBSN and SYMC trade at 6-9x forward EBITDA, application acceleration vendors trade at 18x forward EBITDA (excluding CSCO), and high growth SaaS companies used to compare the cloud security business trade at 6-8x bookings.

    Closing Price % of 52 Wk High Mcap TEV   LTM TEV/R TEV/ EBITDA LTM P/E   NFY TEV/R TEV/ F EBITDA NFY P/E
                           
Application Acceleration                        
Riverbed Technology 31.93
71.4%
4,901.0 4,429.1   7.3x 24.2x 46.3x   6.1x 18.8x 35.7x
Cisco Systems 15.0 57.6% 82,337.8 55,762.8   1.3x 4.0x 9.1x   1.3x 4.5x 9.3x
Citrix Systems 74.2 83.8% 13,947.3 13,024.9   6.0x 20.0x 34.0x   6.0x 19.0x 30.8x
F5 Networks 97.2 66.7% 7,884.0 7,408.7   7.2x 18.4x 30.3x   6.5x 16.8x 26.7x
ACC Average           5.5x 16.6x 29.9x   5.0x 14.8x 25.6x
                           
Security                        
Websense 24.2 86.7% 968.0 951.7   2.8x 8.1x 17.9x   2.6x 9.0x 15.7x
Symantec 18.6 90.5% 14,015.3 13,717.3   2.2x 6.0x 13.1x   2.1x 5.7x 11.5x
Fortinet 22.7 89.2% 3,443.5 3,141.9   9.0x 38.4x 33.8x   7.9x 34.4x 32.4x
Checkpoint 52.0 92.4% 10,800.9 9,718.1   8.6x 13.8x 20.2x   7.9x 13.0x 18.8x
Security Average           5.6x 16.6x 21.2x   5.1x 15.5x 19.6x
                           
              LTM TEV/R TEV / Bookings     NFY TEV/R TEV / Bookings  
Cloud                        
SFSF 29.7 73.4% 2,346.1 1,978.6   8.6x 7.3x     6.8x 6.0x  
CSOD 18.4 78.4% 875.7 787.7   15.8x 11.9x     10.0x 8.3x  
LOGM 38.3 77.3% 920.5 744.3   7.0x 6.3x     6.0x 5.4x  
Cloud Average           10.5x 8.5x     7.6x 6.6x  
                           
                           
BCSI 21.5 66.7% 1,053.4 755.6   1.6x 6.5x 15.1x   1.5x 7.3x 17.0x
 
 

Catalyst

 

Risks

  • Fortune 500 customers begin to transition away from ProxySG when the next security cycle begins late 2012

         - BCSI must continue to invest in the core to keep 1 step ahead of the competition

         - We believe BCSI recognizes this and has allocated resources to continue ProxySG development

  • BCSI loses more than $25M from mid-enterprise ProxySG customers

 

  • Packetshaper and webfiltering decline at faster rates than 5% and 10% respectively

         - Packetshaper will be integrated into the Mach5 where revenue offset will not be 1 for 1 but should be consistent in gross margin contribution dollars

         - Webfiltering is an aging technology that is being bundled into proxy functions or firewalls

  • Despite marketing efforts, BCSI is unable to change customer perception about Mach5 WAN optimization products and the company grows revenue at or below market rates

          - Third party reports and channel checks indicate that BCSI's product is good but needs greater channel support and sales

          - In the next transition to cloud acceleration, RVBD's partnership with AKAM may give them an advantage. However, cloud WAN is further off than cloud security.

  • Delays hinder cloud security efforts

          - We believe the company needs to integrate email and DLP functionality into the cloud product

          - Ongoing trials may also take longer than expected

          - Cloud adoption for large enterprises will begin in private clouds but mass transition may take years

  • Ill advised use of cash

           - With the turnaround and diversity of products, we do not believe the Company should focus on large scale acquisitive activity

           - Q4 cost structure can easily support $100M more of revenues. If the turnaround is not working, the Company should re-adjust its cost structure

 

Catalysts

  • Federal spend in 2Q FY 2012
  • Growth in the cloud security business will force the street to look at the underlying cash flow of BCSI because the software business model requires valuation to be based off of bookings / cash flow
  • Sustained and continued growth of Mach 5 above market rates will begin to demonstrate the Company can effectively compete against Riverbed and potentially help the street revalue the WAN business
  • Stabilization of the security business will give the street comfort that the Proxy SG business is not a continuing risk
  • Potential take-out acquisition
  • Continued share buybacks and insider purchases
    sort by   Expand   New

    Description

    Synopsis

    Blue Coat Systems, herein referred to as "BCSI" or the "Company", trades at a significant discount to intrinsic value which we estimate at $32/ share under our base case.  We believe the Company is a classic example of a turnaround story that is underappreciated as a result of Wall Street's focus on short term results.  There are many aspects of the story that we like: strong cash flow, a new and experienced CEO, expanding TAMs, a replenished salesforce, sticky customers, options on accelerating growth, and an active board.  At $6.08 net cash / share and 6.4x FCF to the enterprise, we believe current prices make a compelling entry point.

    There are 4 key aspects to this story that we believe investors should focus on:

    1.       The Company's FCF is significant and will substantially exceed earnings for the foreseeable future due to a favorable international tax structure, $259M of NOLs, and depreciation in excess of capex

    2.       The cloud security business is not understood/discussed but it is a game changer; cloud is gaining substantial traction and can leapfrog WBSN, FTNT, and disintermediate firewall providers such as CHKP.  This business is based on a SaaS model and should be valued on bookings.

    3.       The WAN optimization business has the potential to be $100M in a few years.  The product is finally competitive and is gaining momentum in a market that is still greenfield.

    4.       The turnaround is progressing well, and at 9 months in, we are still early in the re-alignment.  In our experience, these turnarounds take time but the street has priced in an expectation that it has already failed.

    Business Description

    Historical Product Snapshot          
        FYE FYE FYE FYE FYE   FYE FYE FYE FYE
    $mm's   Apr-07 Apr-08 Apr-09 Apr-10 Apr-11   Apr-08 Apr-09 Apr-10 Apr-11
    ProxySG          115.4        184.4        198.6        221.9        194.8   59.9% 7.7% 11.8% -12.2%
    Mach5              8.2          14.0          18.3          14.7          27.0   71.0% 30.7% -19.8% 84.0%
    Webfiltering          13.2          35.4          29.8          26.5          21.0   168.2% -15.8% -11.1% -20.8%
    Packeteer          -         -            58.9          59.0          49.0   NM NM 0.2% -16.9%
    Total Products       136.8      233.9      305.6      322.1      291.8   71.0% 30.7% 5.4% -9.4%
                           
    Total Services          40.9          71.6        139.1        174.0        195.3   74.9% 94.4% 25.1% 12.2%
    Total Revenue       177.7      305.4      444.7      496.1      487.1   71.9% 45.6% 11.6% -1.8%
                           
    Note: Aside from FY 2010 and 2011, historical product splits are estimated          
    Note: Sales of CacheFlow and ProxyOne are small and not included            

    BCSI operates in 3 business segments: security, WAN optimization, and cloud.  The security division sells webfiltering, malware, SSL analysis, and data loss prevention tools through its ProxySG, ProxyAV, and webfilter product lines.  This business generated $216M of product revenue in the LTM period and sells to Fortune 500, federal, and mid/large enterprise customers though a combination of direct sales and a VAR/reseller channel.  Ex-federal and strategic accounts, 30-35% of sales are to the mid/large enterprise customer segment. 

    The WAN optimization business provides enterprises the ability to accelerate applications over a WAN by eliminating redundant transmissions, staging data in local caches, compressing data, and streamlining chatty protocols.  BCSI's Packetshaper, which shapes and prioritizes applications, and Mach 5, which is similar to RVBD's steelhead product line, generated $76M of product revenue in the LTM period; in addition, WAN optimization can also be sold in the ProxySG appliance.  BCSI's customers range from mid-market to large enterprises and distribution channels include resellers, VARs, and direct.  Unlike RVBD which targets both branch and datacenter to datacenter markets, BCSI specifically targets branch customers.

    Cloud security is based on a subscription SaaS model that brings Blue Coat's high end security to public and private clouds to help secure branches and mobile end-points.  The feature set includes real-time protection, location aware protection, and application level filtering.  BCSI's focus is on small and large businesses and products are sold through a combination of white label OEMs, security VARs, and a direct sales.  Launched last April, BCSI already has 100 trials underway that encompass over 70,000 seats.  By comparison, BCSI's security appliance user base is currently 60 million.  This product is complimentary to the ProxySG for the large enterprise who need hybrid solutions and greenfield for smaller customers that launch directly into the cloud.  

    Greater than 50% of sales are through 3 major resellers: Computerlinks, Westcon, and Arrow.  Several large customer accounts are deemed strategic and are touched by a direct salesforce but over 90% of sales are indirect.  The recent reorganization of the salesforce further streamlined teams under security, WAN, and cloud.

          FYE FYE FYE FYE
    $mm's     Apr-08 Apr-09 Apr-10 Apr-11
    Total Revenues      305.4  444.7 496.1   487.1
    % YoY Total Revenue 71.9% 45.6% 11.6% -1.8%
                 
    Total Gross Profit   237.0 336.8 380.5 386.9
    % GP Total   77.6% 75.7% 76.7% 79.4%
                 
    Research and Development    46.5    71.4    79.5    75.1
    % of Sales   15.2% 16.0% 16.0% 15.4%
    SG&A       143.5    212.0    214.8    217.3
    % of Sales   47.0% 47.7% 43.3% 44.6%
    Operating Income       47.0     53.4     86.1     94.1
    % of Sales   15.4% 12.0% 17.4% 19.3%
                 
    Adjusted EBITDA       53.0     54.3    106.6    116.7
    % of Sales   17.4% 12.2% 21.5% 24.0%
                 
    Net Income       49.2     36.0     59.1     68.5
    % of Sales   16.1% 8.1% 11.9% 14.1%
                 
    Diluted EPS, Non GAAP         1.24         0.94         1.29         1.42
                 
    Shares Outstanding            39.7          38.5          46.0          48.3
     
     
    History and Turnaround Effort
     
    After experiencing consistent top-line product growth from FY 2007 through FY 2010, BCSI's revenue began to slow while the security and WAN markets continued to be robust.  The primary culprit was the security business.  BCSI is 90% penetrated into fortune 500 accounts and this market is not expanding quickly; incremental growth in Fortune 500 accounts is tied to customer expansion.  The growth in the security market is being driven by the mid-enterprise customers where WBSN and various unified threat management companies have started to gain a foothold.  Second, BCSI never had a truly competitive WAN optimization product until recently and even then, the product was not well marketed.  Recent Mach 5 growth of 84% is coming off of a small revenue base that was not enough to offset declines in security. 

    Additional issues also plagued the company.  Our research has uncovered that a lethargic salesforce, poor customer support, and increased competitiveness from WBSN and FTNT were critical factors that eroded BCSI presence in the channel.

    To address these challenges, BCSI embarked on a turnaround beginning with the appointment of Mike Borman as CEO in September 2010. Following the announcement and Mr. Borman's promise to demonstrate results after 9 months, BCSI's stock began to move off its $18 lows and touched year highs at $32/share. 

    The restructuring over this period has been significant.  The salesforce has been replenished after massive turnover and has been recently stabilized. Many of the sales representatives that customers deal with are new, and they are still ramping on the productivity curve.  The organization was also split into 3 business units: security, wan optimization, and cloud.  New division heads were assigned to each of these units to create better P&L accountability and clearer go-to-market messages.  Heads of sales were replaced geographically in North America, Europe and APAC and a new CMO was brought onboard.  In addition, stronger sales incentives, including better margins for the channel versus Riverbed, were put in place to help focus on WAN optimization.      

    Concurrent with the restructuring, the Company began to release both new and upgraded products.  All appliances were refreshed with 64-bit operating systems, bringing densities in line with the market.  The Mach 5 WAN appliance was simplified for easier installation (previously a major complaint), and it now boasts leading technology over RVBD in video acceleration and file sharing.  The new mid-market ProxyOne appliance was launched last quarter and in April, the cloud based security product was introduced. 

    Despite these changes, it became clear at the end of FY Q4 that the restructuring efforts would take longer than anticipated.  The company pre-announced unfavorable results for the April quarter - 9 months into the CEO's promise to demonstrate results - and the stock traded down on the news.  Further, BCSI guided down during its earnings call citing greater competition in the mid/large enterprise security business.

    The Opportunity

    We believe current valuations support a worst case scenario for the Company and provide a high margin of safety for long-term investors.  Under a worst case scenario, the company will generate over $2.00 / share in FCF with current cash on hand of $6.08 / share.  However, we believe the turnaround has a high probability of success and there are options for sustained long-term growth from cloud security and WAN optimization.  These options to the upside could significantly move the price / share to the $40 range over the next couple of years.  Probability adjusted, we are setting a base case target price of $32 / share.
     
    Strong New Management
     
    In September of 2010, Brian NeSmith, who served as CEO since 1999, was replaced by Mike Borman.  While Brian came from an engineering and product development background, Mike came with much needed sales and turnaround experience.   Prior to his current role, Mike was the CEO of Avocent where he was credited with successfully restructuring and selling the business to Emerson Electric.  In addition, Mike spent nearly 30 years at IBM in senior sales positions and built a reputation as a strong channel executive.  Given that BCSI needed greater sales focus, channel presence, and organizational changes, we view the sum of Mr. Borman's experiences favorably.     There are other things to like about Mr. Borman.  Channel partners have re-iterated their belief that Mike is very "capable" and that he is the "right person for the job".  And our conversations with Mike have given us comfort that he is addressing the turnaround methodically and in the right steps.  Specifically, he is re-organizing around key initiatives rather than a scattering of products (as was previously done) and is aligning interests across the organization.  Critically important, he understands that cloud security is necessary to penetrate mid-market security and move BCSI's fortune 500 accounts into the next stage of growth.  If there is anything to fault, we believe it is his communication to the street.  In our experience, turnarounds take time, especially when there is a major re-organization.  Consequently, we are not sure why Mike only gave himself 9 months to fix the business or why he continued to keep guidance at existing levels while the salesforce churned.  We believe he was correct in focusing on better sales efforts for WAN optimization, but it is likely that the organization took its eyes off the mid-enterprise security customers as a result.  However, we believe the vast majority of the "bad news" is now behind us and are comfortable that BCSI is re-focusing to ensure these issues do not recur.
    The vast majority of Mr. Borman's compensation resides in 225K options and 75K RSUs that vest over 4 years. In addition, a recent restructuring of the bonus calculation effectively dropped his target bonus to $0.

    Security Products Are Not Dead

    Our sense is that BCSI's security franchise is a key risk in the minds of investors today, and to better understand this risk, it is important to understand the differences between the large and mid-enterprise customers.  65-70% of BCSI's customers are large, Fortune 500 customers who, for the most part, buy best-of-breed for their security solutions and will continue to do so in the future.  Our calls to this segment have revealed that the Proxy SG is preferred over its peers in the labs and in practice because it is multiples more robust.  Many customers test the competitive products by attempting forced breaks to reveal weaknesses for each type of security feature (firewall, proxy, filtering) and then assemble the best pieces. Unlike the Fortune 500 market, the mid-enterprise is highly competitive.  Two key points came through in our research: customers want to buy 1 appliance with multiple features rather than multiple appliances with 1 feature and "good enough" proxy functionality may suffice for some businesses.  Consequently, WBSN has been moving from the low-end into the mid-enterprise market with their Triton appliance and Fortinet has been selling UTM (unified threat management) architecture with "good enough" proxy features.  It is likely that some of the losses BCSI had in the last quarter were self-inflicted; they have the right feature set but not all are within the same appliance.  For example, WBSN's sales of Triton products may have been boosted with their integration of DLP features and recently attributed growth to a combination of feature integration and competitors losing focus on the market.  BCSI has also conceded that some functionality it sold to the mid-enterprise was too rich in functionality, and thus in price as well.  Management is now refocusing maintaining existing accounts and reconfiguring the product to be more mid-market appropriate. The mid-enterprise segment, which comprises 30-35% of Proxy SG revenue, is roughly $69M or $17M / quarter.  Sales of Proxy SG were $45M in Q4 2011 which implies that mid-enterprise sales dropped from $17M to $9M in the quarter.  As such, we believe the maximum residual risk to the security business is ~$36M on an annualized basis.  Our base case assumes a loss of $25M in the mid-market from Q4 2011 to FYE 4/2012.   
     
     
      Downside Base Case Upside
    Assumptions      
     Proxy SG    -9% 2012, -2% 2013,   -9% 2012, 0% 2013,   -9% 2012, 0% 2013,
        -2% 2014    0% 2014    0% 2014 
     Cloud Security     No SaaS revenue   433K users at EY   675K users at EY 
           
    2013 Revenue      
     Proxy SG  173.7 177.9 177.9
     Webfilter  14.6 14.6 14.6
     SaaS  0.0 12.6 19.8
     Total Security  188.3 205.1 212.3
     
     
    WAN Optimization Markets Provide Upside

    Similar to the security business, we believe the WAN optimization business is of higher quality than most analysts believe.  Although the Company has provided the Mach 5 product for some time, the first iteration was admittedly sub-par relative to RVBD.  As a result, RVBD grew to become the dominant WAN player in the first installation cycle.  In 2008, the Company bought Packeteer for $268M which provided application performance visibility, application shaping, and more importantly, a sales channel.  However, Packeteer was never fully integrated and the basic Mach5 was still marred with issues including difficult installation and management.    

    Today, the new WAN optimization product appears to be solid.  It is perceived as being just as capable as Riverbed's and even better in some aspects including video acceleration through object caching (RVBD is byte level caching), consolidation of SSL acceleration into the same appliance, and asymmetrical acceleration into the cloud.  An independent organization, Broadband Testing, confirmed these results and channel checks confirmed that the new products are highly regarded and more competitive on price. 

    The issue for BCSI is that they face the reverse problem from high end security; it is difficult to unseat the incumbent, especially when they are already installed within a customer's premise.  However, unlike the security market, we believe there is a strong path to growth.  Management has taken a strategic angle by focusing specifically on branch offices - rather than the datacenter to datacenter market which is dominated by RVBD and SilverPeak - and is targeting customers to which video and cloud are key decision factors.  Moreover, BCSI has significantly increased its marketing spend, focused on providing more test/demo models quickly into customer labs, and began providing the channel with better incentives to push sales.  Our checks have commented that the BCSI salesforce now seems refreshed, focused, and aggressive.

    There are two macro tailwinds that should also help the Company.  First, the WAN market is healthy and growing at a 14% CAGR through 2014.  Moreover, RVBD's consensus growth for 2011 and 2012 are 32% and 23% respectively.  Driving this growth is a combination of datacenter consolidation and network intensive application upgrades such as Sharepoint and Exchange.  Bandwidth is also expensive, so as consolidation occurs, WAN optimization has become a more efficient path for companies to upgrade their networks.  Second, we are now approaching the next upgrade cycle for initial WAN optimization installs.  Many companies initially bought RVBD appliances for moderate deployments 4-5 years ago and are now architecting for larger build-outs.  Our checks have indicated that BCSI has already started displacing RVBD in major accounts like Citibank Retail.  There is also a large greenfield opportunity in WAN, especially with mid-enterprise companies who are now adopting the technology as it has matured.  VARs, and even RVBD's management, have indicated that a significant portion of the market is still greenfield.

    We believe that breaking out the WAN organization will help the company focus on delivering a cleaner message to the market and create much greater accountability in terms of sales performance.  Already, the results are beginning to show with sales increasing 82% YoY to $27M.  Although these are smaller numbers, we believe BCSI should be able to grow this business in excess of market rates and that it could potentially be a $100M business over several years.  Management believes it can get the business to at least double in the short term.

     
     
     
      Downside Base Case Upside
    Assumptions      
     Mach 5  45% 2012, 32% 2013,  50% 2012, 37% 2013  54% 2012, 38% 2013
        19% 2014   23% 2014   25% 2014 
     Packeteer   No growth   No growth   No growth 
           
    2013 Revenue      
     Mach 5  51.8 55.6 57.6
     Packeteer  44.2 44.2 44.2
     Virtual WOC  0.0 0.0 0.0
     Total WAN  96.1 99.9 101.8
     
     

    Cloud Security is the Next Growth Wave

    As businesses move to public and private clouds, protecting the cloud and mobile endpoints is becoming a greater priority for CIOs.  Currently, only zScaler (~$65M in sales) and CSCO's Scansafe have options on the market, but neither are as robust as Blue Coat's offering.  In addition, zScaler's products are not appropriate for large enterprises.  The cloud product also bakes in firewall functionality which allows it to be very competitive against players like Checkpoint and UTM players like Fortinet.  According to 1 super regional bank, the migration to BCSI's cloud security platform will allow them to "tear down 15 Checkpoint implementations". 

    Gartner is forecasting that 40% of secure web gateways will be delivered through the cloud by 2015 from 5% today, and Blue Coat's initial uptake seems to support this trend.  Since the launch in April, BCSI began 100 trials encompassing over 70,000 seats.  At an average price per user of $12 / year and a total security install base of 60M users, the TAM on BCSI's install base alone can be $840M.  It is important to note that this TAM does not eliminate the need for the ProxySG appliance but rather compliments existing implementations. 

    Moveover, because this business is based on a "software as a service" (SaaS) model, the valuation of cloud security should be based on bookings and cash flow.  SaaS companies such as SFSF, LOGM, and CSOD trade at forward multiples of 7x bookings.  Based on the above install base, we believe at least $50M in bookings should be easily achievable within the next couple years which would add ~$350M of additional market capitalization.

    BCSI is committed to growing this business and has invested over 70 engineers to cloud security to date.  The existing trials are evenly split 50/50 between large and small enterprise customer segments and while smaller customers will be early adopters, large customers will comprise the majority of the market in the future.
     
    Government Channel Could Add Near Term Growth
     
    The federal business, which was 10% and 9% in FY 2010 and 2011 respectively, could potentially add additional upside.  BCSI has a large installed base with the federal government because they were one of the first companies architected into security designs.  Today, FTNT, RVBD, and others are now qualified vendors as well, and while they may win business on the margin, it is likely that existing government installs will continue to upgrade with the Proxy SG product.  Unlike the mid-enterprise segment, we believe federal spending will be at worst flat and at best, substantially up. 

    After the end of the Continuing Resolution, government VARs raised federal spend targets; while the DoD budget remains flat, there appears to be a shift in spend away from military equipment towards IT. One large government reseller believes that security based spend will increase this year and another believes that BCSI is the default vendor because it is easier to upgrade rather than re-architect.  However, government preference for security vendor depends on the department and some, like education, have historically placed large purchase orders and only fulfilled a fraction of them.

    Westcon and Arrow, BCSI's largest government channel partners, are both forecasting YoY growth for this fiscal year.  Our base case does not assume any impact from the government channel.
     
    Management is Better Aligned with Shareholder Interests
     
    At the end of FY 2011, the Company made its first major change to the bonus plan since 2007.  The prior plan was based on an easily achievable operating margin calculated after multiple add-backs.  The plan called for an award of 10% for every 1% operating margin above 15% such that at 25% operating margin, employees received 100% of their bonus.  The plan was calculated on a quarterly basis.  Under the new plan, the compensation is set bi-annually and is based on both topline and margin targets.  The hurdles are now set higher.  At 90% of revenue targets and 70-80% of operating margin targets, the company can pay a bonus of up to 25%.  Management bonuses, which were close to 100% payout went to $0 based on current results.

    Also of significant importance for shareholders is the magnitude and speed of the recent $50M stock buyback.  The repurchase was the first buyback authorized by the Company based on trading levels rather than as an offset for option dilution.  This buyback was announced after Q1 2011 earnings and will be completed prior to Q2 2011.  At an estimated average cost of $23/share, share count will now be reduced by 5%. 

    Activism and a Takeover Candidate
     
    One of the most interesting aspects of BCSI is its relationship with Elliot Associates.  In 2008, Elliot attempted to buy the Packeteer asset but was outbid by BCSI.  As part of the transaction, Elliot and Francisco Partners financed the transaction with an $80M, 0 coupon convertible note due in 2013 at a conversion price of $20.76.  BCSI also issued warrants to Elliot and Francisco to acquire 385K shares at the initial conversion price of the convertible notes.  Today, Keith Geeslin, a partner at Francisco Partners, sits on the board.  In addition, Elliot increased its stake in 4 of the last 5 quarters with the largest % increase occurring after the appointment of Mike Borman.  The activist now owns 9.9% of the equity and an additional 2.7% in derivatives convertible into equity. 
    Given Elliot's history in technology, including the recent Novell transaction, we view their presence as a positive for the stock.  We take comfort that Elliot will be involved in key decisions, help minimize poor uses of cash, and keep management focused on the turnaround.
    Moreover, we believe BCSI is a strong takeover candidate.  Elliot has been known to bid for companies themselves, and based on the Company's cash flow, an LBO is easily achievable.  Even assuming that 50% of the transaction is in equity, a 20% IRR can be achieved at a $50 acquisition price.  If strategic investors get involved, the purchase price could be even higher.  Moreover, Blue Coat does have strong products and leading technologies; we believe the company could be a strategic asset for companies such as Cisco, Dell, and HP.
     

    Valuation

      FY FY FY FY FY FY-Est FY-Est FY-Est
      Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
    ProxySG          115.4        184.4        198.6        221.9        194.8        177.9        177.9        177.9
    Mach5              8.2          14.0          18.3          14.7          27.0          40.6          55.6          68.7
    Webfiltering            13.2          35.4          29.8          26.5          21.0          16.3          14.6          13.2
    Packeteer                -                -            58.9          59.0          49.0          46.6          44.2          42.0
    Cloud Security                -                -                -                -                -              1.2          12.6          39.5
    Total Products         136.8       233.9       305.6       322.1       291.8       282.5       304.9       341.3
                     
    Total Services            40.9          71.6        139.1        174.0        195.3        211.5        228.1        247.6
    Total Revenue         177.7       305.4       444.7       496.1       487.1       494.0       533.0       588.9
    % YoY   71.9% 45.6% 11.6% -1.8% 1.4% 7.9% 10.5%
                     
    Gross Margin          134.1        237.0        336.8        380.5        386.9        387.1        417.9        464.2
    % of Sales 75.5% 77.6% 75.7% 76.7% 79.4% 78.4% 78.4% 78.8%
                     
    Research and Development            35.0          46.5          71.4          79.5          75.1          74.0          75.2          84.2
    % of Sales 19.7% 15.2% 16.0% 16.0% 15.4% 15.0% 14.1% 14.3%
    SG&A            82.9        143.5        212.0        214.8        217.3        229.7        237.2        246.2
    % of Sales 46.7% 47.0% 47.7% 43.3% 44.6% 46.5% 44.5% 41.8%
    Operating Income            16.1          47.0          53.4          86.1          94.1          83.5        105.4        133.9
    % of Sales 9.1% 15.4% 12.0% 17.4% 19.3% 16.9% 19.8% 22.7%
                     
    Adjusted EBITDA           20.9         53.0         54.3       106.6       116.7       103.7       125.4       147.5
    % of Sales 11.7% 17.4% 12.2% 21.5% 24.0% 21.0% 23.5% 25.0%
                     
    Net Income            18.8          49.2          36.0          59.1          68.5          60.0          76.0          96.9
    % of Sales 10.6% 16.1% 8.1% 11.9% 14.1% 12.1% 14.3% 16.4%
                     
    Diluted EPS, Non GAAP           0.64         1.24         0.94         1.29         1.42         1.27         1.57         1.97
                     
    Shares Outstanding            29.2          39.7          38.5          46.0          48.3          47.4          48.3          49.1
     

    Cash Flow

    Under our base case scenario, we believe BCSI is worth $33/share.  The Company closed FY 2011 with $6.08 net cash / share and $2.40 FCF / share and is trading at 6.4x FCF to the enterprise.  By contrast, WBSN is trading at 12.3x, RVBD at 45.2x, FTNT at 29.1x, and SYMC at 8.5x.

      FY FY FY FY FY FY-Est FY-Est FY-Est
      Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14
    Net Cash            52.0        162.2          37.8        159.1        297.8        342.7        456.4        604.6
    Shares Outstanding            37.2          39.6          43.6          47.8          49.0          47.7          48.6          49.4
    Net Cash / Share           1.40         4.10         0.87         3.33         6.08         7.19         9.40       12.23
                     
    FCF / Share            0.61          1.15          0.73          1.92          2.40          1.99          2.34          3.00
    Multiple 10.0x 10.0x 10.0x 10.0x 10.0x 10.0x 10.0x 10.0x
    Value of FCF              6.1         11.5           7.3         19.2         24.0         19.9         23.4         30.0
                     
    Value of FCF + Net Cash             7.5         15.6           8.2         22.5         30.0         27.1         32.8         42.2
     
     

    Despite a decrease in absolute dollars in cash flow for the next fiscal year (we are assuming the mid-market Proxy SG customers churn), BCSI's FCF yield will remain above 9% and likely climb to 14% by 4/2014 under our base case.  There are several structural reasons for this.  First, The Company has $259M of NOLs and a favorable tax structure that burdens the US with much of the R&D expense.  In FY 2011, BCSI had a 3-5% cash tax rate which will continue into the foreseeable future with NOLs likely to expire sometime in FY 2015. The cash tax rate will be in the 10-15% range after the expiration of NOLs.

    Second, the services business is much stronger than most analysts realize.  Services and support are tied to each net new product sale with terms of 1.0-1.5 years on average.  With 90% retention on service contracts after expiry, each incremental net new product sold increases the deferred revenue stream.  Over the past 3 years, deferred revenue has increased from $90M to 178M or 23% to 40% of sales respectively.  While this portion of the business is mostly ignored, once cloud security begins to gain momentum, the sell side will have to focus on deferred revenue and backlog.

    Finally, capex will continue to be low as a % of sales.  The spike in capex to $18M in FY 2010 relates to a facility buildout, and much of the current capex relates to the cloud business.  Management expects current run-rates to continue for the foreseeable future at around $3M / quarter. In addition, the Company is amortizing past acquisitions and cloud security investments which will keep D&A greater than capex.

     

    Comparables

    BCSI trades at a discount to its peers in both security and WAN optimization despite superior cash flow characteristics.  Based on comparables, we believe the Company is worth $34 / share using separate valuations for security, WAN, and cloud.  Security company multiples for WBSN and SYMC trade at 6-9x forward EBITDA, application acceleration vendors trade at 18x forward EBITDA (excluding CSCO), and high growth SaaS companies used to compare the cloud security business trade at 6-8x bookings.

        Closing Price % of 52 Wk High Mcap TEV   LTM TEV/R TEV/ EBITDA LTM P/E   NFY TEV/R TEV/ F EBITDA NFY P/E
                               
    Application Acceleration                        
    Riverbed Technology 31.93
    71.4%
    4,901.0 4,429.1   7.3x 24.2x 46.3x   6.1x 18.8x 35.7x
    Cisco Systems 15.0 57.6% 82,337.8 55,762.8   1.3x 4.0x 9.1x   1.3x 4.5x 9.3x
    Citrix Systems 74.2 83.8% 13,947.3 13,024.9   6.0x 20.0x 34.0x   6.0x 19.0x 30.8x
    F5 Networks 97.2 66.7% 7,884.0 7,408.7   7.2x 18.4x 30.3x   6.5x 16.8x 26.7x
    ACC Average           5.5x 16.6x 29.9x   5.0x 14.8x 25.6x
                               
    Security                        
    Websense 24.2 86.7% 968.0 951.7   2.8x 8.1x 17.9x   2.6x 9.0x 15.7x
    Symantec 18.6 90.5% 14,015.3 13,717.3   2.2x 6.0x 13.1x   2.1x 5.7x 11.5x
    Fortinet 22.7 89.2% 3,443.5 3,141.9   9.0x 38.4x 33.8x   7.9x 34.4x 32.4x
    Checkpoint 52.0 92.4% 10,800.9 9,718.1   8.6x 13.8x 20.2x   7.9x 13.0x 18.8x
    Security Average           5.6x 16.6x 21.2x   5.1x 15.5x 19.6x
                               
                  LTM TEV/R TEV / Bookings     NFY TEV/R TEV / Bookings  
    Cloud                        
    SFSF 29.7 73.4% 2,346.1 1,978.6   8.6x 7.3x     6.8x 6.0x  
    CSOD 18.4 78.4% 875.7 787.7   15.8x 11.9x     10.0x 8.3x  
    LOGM 38.3 77.3% 920.5 744.3   7.0x 6.3x     6.0x 5.4x  
    Cloud Average           10.5x 8.5x     7.6x 6.6x  
                               
                               
    BCSI 21.5 66.7% 1,053.4 755.6   1.6x 6.5x 15.1x   1.5x 7.3x 17.0x
     
     

    Catalyst

     

    Risks

             - BCSI must continue to invest in the core to keep 1 step ahead of the competition

             - We believe BCSI recognizes this and has allocated resources to continue ProxySG development

     

             - Packetshaper will be integrated into the Mach5 where revenue offset will not be 1 for 1 but should be consistent in gross margin contribution dollars

             - Webfiltering is an aging technology that is being bundled into proxy functions or firewalls

              - Third party reports and channel checks indicate that BCSI's product is good but needs greater channel support and sales

              - In the next transition to cloud acceleration, RVBD's partnership with AKAM may give them an advantage. However, cloud WAN is further off than cloud security.

              - We believe the company needs to integrate email and DLP functionality into the cloud product

              - Ongoing trials may also take longer than expected

              - Cloud adoption for large enterprises will begin in private clouds but mass transition may take years

               - With the turnaround and diversity of products, we do not believe the Company should focus on large scale acquisitive activity

               - Q4 cost structure can easily support $100M more of revenues. If the turnaround is not working, the Company should re-adjust its cost structure

     

    Catalysts

    Messages


    SubjectRE: BCSI Price
    Entry07/25/2011 04:02 PM
    Memberbank999
    Cuyler, I typed in the wrong price from a couple weeks ago but it still doesn't change the thesis / recommendation.

    SubjectRE: FCF
    Entry08/01/2011 08:10 AM
    Memberbank999
    gary9, FCF is calculated as GAAP net income + non cash + differences in cash tax to book tax (big difference here) - changes in working capital + changes in deferred revenue - capex.  I am also assuming seasonality with the working capital so there should be 1 quarter per year that is a gain and the other 3 should be a use of cash.  The biggest difference to your model may be the cash/book tax difference and the deferred revenue.  Hope that helps.

    SubjectWAN Optimization
    Entry08/01/2011 04:27 PM
    Memberstraw1023
    The upside here seems to depend on their ability to grow the WAN optimization biz (or be acquired). Given that Blue Coat is far behind the leader (RVBD) and that there are several other credible competitors, why will Blue Coat gain traction in WAN optimization? Is the play mainly to cross-sell the WAN optimization to existing large-enterprise security customers or do they need to break out beyond the existing security customer base? 
     
    Also, does their "cloud" strategy include anything that Websense and others do not already offer? If I understand it, the cloud strategy is simply a product-delivery platform that others have had for some time. If I am correct, I do not see why BCSI would ever get a "cloud" multiple more so than say, Websense.
     
    thanks
     
     

    SubjectRE: WAN Optimization
    Entry08/01/2011 10:00 PM
    Memberbank999
    Thanks for your questions.  Yes, in the short term, the upside is dependant on WAN growth and stabilization of the security business and in the longer run, the upside is based on cloud.  RVBD is the leader in WAN at the moment, and I believe they will remain so.  However, this market is still growing and, as RVBD's management described on their earnings, still greenfield.  BCSI does not need to catch RVBD but if they are competitive with the product, getting 10% of the revenue RVBD generates will be meaningful.  BCSI's WAN product is competitive this time around and over the last 3 months, the Company has also expanded its VAR presence by 10% to help sell the product.  In addition, RVBD's new acquisition supposedly helps them in acceleration of applications like Sharepoint.  In terms of cross-selling, I believe there is opportunity in leveraging the existing user base, but the point of splitting up a WAN division separately was to also target new, standalone opportunities.
     
    WBSN also has a cloud product as does CSCO.  However, the difference lies in the robustness and reliability of the features (a fortune 500 customer will tell you that ProxySG is much better than a Triton product) and an ability to leverage 70 million existing ProxySG user through the cloud.  Niether CSCO nor WBSN can leverage as large of a user base / database.  You have a good point in that WBSN trades at a lower multiple than the cloud comps I used in the writeup.  However, when WBSN was ramping up, it commanded 5x revenue and 20x cash flow.  Right now, WBSN trades at 12.5x cash flow, but regardless, the street will have to pay attention to the FCF as the product ramps.

    SubjectThoughts on the quarter??
    Entry08/17/2011 12:24 PM
    Membergreenshoes93
     

    SubjectRE: Thoughts on the quarter??
    Entry08/17/2011 04:42 PM
    Memberbank999
    The quarter was dissapointing and especially the guide.  It sounds like there are more issues to churn though but this quarter does leave on the table a couple of options.  1) their cost structure is out of line for their run rate and 2) there could be higher activist involvement.  The new CEO formerly led Mincom, a former Francisco Partners portfolio company, before selling it to ABB.  Francisco Partners also sits on the board of BCSI.  These options along with $5.53 of net cash probably provide a floor as long as 1 or both of the options start materializing.

    SubjectRE: RE: Thoughts on the quarter??
    Entry08/17/2011 05:26 PM
    Memberstraw1023
    Although the revenue numbers were horrible, I was surprised by the cost situation and the drop in deferred revenue.
     
    - Why didn't sales and mktg costs come down at least a little with the drop in sales? Is this a product mix issue? 
     
    - On a larger point, is this cost structure almost completely fixed? If so, how confident are you that they can take out costs? Where?
     
    - Were you surprised that deferred revenue came down? If I understand, this is terribly bearish going forward. At this stage in their transition to revenue type, I expected deferred revenue to continue to rise steadily even if there was a drop in actual revenue.
     
    - This is a bit unfair, but why do you see a floor in here? Don't these numbers bring in play the possibility that this company will never make a dollar again? Multiple of cash earnings does not seem to provide guidance any longer as it is near zero. Is it based on the idea that surely someone would buy it for 2x revenue (which would be about $20 per share)? And this is related to whether someone could buy and slash expenses.
     
    Thanks

    SubjectRE: RE: RE: Thoughts on the quarter??
    Entry08/17/2011 09:08 PM
    Memberbank999
    Thanks for your question.  The S&M costs didn't come down because they are still investing in the sales channel and ramping their new products.  The cost structure can support up to $100M more in sales and management said if there is not material growth by Q3, they would have to re-evaluate their cost structure.  I think this is a positive for the stock and probably one of the biggest reasons for the floor.  This is not a fixed cost business; its the software that runs on the hw that is valuable and the cloud security platform is an extension of the same sw that runs in the ProxySG. 
     
    Because its the sw thats valuable, the company should be able to keep its gross margins up close to the 80% range.  This quarter also had some of the cloud launch costs run through GM. 
     
    The decline in deferred was not huge (only a couple million) so its not an immediate concern, especially since 90% of their fortune 500 customers still renew their contracts.  Over the long term, if revenues cannot grow, then deferred becomes a larger issue. 
     
    At this point, it looks like they are continuing to cycle through their mid-market customers.  It should look like a more stable business when the churn is through.
     
     

    SubjectStandstill with Elliott
    Entry09/14/2011 01:52 PM
    Membergs1
    Any thoughts on this?  Curious to hear your thoughts on potential acquirors for this business, and what they might pay.

    SubjectRE: RE: Standstill with Elliott
    Entry11/06/2011 09:40 AM
    Memberbank999
    No update at the moment, but I think an LBO is feasible given the FCF the company generates, the cash on the balance sheet, and as you mention, the saturation of its products in the fortune 500 install base.  The cost structure is higher than what it should be at the current revenue run rate so private equity may be able to expand the margins. 
     
     
     

    SubjectRE: Boom! Congrats.
    Entry12/09/2011 09:30 AM
    Memberbank999
    thanks.
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