Description

CTCH recently expanded its market opportunity by 40x positioning itself to exploit a fundamental shift in the information security space with moderate incremental expense. Meanwhile, its legacy business generates north of $6m FCF per annum, handily supporting what we believe to be a depressed valuation. 

THE COMPANY
Over the past decade, CTCH has pioneered a patented set of statistical algorithms that enable real-time threat detection, is future proof, and threat agnostic. The Company’s software protects PCs, servers, data centers, smart-phones, and other network-connected devices from viruses, email outbreaks, and web-based threats.

The company’s primary source of revenue is email security software, sold as a multi-year subscription service to over 180 OEMs (e.g. HPQ) and email service providers (e.g. GOOG). CTCH’s technology secures 30% of the global email market. Antivirus and web security are newer markets for Commtouch.

Comtouch’s revenue is 100% recurring with >80% gross margins. The Company’s superior technology is sticky and boasts >90% renewal rates. CTCH offers a Software Development Kit which enables third-parties to integrate its mail security solutions into security appliances for sale to enterprise, government, and institutional end users. Those third-parties then pay CTCH a monthly subscription fee.

CTCH’s proprietary Recurrent Pattern Detection (“RPD”) technology involves analyzing billions of messages and directs the blocking of email outbreaks without the need to analyze messages at an individual level. CTCH’s market leading detection services see 12bn transactions per day across 550m end users, 60x more than any other vendor. RPD has over 99% detection accuracy, zero-hour detection of global threats, and is language agnostic. CTCH’s software has a small footprint with high performance and is well-suited for embedded applications

CTCH owns and operates its robust cloud infrastructure distributed across twelve data centers globally. Though incorporated in Israel, CTCH’s new CEO has relocated his hand-picked management team to Virginia in order to be closer to customers. Insiders own 23% of the company.

EXPANDED OPPORTUNITY
CTCH’s subscription model is like selling “gold for pennies,” as new management puts it. This is why despite powering a third of the world’s email, CTCH’s core email business generates less than $20m p.a. (albeit at very high margins). CTCH’s OEM customers (e.g. CKP) sell high-priced security appliances powered by CTCH’s detection service to end-users and pay CTCH a small monthly subscription fee per user connected to the box.

OEM Model:
*Vendor sells appliance and charges $50/seat/year
*CTCH gets 3-5% of this or $2.50/seat/year
*A 10k user deal generates $25k revenue for CTCH
*The same deal generates $500k revenue for vendor

In November of 2012, CTCH acquired Eleven GmbH, a German provider of mail-based Security-as-a-Service (“SecaaS”) solutions. CTCH’s IP, brand reputation, and existing customer base coupled with Eleven’s cloud-based delivery platform opens up a large, obvious, adjacent market for CTCH requiring moderate incremental opex and minimal capex to exploit.

The Eleven acquisition gives CTCH all of the assets needed to offer services to new and existing OEMs that they can then private label and resell. Where OEMs were building boxes and paying CTCH for the service, they can now offer end users complete services in the cloud without building anything; they can simply put their own logo on CTCH’s service and offer hosted email, web, and antivirus security. As enterprises move toward outsourcing a greater chunk of their infrastructure, SecaaS is a natural extension of the managed services movement. Gartner sizes the Email and Web SecaaS market at $1.8bn in 2013, growing to $2.6bn by 2016 (13% CAGR). This is the fastest growing segment in the information security sector and a substantial opportunity for CTCH.

CTCH’s legacy business has 30% email market share and <$20m of email revenue pegging their legacy market opportunity at $65m. CTCH can now chase a $2.6bn market, or 40x larger than before. Importantly, new management has transformed the business from an on-premise solution to a complete cloud-based SecaaS provider in order to avoid the legacy pennies-for-gold model.

Private Label Model:
*Vendor charges $30/seat/year for cloud service
*CTCH gets 60% of this, or $18/seat/year
*A 10k user deal generates $180k for CTCH, 7x the size of the legacy model with similar margins

Our diligence suggests that while enterprises aren’t throwing their boxes away given that they contain firewalls, gateways and other key functionality, they are going to the cloud for mobile security and other network connected devices (M2M, embedded, etc.). This has on-premise appliance vendors on edge and plays directly to CTCH’s private label strategy which is designed to be a win/win for OEMs and CTCH.

Under the private label model, the vendor realizes less revenue, but triple+ margins given they don’t have to design, build, sell, install, and maintain boxes in the field. They can simply push licenses to existing customers. In addition, the vendor keeps customers under the vendor umbrella. According to Gartner:

“Good opportunities are being made available in a number of security segments to technology and service providers with cloud delivery capabilities.”
-Gartner September 2012

CTCH’s private label solution is partner-centric, providing partners with interfaces to issue licenses, change logos, manage renewals, etc. CTCH built the solution with partners in mind and cloud offerings significantly expand the market opportunity beyond large enterprises to SMBs. As such, they’re not going head-to-head with the SYMCs or MFEs of the world who are large enterprise focused. SMBs also happen to be the fastest adopters of cloud-hosted services.

In light of the large market opportunity management targets $100m of revenue in 2016 (more conservatively 2015 exit rate) via organic and acquisitive growth.

ANCHORED BY A SOLID CORE BUSINESS
Given the accuracy of their technology, CTCH’s core detection services business grew revenue at a 29% CAGR over the past eight years and, before reinvesting operating income in new market opportunities in 2012, generated more than $6m of FCF per annum. We think that the period from 2005 to 2011 is most representative of CTCH’s “Core” detection services business before it began investing in expanded opportunities.

Note: We adjust out the change in non-cash working capital because this number swings both positive and negative irrespective of the consistent upward trajectory of sales (i.e. it’s too difficult to forecast and washes out anyway)

If management cash-flowed the business, we believe CTCH could generate this level of FCF with their core technology / customer base. We believe that a business with superior patented technology, long-term contracts with 90%+ renewal rates, 100% recurring revenue, and consistent FCF generation deserves a FCF multiple of 10-15x which approximates CTCH’s current market value. We note that Vista Equity Partners’ takeout of WBSN yesterday values that company at 21x trailing FCF despite sales and EBITDA declines.

VALUATION
CTCH has an $81m market cap and $4.9m of cash resulting in a $76m enterprise value. We model 2013 and 2014 sales of $34m and $41m, respectively. We model EPS of $0.13 in 2013 doubling to $0.26 in 2014 given that product introductions are slated for 2H13. At the current price, the market is valuing CTCH at 12x next year’s earnings despite a 2-year earnings CAGR of 30% which is likely conservative. Considering management’s guidance of $100m revenue in the next few years with high gross margins and moderate incremental operating expense, we could see CTCH being worth $250m+ on a long-term basis (200% upside).

Businesses with primarily recurring revenue models and open-ended growth opportunities tend to trade at a significant multiple of sales. We see companies such as BIRT, INFA, MSTR, PEGA, and QLIK trade for an average of 6x 2014E recurring revenue. If we gave CTCH a 25% haircut and apply the resulting 4.5x multiple to our expectation of $42m of revenue in 2014, we arrive at a value of $7.24 per share, or 130% upside.

If we look at acquisitions of companies that provide a mix of cloud/on-premise security, valuations are ridiculous frankly (Vista/WBSN 34x FCF, CSCO/Iron Port 8.3x sales, MFE/MX Logic 7.0x sales).

Ultimately, we like to be conservative and generate an attractive return while reserving the potential benefit of continued open-ended upside. As such we value the shares at $6.50 representing 25x 2014 earnings, a discount to CTCH’s security peer group trading at a median 30x ’14 EPS.

DISCLAIMER
This report is neither a recommendation to purchase or sell any securities mentioned. The authors may or may not have a position in any security discussed in this report. Further, the authors may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be correct as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report. The authors undertake no obligation to update this report based on any future events or information.

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