Description

CARB VIC

Overview

Carbonite is a provider of data backup and disaster recovery services.  Historically a consumer focused company, after the arrival of CEO Mohamad Ali in late 2014, the Company has purchased eight SMB focused backup companies as it looks to diversify away from the hyper-competitive consumer segment.  

Today, SMB represents 68% of 2018E bookings.  Revenue has grown from $122mm for 2014 to $303mm for 2018E.  The Company touts its business model as able to generate 6-12% organic growth with 22-26% operating margins.  Yet, PF non-GAAP revenue is only growing 1.0% in first 9mo of 2018, and was -1.1% in 3Q18.

Our short thesis is: 1) rollup of poor performing SMB backup services masking lack of underlying growth; 2) demand of products should be impacted as enterprise migrates to cloud providers (AWS/Azure) who offer their own backup services; 3) questionable non-disclosure of license revenue weakness and channel partner dispute prior to $200mm equity raise in July 2018 only to miss materially in 3Q18; 4) sell side estimates for FY2019 sales growth are far too aggressive; and 5) company cutting S&M significantly to boost near term earnings and cash flow after its latest acquisition, jeopardizing long term revenue growth.

Carbonite reports tomorrow Feb 7 after the close.  While most of our short thesis isn’t predicated on whether their guidance can meet FY2019 top line expectations, we do view that as a near term catalyst.

1) Acquired companies performing poorly and also hiding lack of underlying organic growth

Carbonite has been on an acquisition spree since 2014.  

• 2014: Acquisition of MailStore for $19.9 million

• 2015: Acquisition of Rebit for $1.3 million

• 2015: Acquisition of SMS Backup for $0.3 million

• 2016: Acquisition of EVault for $9.6 million

• 2016: Acquisition of Datacastle for $9.6 million

• 2017: Acquisition of DoubleTake for $65.9 million

• 2018: Acquisition of Mozy for $145.8 million

The last two are of particular concern as they are the largest and come at a time when core growth is slowing.  DoubleTake will also feature prominently as being blamed for their 3Q18 miss (more on this in #4).

DoubleTake

Acquired for $65.9mm on 1/31/17, financials show $40.7mm of revenue in FY2016 (https://www.sec.gov/Archives/edgar/data/1340127/000134012717000065/exhibit994-proformafinanci.htm).  Carbonite guided at the time of the acquisition that DoubleTake would contribute $22.5-27.5mm in bookings and $20-25mm in non-GAAP revenue for 11 months of FY2017.  Assuming guidance was correct, combined with the $3.3mm it did in the month of January, DoubleTake declined between 30-43% in FY2017, or 36.7% at the midpoint (see table below).  

In FY2017, non-GAAP revenue increased 17.6% due to the acquisition, while PF for DoubleTake, it declined 0.3%.  If you assume that DoubleTake revenue landed in the middle of guidance, it would imply the core business ex DoubleTake grew at 6.8%.  

Mozy

Mozy was acquired for $145.8mm on 3/19/18.  It did $71.8mm of revenue for the year ended 2/2/18.  Based on PF revenue disclosures in the 10-Qs, Mozy revenue is down 9.6% for the 9mo ending 9/30/18 from $53.2mm to $48.1mm.  Revenue ex Mozy grew 2.3% during that time frame, and total combined revenue declined 0.4%. In 3Q18, total non-GAAP revenue growth was down 1.1%.  

So the best we can tell is that the last two large acquisitions were of declining businesses and that in 2018 the business ex Mozy was trending below the targeted 6-12% range.  On a go forward basis with Mozy included in the financials, reaching the target will be even harder.

2) Competition is already fierce and will only increase as more customers migrate to the cloud

On the SMB side, Carbonite is going up against both legacy and newer entrants such as Barracuda, Dell/EMC, Veritas, Commvault, etc.  On the consumer side, competitors are Dropbox, Box, Backblaze, Acronis, etc.

However, as SMB transitions from on-prem to cloud (AWS/Azure), channel checks with various IT consultants have suggested that many are getting rid of their backup/disaster recovery vendors and utilizing the cloud offerings.  In fact, this week AWS announced AWS Backup (https://aws.amazon.com/blogs/aws/aws-backup-automate-and-centrally-manage-your-backups/) to streamline the process.  This covers both cloud and on-prem data.

3) Questionable lack of disclosures prior to July 2018 $200mm secondary

On 7/16/18, Carbonite positively preannounced and announced a secondary.  The Company announced 2Q18 revenue would come in at the top end of the range and increased non-GAAP EPS from $1.51-1.59 to $1.62-1.68.  The secondary was ultimately upsized to 4.8mm shares by the Company and 700k shares from cofounder and director David Friend at $37.50, raising over $200mm.

All seemed fine on 8/2/18 with the full 2Q18 results - business bookings were reaffirmed for the year and consumer bookings were guided up.  The company made a brief mention about perpetual business bookings being a bit light in the Q&A but brushed it off as lumpy.

Fast forward to 3Q18 results on 11/2/18.  FY business bookings guidance was reduced from $223.8-234.8mm down to $205-210mm, or a 8.4-10.6% reduction.  This was blamed on i) declining perpetual business bookings from the aforementioned DoubleTake acquisition (and also another acquisition Evault), and ii) a dispute and filed lawsuit against a top 5 channel partner.  

The commentary around perpetual bookings was decidedly different than just a quarter ago - it went from “lighter than expected results” (2Q18 cc) to the perpetual business “underperformance really almost accelerating in the third quarter… I think that business instead of looking like $55mm this year, it looks like low $40mm” (3Q18 cc).  Given â…“ of the quarter was already over when the Company presented their 2Q18 results, it seems pretty drastic that they didn’t realize that perpetual bookings would miss by over 20% with 7 months in the books.

The same goes with the dispute and lawsuit with a top 5 channel partner.  A long-lasting relationship must have deteriorated quickly if it wasn’t worth mentioning on 8/2/18, and by the end of the quarter Carbonite had filed a breach of contract lawsuit against them.  

4) Expectations of $336mm of revenue in FY2019 implies 5-6% organic growth for the whole business.  

PF for Mozy, organic non-GAAP revenue growth was -1.1% for 3Q18 and +1.0% for YTD 3Q18.  Based on 4Q18 guidance, 4Q18E organic growth will be 0.3% and bring FY2018 organic growth to 0.8%.  

In FY2019, perpetual business revenue (13% total) will trend lower from low $40s to mid-to-high $30s.  Mozy (20% PF revenues), which declined from $72mm in FY2017 to ~$63mm, will likely continue to trend lower.  Consumer ex Mozy (28%), which will grow 12.5% in FY2018 largely due to a price increase in 2Q, will have harder comps.  

If we assume that perpetual business revenue declines the way the company guides, Mozy declines another 5%, and consumer ex Mozy grows 5%, then core subscription business revenue ex Mozy will need to grow 16% to hit sell side figures, up from our 8% estimate.  That seems like a hard stretch.

5) FCF and margins inflected in FY2018, but it could be due to sales and marketing underinvestment

In the PF Mozy financials (https://www.sec.gov/Archives/edgar/data/1340127/000134012718000091/exhibit993-proformafinanci.htm), PF sales and marketing for FY2017 was $99mm.  Through the first 9mo of 2018, S&M expense has declined from $68.2mm in the 2017 period (when Mozy wasn’t in the financials) to $63.1mm in the 2018 period (Mozy in the numbers starting 3/19).  Even when you factor the accounting change of ASC 606, the $63.1mm increases to $67.6mm. So with over 5mo of Mozy, S&M is essentially flat. On an annualized basis, S&M could end up around $90mm (before 606), which would be a $9mm decrease in S&M.  

It should come as no surprise that one of the variables that goes into calculating annual cash incentives is free cash flow.  

However, given the miss in 3Q18, it seems that management has realized that there are repercussions from cutting S&M: “I expect that we’ll make investments to drive sales of our new products in the fourth quarter and into 2019 as well.  As a result, our sales and marketing spend may show a sequential increase in the coming quarters.”

If the company wants to try to hit sell side expectations of sales growth, it will likely have to come at the expense of margins.

Valuation

Based on sell side expectations, the company trades at 3x 2019E sales, 10.3x 2019E EBITDA, and 16.4x 2019E non-GAAP EPS of $1.80.  

We forecast 1% organic growth in 2019E and EPS to be broadly flat at $1.65 due to the step up in S&M and a slowdown in high margin perpetual business revenue to limit margin expansion.  

We apply a lower 12x multiple to EPS to take into account i) the vast gap between GAAP and non-GAAP earnings (2018E GAAP EPS of $0.28 vs non-GAAP of $1.63); ii) use of 8% tax rate to calculate non-GAAP EPS; and iii) our belief that this is a no-to-slow growth commoditized business with potential secular pressure coming from public cloud providers.  We see downside to $19.80.

Catalyst

- True organic growth shows up once acquisitions are lapped

- FY2019 guidance could be lower than expectations

- Increased competition 

- Company needs to invest in sales and marketing to reinvigorate revenue growth