April 27, 2019 - 9:01pm EST by
2019 2020
Price: 7.60 EPS 0 0
Shares Out. (in M): 1 P/E 0 0
Market Cap (in $M): 423 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0

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We recommend purchasing shares of ZIXI. We think this is a very timely investment as we expect to see the Q1 report show a confluence of (1) headwinds turning into tailwinds in the core business (2) misconceptions around recent transformative acquisition being dilutive and unstrategic to be assuaged (3) significant EBITDA beat (40%) serves as catalyst to correct these market views above. Furthermore, we expect further sellside coverage over the next few quarters as well to improve investor awareness. We have a $12PT in 12 months (60%+).


Key Thesis Tenets

  1. Improving fundamentals at Core ZIX
  2. AppRiver acquisition higher quality than advertised
  3. Significant incremental synergy potential
  4. Opportunity exists as stock down due to noise around acquisition and significant mismodeling
  5. More coverage and transition to SMID cap from Microcap

Company Overview


Zix is an email security company. Their claim to fame is encryption technology. Historically, they have dominated healthcare and financial services verticals. Retention has been ~90% fairly consistently. Zix has created a mini network effect around their verticals. If you email another hospital with Zix encryption, the process is just like emailing without encryption. However, if you email a hospital that uses another encryption technology, the user has to log in through a separate portal. This creates both a nice free advertising channel as well as creates an extra painpoint to switch away from Zix. Zix competes primarily with PFPT, MIME, Barracuda (Private), Sophos, and no decision (just using MSFT). Recently, the company doubled their scale by purchasing AppRiver, a competitor in the space mostly playing in the SMB world vs Zix who plays in enterprise. Complexity around the deal has created this opportunity.


Detailed Investment Thesis


A) Improving fundamentals at Core ZIX


For a period of time from 2016-mid 2018, Zix’s fundamental performance and stock price was lackluster. We think the negatives are now behind the company and fundamentals are improving.


  1. First outside CEO Dave Wagner was hired to professionalize the company in early 2016 and needed time to do his job. He has deep experience in security and brought on many team members from a previous life to run the company.
  2. During 2016/17, the industry moved towards a bundling solution to include Encryption, Archive, and Threat Protection. Zix was late to the game which impacted revenue growth and churn but has since caught up after integrating their acquisitions of Greenview and Erado made in mid 2017 and early 2018. The below chart illustrates the quarterly bookings cadence. Orders are up 25% since 2017 driven by the new bundling strategy. Attach rates for Protect (Legacy Greenview) is now over 15% which was originally their 2022 target, up from 0% in Q2 17 when launched. Attach rates for Archive are 2% which was first rolled out Q2 of 18 – a new integrated product just launched in Q1 19 and we expect adoption to start picking up. There is also cross-sell potential with Appriver that we will detail below.                                                  
  3. Merger of largest customers caused a temporary spike in churn in Q1/Q2 of 2018 which will now lap for the first time next quarter
  4. Zix has also signed up their 25 largest on-prem customers to longer term contracts which will incrementally lower churn as well


Putting together lower churn and improved cross-sell, we expect revenue growth in the core to improve.


B) AppRiver higher quality business than advertised

Zix recently acquired a company called AppRiver and doubled their revenue scale. AppRiver has built a nice business as a Microsoft partner, recently accelerating revenue growth by helping SMB move to the cloud. For a monthly fee, they will set up email for a SMB, act as tech support, give IT a portal to manage the service, and also layer on a proprietary spam filter. As the acquisition just recently happened, we think there are a few things misunderstood about the business.


  1. PF business now mixing into higher retention rates - This is a good value for SMBs and they have seen 93% retention historically which is best in class in the structurally higher churn SMB world. As the acquisition just occurred a few months ago, this is not a metric that mgmt. has yet talked about but we expect to become part of the narrative going forward.
  2. Large tailwinds from O365 migration – The mgmt. team has shared that the entire business is growing LDD. Our calls suggest that we should actually think about this buisness as half on prem, half cloud O365. The legacy on-prem mailboxes is stable. This implies that the cloud piece is growing in the 20s. O365 is still only about 30% penetrated so we expect this will drive the cloud piece of the business for many years to come. Revenue growth should accelerate as the cloud piece becomes a larger part of the business.
  3. SMB O365 penetration - Various data sources we track suggest that SMB has actually been slower to adopt to the cloud (fairly unintuitively but experts we have talked to suggest that this is driven by the fact that MSFT has been pushing enterprise agreements to larger companies first and so while new 100% of NEW SMB companies are on the cloud, existing SMB conversion has been slower). Given Appriver is focused on SMB, there may be more market share to grab than the 30% penetration above. Its hard to read into conclusions from alternative datasets especially in a market this large so we view this as a nice free option if directionally correct.  
  4. Competitive moat from top tier MSFT partnership - From a competitive landscape perspective, and as mentioned above, AppRiver is only of only 6 Tier 1 partners (Intermedia, TechData, Ingram Micro, SherWeb, GoDaddy are the others) with advantaged support, integration, and pricing from MSFT which gives them a big leg up on winning business. Lastly, out of the tier 1, only Intermedia is as focused selling email-focused valued added services to SMBs so we effectively see these two splitting the rest of the SMB pie as they move to the cloud – a very large market.


C) Significant incremental synergy potential


There is significant industrial logic in the acquisition. Starting on the cost side, Zix was able to cut $8M of synergies out of the combined company 1 month after the close and well in advance of the plan / guide. On a base of mid $30s 2019 EBITDA, this is a big deal and we expect this number to be raised over time. To give a sense of scale, an incremental $8M of synergies would be worth roughly 25% of share price.


On the revenue side, there are several sources of upside not contemplated in guidance:


  1. Lead gen for core Zix – Zix has historically had direct sales reps and have been building out their MSP presence with limited success – the acquisition of Appriver suddenly expands their MSP channel to 4500+ partners and this should accelerate the pipeline. In fact, the team was able to put the ZixEncrypt product on the Appriver platform for their partners just two months after the acquisitions and partners started selling as of April 25th. Related to the moat point above, these partners enjoy getting new products to sell and as Zix extends the product suite, the partner count can continue to grow and the competitive positioning vs Intermedia will improve.
  2. Bundle – as mentioned above, the industry has moved to a bundle model. AppRiver has historically never had in-house solutions for Archive and Encryption and instead partnered with 3rd parties. However, because the license fees for these services were so high and the commission structures were out of wack, sales reps were incented to never sell these and thus attach rates are low. Any improvement here would be super high flow-through.
  3. Zix cloud – Core Zix has 1M mailboxes that will eventually be moved to the cloud – it would be logical for AppRiver to help those mailboxes move over – these were clients unaccessible to Appriver previously.


D) Opportunity exists as stock down due to noise around acquisition and significant mismodeling


It is often hard to time exactly when the market will realize misconceptions about the fundamentals so the area we like most about this idea is that there is a built in earnings beat catalyst to help the market reevaluate. To be clear, we think the fundamentals will beat consensus meaningfully but there appears to be a guaranteed and large beat on EBITDA due to significant mismodeling around the deal.


By way of background, the stock to sell off hard from over $9 down to $6.50 (since recovered to $7.50) due to a confluence of very unusual circumstances. This deal was fairly complex deal, PF impact was poorly communicated, and limited sellside coverage has resulted in a very unique situation where consensus believe the deal is highly dilutive to margins and thus a bad deal.


We think this is solely due to mismodeling and miscommunication and that something like a 40% EBITDA beat in Q1 is fairly uncontroversial. This propagates through the rest of 2019, setting up the year for beats and raises, but much more importantly, will be a forcing function for the market to do more research around the deal and ultimately change how consensus thinks about the merits of the deal and give credit for how many synergies were achieved and are about to come.  


The cause of the confusion was driven by the fact that mgmt. guided for a Q1 EPS number and a Q4 run-rate ARR and EBITDA margin target. The problem very simply arises because the company historically has not had debt and sellside just doesn’t model interest. As such, since they were given Q1 EPS numbers, they had to back into implied AppRiver / PF opex to get to the right EPS numbers. Given limited details around the financial profile around AppRiver, it makes the acquisition look quite margin dilutive. It is really as simple as that but it has very importantly impacted the qualitative thinking around the industrial logic of the deal. We have done a number of calls around AppRiver which has lead us to a different conclusion as laid out above.


To give a sense of scale, one report models $8.5M of incremental revenue from Q4 to Q1 and $13.5M of incremental costs…


This simple issue will sort itself out in the next print or Q2 setting up the opportunity for a very fast re-rating back to above pre-drawdown levels.


Some further small points but incremental to this, reading through the filings, you see that the deal closed about 1 month and 1-2 weeks before the quarter end. Mgmt is guiding to 1 month of AppRiver revenues so there is some buffer here on revenue as well. Also, the idea for guiding to simply Q4 margins was to show what the business could do PF for cost cuts. Since the initial guide, all the cost cuts have been effectuated, the Q4 guide is significantly de-risked, and we expect the business to get to these margin targets much faster than the guide.


E) More coverage and transition to SMID cap from Microcap


There are a number of other sellside banks on the debt deal and we expect more coverage over the next few quarters. We expect the company to trade more in-line with comps as coverage and liquidity improve.


Valuation / Projections / Comps

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


  • Q1 earnings
  • Beats and raises throughout the year 
  • Increased sellside coverage
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