Description

Thesis

We see extremely compelling value in Cellebrite (CLBT), the leading digital forensics and intelligence platform, offering software solutions designed to collect, review, analyze and manage digital evidence and investigative data with respect to legally sanctioned investigations conducted by law enforcement agencies, governments, and private sector clients. As a former SPAC, CLBT has the scarlet letter investors have been avoiding like the plague. However, while most former SPACs are structurally flawed businesses that came public at a time where growth was rewarded without regard to cash burn and are deserving of the bad label, we think the bias against them has created a few terrific opportunities to own quality businesses trading at arbitrarily discounted valuations. CLBT is one of those opportunities. 

The fact it came public via SPAC is where the similarities end for Cellebrite, which is generating substantial GAAP profits and free cash flow. Cellebrite is a differentiated digital forensics subscription business expected to grow ARR at ~25% and nearly double EBITDA this year. Trading at only $5.75, CLBT’s EV trades at 22x/16x ‘23/’24 EBITDA or with a 7%/8% FCF yield, respectively - extremely palatable for a company expected to compound EBITDA at more than 50% annually through 2025. Furthermore, in January, Cellebrite’s subscale competitor, Magnet Forensics (MAGT), was taken out by Thoma Bravo at ~9x sales/49x 2023E EBITDA. 

While CLBT has traded up ~30% since that deal was announced, a substantial valuation gap still remains. CLBT reported strong Q4 results and 2023 guidance, and we believe CLBT will continue to perform well as the business should be fairly insulated from real or perceived macro headwinds, with law enforcement agencies representing ~90% of CLBT’s revenue.

As the SPAC label wears off, we anticipate the stock will re-rate. However, even without a re-rating, the stock should perform very well on compounding earnings. Finally, we suspect there is a real possibility the Company is acquired - by either a strategic or private equity, with Thoma Bravo taking out its top two competitors (Magnet Forensics and Grayshift) in the last year.

Company Description

Cellebrite is the leading digital forensics intelligence platform that offers solutions designed to help customers collect, review, analyze and manage digital investigative data with respect to legally sanctioned investigations conducted by law enforcement agencies, governments, and private sector clients. The company specializes in digital forensics for mobile phones and other devices, enabling investigators to access and analyze encrypted data and metadata ranging from text messages and photos to GPS trails and Wifi networks accessed - information vital to conducting successful investigations in the modern age. The company's technology is widely recognized as the gold standard in the industry and its growth has been propelled by the increasing importance of digital evidence in investigations. Cellebrite has expanded its product offering beyond baseline data extraction capabilities into areas such as analytics and digital evidence management, allowing the company to position itself as a one-stop-shop for all digital investigative needs. Cellebrite was founded in 1999 and is based in Israel.

Value Proposition

Cellebrite’s product suite is critical to evidence collection and digital investigations at law enforcement agencies. Digital devices, particularly mobile phones have become increasingly ingrained in people’s lives and thus crime as well. According to an industry survey, 63% of crimes now have a major digital component. That means, where evidence used to be predominantly physical, crucial evidence is now locked away in cell phones, computers, drones, etc. Cellebrite’s toolset gives law enforcement the ability to bypass locks and encryptions in confiscated devices, extract information vital to the investigative process and quickly organize/analyze the data. Currently, Cellebrite has over 7,000 customers including over 100 US federal agencies and over 3,000 US state and local accounts in all 50 states - this includes all of the top 20 largest police departments. Cellebrite is also utilized by police departments in 15 of the 20 largest European cities, and is expanding internationally - recently signing a 5 year contract with the national police agency in Singapore. Finally, Cellebrite has over 1,000 private enterprise customers, including 68 of the Fortune 100.

ARR Growth Story

While highly penetrated (accessible to 90% of US law enforcement agencies), Cellebrite is underpenetrated within each agency, particularly at the State and Local level. Its NRR of more than 125% in each for the last twelve quarters reflects their ability to consistently expand relationships with existing customers as digital forensics solutions become more and more valuable to the investigative process. In fact, 83% of their gross ARR growth last year was from existing customers, driven by customer needs for incremental licenses and upsells to premium offerings, including new analytics and evidence management products.

Multiple Growth Levers

Upsells at Existing Law Enforcement Agencies

Most law enforcement customers, when onboarding, start with Cellebrite’s basic collect and review offering, which is aimed at digital forensics units within law enforcement agencies. Customers usually start with mobile phone capabilities and can upgrade to add cloud application and/or desktop computer forensics. Their base offering enables examiners to extract data from digital sources, decode the unstructured data and finally, review and analyze the data, which may be instrumental in solving a crime. Law enforcement agencies are then able to upgrade to Cellebrite’s premium offering, which provides superior decoding abilities, capable of getting past the latest iOS locks and encryptions. Given the growing backlog of warrants for data extraction, Cellebrite has had much success selling additional capacity (seats/licenses).

Larger customers usually start with a few seats at one department or buying center (typically the forensics lab). They then expand licenses to the whole department and potentially to additional departments. This dynamic is nicely illustrated by the Company’s relationship with the FBI, which first agreed to Cellebrite licenses for examiners in the forensic lab at its headquarters. The FBI has since expanded licenses to technicians at its various field offices and recently started purchasing additional licenses for direct use by their individual investigative units to quickly extract data at the crime scene. This type of adoption within the investigative unit represents a step-change in Celleberite’s global TAM from an estimated ~50k forensic examiners to more than 700k investigators in the markets in which they serve, and highlights the massive opportunity for continued license growth.

Opportunity at State and Local Police Departments

In conversations with former law enforcement officers, it is evident that smaller regional and local police departments have been slower to adopt digital forensics tools, partially due to budgetary concerns. These police departments have previously had to go up the chain to get help from state and federal forensics labs or task forces for data extractions. However, as digital evidence needs and expectations in court have risen, States have become so backed up and slow in getting forensics work back to local agencies, it has interfered with investigations.  The courts expect digital evidence, the judges expect it, the prosecutors expect it, and as this problem has worsened, smaller agencies are more and more frequently bringing digital forensics capabilities, and therefore Cellebrite, in house. Data extraction tools are an increasingly important part of police department budgets.

Evidence Management Solution

With all of the digital evidence being created, the need for digital evidence management has grown drastically. While Police units are notoriously great at dealing with physical evidence, their solutions for maintaining digital evidence currently consists of a severely disjointed combination of printed PDFs, network share drives, thumb drives, and even CDs . Cellebrite’s new evidence management solution (launched one year ago) seeks to help law enforcement manage the sensitive data they create. Their software offers a secure and seamless way to store digital evidence as it is created and share it across units and relevant agencies. This evidence management solution has been launched alongside a new investigative analytics product, which allows customers to digest and align data coming from multiple sources and utilizes AI capabilities to hone in on the most relevant pieces of data. These modules so far have small revenue contributions as of now, but offer additional avenues for growth and nice longer term opportunities.

Adoption in the Private Sector

Finally, adoption of Cellebrite’s data extraction tools has been increasing in the private market. Law firms are frequently finding it as useful in helping defendants to build cases and major corporations will use it to investigate potential misconduct such as the dissemination of trade secrets to competitors. While private enterprises are not given the ability to bypass mobile device lock screens, defendants will voluntarily consent to data extraction in order to obtain digital forensics that may prove innocence, and corporations are able to perform extractions on company-issued devices. 

Revenue Accounting Transition

It’s important to note that subscription revenue now represents 84% of the total, giving Cellebrite strong visibility and favorable working capital dynamics. However, this hasn’t always been the case. The Company formerly contracted with much of their customer base through perpetual licenses, recognizing all of the revenue upfront, compared with subscription revenue, which is recognized over time. As subscription deals have replaced perpetual license deals, GAAP revenue growth has lagged ARR growth, with much of the new revenue being deferred - this gap will narrow as the license deals roll off and the deferred revenue kicks in. 

Non-Cyclical

As law enforcement agencies represent 90% of CLBT’s revenue, the Company is very insulated from macroeconomic headwinds. US law enforcement budgets continue to climb. The 2023 Federal Budget provides $1.97 billion in discretionary funding to support state and local law enforcement, an increase of 12% over the FY22 enacted level. Additionally, the total DOJ Budget request for $37.7billion, is nearly 13% higher than the 2021 enacted level. 

Operating Leverage

As Cellebrite grows revenue, we expect they will benefit from substantial operating leverage. An increase in salesforce by ~100 employees in 2022, brought their headcount to ~1,000 - a 10% increase - however, the Company does not expect to grow the team any further this year. This contributed to Adj. EBITDA margins falling from 19.5% in 2021 to 8% 2022. As Cellebrite grows into the larger salesforce and continues to invest in R&D, we expect EBITDA margins will return to the 20% range by 2025, resulting in over 50% compounding EBITDA growth on a 17% revenue CAGR. 

Financial Performance

Valuation Multiples

Competition

• Competitors include Magnet Forensics, Grayshift, NICE and Nuix, with Magnet and Grayshift being the most relevant in data extraction

  • Magnet Forensics is focused on desktop computers with some capabilities in Cloud

  • Grayshift is a collection tool for modern phones with good decoding capabilities, but poor forensics and analytics capabilities

• Magnet and Grayshift were both acquired by Thoma Bravo in the last year

  • They had already worked together for years and bundled their products together to sell to law enforcement

• Cellebrite has all the extraction capabilities of Magnet and Grayshift combined plus more on the analytics/evidence management side, with greater scale

  • Cellebrite has off the shelf continuity, whereas Magnet + Grayshift offer a cobbled together disjointed service with inferior the analytics capabilities

“And I mean in terms of focus on Cellebrite, we use Cellebrite, or I certainly use Cellebrite for 95% to 99% of every phone job that I did in my time. Of the hundreds and hundreds of phones that I have processed, it's always pretty much been Cellebrite because it's the best tool, it's the fastest tool, and it presents in the best method to allow you to hand it to investigators for them to go and weed through the content or identify what they need you to report on.” - Former Forensic Examiner

Thoma Bravo Takeouts

CLBT’s top two competitors (Magnet Forensics and Grayshift) were just acquired by Thoma Bravo at a significant premium to CLBT’s valuation

• Magnet Forensics, which specializes in desktop computers, was acquired at ~9x sales/49x 2023E EBITDA or a ~15% above prior trading day close

• CLBT is much larger (3x the revenue and 2x the EBITDA) and dominant in the more relevant mobile device space

• CLBT has moved up 35% since the announcement, but still trades at a substantial discount – 3x sales/23x EBITDA

Regulatory Questions & Concerns

Because Cellebrite’s solution is so effective, there are continually concerns around privacy abuse, particularly if their product is in the wrong hands. Firstly, Cellebrite adheres to strict guardrails dictating authorization of use only when a judge has granted a search warrant - this is similar to a warrant enabling law enforcement to enter a home. Secondarily, use is authorized in cases where the suspect under investigation provides consent in an effort to prove innocence. Furthermore, Cellebrite has proactively pruned its customer base, eliminating new sales into countries where legal / regulatory issues run counter to their ethical standards (ie. China and Russia). It is worth noting that this has represented ~20% of churn in recent quarters as licenses expire and are not renewed in these countries - underlying growth is actually stronger than it appears and the impact of contract terminations is expected to begin receding over the next 4-6 quarters.

Conclusion

CLBT is a high quality defensive software subscription business poised to continue compounding earnings as law enforcement agencies increasingly rely on their digital forensics solutions. The stock has limited coverage and trades at a discounted multiple due to its association with SPACs. We believe the stock can grow substantially with earnings, but a re-rating as the SPAC label wears off and a potential sale of the business offer additional upside.  

Catalyst

• Compounded earnings growth

• SPAC discount wears off

• Potential sale

  • Potential strategic acquirers could be cybersecurity or defense names

  • Public to private, i.e. Thoma Bravo