Description

We believe that Carbonite is an interesting special situation trading at a low absolute and relative valuation. Carbonite is a leading provider of cloud and hybrid continuity solutions for individual and small and midsized businesses (“SMB”). The Company support more than 1.5 million individuals and small businesses around the world who rely on Carbonite to ensure their data is protected.

Why the company is mispriced or misunderstood?

1.    The company recently announced the end of a strategic process that was initiated when a competitor launched a tender offer to buy the company at $15 per share. As a response, the Company initiated a process that was recently unsuccessfully terminated. We believe that arbitrageurs and event-driven funds have been exiting the stock creating non-economical selling pressure. For context, the stock was trading at $11.76 in December 2014, the day before J2 sent a letter to buy the Company at $15 per share.

2.    The company is going through a transition period (a) a new CEO has taken over from the prior CEO/founder of the Company. The new CEO is a smart business executive who has many ideas (and is focused on execution) to accelerate the growth of business. The founder is more an entrepreneur type who was more interested in the technology side of the business (b) many people (including investors) believe that CARB is a company focused on serving consumers. In reality, CARB is now 100% focused on growing its SMB business. This business was up more than 40% in Q1 2015 and represented 36% of the bookings in Q1 2015. We believe the opportunity on the SMB side is significant and the company has barely started exploiting the opportunity. Because of this switch from consumers to SMB, CARB is also retooling its go to market strategy and growing its network of partners/resellers. We are at the early stage of this transformation.

Description of the business:

We like the business as it is a subscription-based business model and therefore has recurrent revenue. I have personally used their product for years to back up my personal computers at home. They have my credit card and we are charged annually! The consumer side of the business is pretty competitive and nowadays there are many options to back up your computer. We like the fact that Carbonite has a large installed base of business which is not going away although also not growing very much (bookings were up 2% in Q1 2015 – company is guiding flat to positive 5% for the year). Over the last couple of years, the business has been transitioning from a consumer-focused business to a SMB-focused model. SMB bookings are growing fast (was up 42% year over year in Q1 2015). SMB bookings represent 36% of total bookings in Q1 2015 compared to 28% of bookings in Q1 2014. Overall bookings grew 13% year over year in Q1 2015. The company expects to generate between $16 and $18 million of free cash flow in 2015. SMB has higher gross margin than the consumer business (75% versus 65%).

SMB opportunity

We believe the SMB opportunity could be very significant. The company provides the following statistics: 35% of SMBs do not have a business continuity solution in place at all today and only 30% of SMBs are currently using a cloud backup solution (others still use tapes/disks or external hard drives) . The company competes with companies such as Symantec or Mozy (a division of EMC). Carbonite’s products are much cheaper than its peers. We think the opportunity is large given the trends, the growth rate of the business, the fact that the company is already generating north of a third of its bookings in this space when CARB has barely finished developing its product suite (it still need to add more products) and is still building its network of partners. Management believes that once they have optimized the network of partners and finished building the suite of products, SMB growth could be significantly higher. As part of our due diligence, we have spoken to a number of the resellers and they were enthusiastic about the products, its simplicity and reliability and its price.

Valuation

We are looking at valuation a few different ways.

1.      Enterprise value is around $210 million. The company will generate $17 million of FCF this year for an 8% free cash flow yield. The business is growing intrinsic value at 10-15% per year (bookings grew at 13% year over year in Q1 – I think booking growth is a proxy for the growth in intrinsic value). So you get 8% FCF yield and the value of the business grows at 13% for a total return of 21% (assuming the business continues to trades at 8% free cash yield and the free cash flow growth track the growth in intrinsic value). That’s very cheap especially given the stability of the business.

2.      Assuming SMB bookings continue to grow at this rapid pace, by 2017 half of the bookings will be from SMB. As this happens the overall bookings growth of the business will accelerate and its margin will improve as well (SMB margins are better than margins on the consumer space). The financial profile of CARB will start to look more like companies like Barracuda or LogmeIn that trade at valuation around 5x Revenue versus CARB currently trading at 1.5x Revenue. Assuming 15% revenue CAGR to 2017, 2017 revenue could be around $180 million. Applying a 2x revenue multiple (still a very big discount to peers) would yield a EV of 360 million. Add around 40 million of FCF generated in 2015 and 2016 on top of the existing cash and the equity value at the beginning of 2017 could be around $460 million or $16.8 per share. At 2.5x revenue, the stock would be at $19.3 per share.

3.      Assuming $180 million in revenue in 2017, EBITDA margin around 20%, $40 million of cumulative FCF generated in 2015 and 2016, and a 10x multiple (appropriate given the quality of the business and its growth profile), we get to a stock around $16 per share in early 2017.

4.      The optionality here is that the SMB business grows faster given the large opportunity and we wake up one day with the SMB growth at a very big number and the revenue multiple rerates.

Why did the process fail?

We believe the process failed because fundamentally CARB is in 2 different businesses – the consumer business and the SMB business. We believe there were buyers interested in either the consumer business or the SMB business but not both. This is also why J2 decided to pass – they were only interested in the consumer space (at least that’s their official reason).

Financial model

For 2017, we model revenue close to $180 million with gross margin north of 73%. Assuming a little bit of leverage of R&D, marketing and G&A, we get to EBITDA margin close to 20%.

Catalyst

.      Selling pressure from arbs abates

2.   Growth acceleration on the SMB side

3.   Share buyback – would help with point 1 - we believe the company is considering it.