|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|
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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
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.
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.
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:
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
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