Description

UK-based Surfcontrol (SRF LN) is the world’s 2nd largest player in web filtering, secure email messaging, and enterprise threat shield software. The company has 25% market share in the enterprise security sector, which is forecast to growth at 20% pa in coming years thanks to increased penetration into SME’s, new applications such as spy-ware detectors, and email URL browsers.

Though SRF is a best of breed provider in a fast growth industry, its new license sales have been disappointing (down 4% in the last quarter, though overall sales were up 7%). The company has recently brought in a new CEO, Patricia Sultz, who was previously head of global operations at Salesforce.com, to rejuvenate sales growth. Pat joined 1 month ago and has divulged her review of the company on September 6th.

According to the new CEO, poor sales development over the past 3 quarters can be attributed to poor marketing and sub-optimal packaging of their software. She is therefore changing incentive schemes and pricing structure, closing satellite offices, removing management layers, recruiting new / experienced sales staff, and increasing client education.

We believe that SRF can again generate growth rates at least in line with industry average as our conversations with re-sellers, clients, and competitors conclude that the product is very competitive in terms of technology / content, as well as price. These findings are consistent with various awards that the company has received from IDC / Frost and Sullivan etc.

Valuation

With a $243 million market cap, $89 million in net cash, and double-digit FCF yield, the valuation is very compelling. The company is trading at 5.47 times EV/FCF, and 1.6 times EV/sales. Note that recent changes in revenue recognition announced on Sept 6 (from 60% of license sales recognized upfront to 50%) coupled with a $3-5 million restructuring charge (from which we expect 0 cost saves) have resulted in a meaningful decrease to our P&L estimates, but not to our CF. We also believe that the new guidance is overly conservative. Still, the company still trades at a meaningful discount to its closest comps WBSN, which is valued at 17 times EV/FCF, 6 times EV/sales, and 35 times earnings.

Our $ estimates for Surfcontrol (blomberg ticket: SRF LN) are as follows :

Market Cap million 240
Net Cash 89

Sales (05e) 97 (06e) 96 (07e) 105
EBITDA (05e) 17 (06e) 9 (07e) 12.4
Net Profit (05e) 6.44 (06e) 1.3 (07e) 8.17

FCF (05e) 23 (06e) 22 (07e) 25

EV/Sales (05e) 1.5 (06e) 1.34 (07e) 1
EV/FCF (05e) 6.9 (06e) 6.1 (07e) 4.7
EV/EBITDA (05e) 8.8 (06e) 16 (07e) 9

The valuation is compelling and should yield support at these levels. Indeed, we cannot think of many software companies that are co-leaders in 20% growth industries and still are valued at only 6 times forward cash flows. More importantly, it seems to us that SRF is a CLEAR take-out candidate for a slew of natural buyers keen to capitalize on the industry’s dramatic sales growth prospects. Such buyers include Checkpoint, Symantec, Microsoft, MacAfee. Further, the company has resumed its share buy-back program, and has room to buy back 10% of shares outstanding. Clearly, there is room for much more.

At 15 times CF, the stock is worth 9 GBP, implying over 100% upside potential.

The risk is that that the product line really has holes or that the industry is set to decline from this point (though my conversations with competitors, re-sellers and consultants indicate otherwise). The industry growth rates could also slow in coming years, but the company is now in a position to build its own future.

Catalyst

Execution of turn-around plan
Potential take-out or expression of private equity Interest