Description

Zix is a $200m EV technology firm trading at a trailing FCF multiple of 15x.  Revenues have grown at close to 10% annually over the past five years, margins are stable, and this appears set to continue for the foreseeable future.  The business benefits from network effects making it challenging to compete with, and the industry structure makes an eventual acquisition of Zix by far the most likely outcome.  Management and the board are of excellent quality and are likely to engineer a sale of the business within a reasonable time (a $250m NOL balance complicates this somewhat, but this is likely surmountable).  Capital allocation is good, with essentially all free cash flow dedicated to share repurchases.  Overall, Zix should compound value at a mid-teens rate until an acquisition at a premium, with minimal risk to the business or of capital mis-allocation in the meantime.

Background

Zix sells email encryption services to small and mid-size corporations in the US.  While most email sent is encrypted by default (~80%, according to Google – see data), if anyone along the email chain (sender, various servers, and the recipient) does not have their software correctly configured then the email will be sent unencrypted, leading to vulnerability. This risk is unacceptable to businesses in regulated industries, where failure to protect consumer data can lead to fines and sanctions.  Zix provides a solution to ensure email remains encrypted. If both the sender and receiver are Zix customers, the encryption is all handled by Zix hardware and software and the user doesn't notice anything.  If the recipient is not a Zix user, the email is kept on an encrypted web interface and the recipient needs to retrieve it there – a video describing the process is here.  It's somewhat cumbersome, but it's necessary in the relevant industries.  Zix generates 51% of revenues from healthcare clients and 29% from financial services clients, so these are risk-averse clients who are unlikely to risk changing.  Zix’s product is fairly good and user feedback is fairly positive – see reddit discussion thread.  

Network effects protect the franchise

I think the reason Zix trades at such a low valuation is that people assume that the winner-take-all dynamic present in the technology sector means that Zix will inevitably be destroyed by Google, Microsoft, or ‘the cloud’.  This fear is misplaced.  Zix’s position is defensible because it occupies a strong market-share in a small niche with network effects, making it both costly to enter and too insignificant to bother with for larger players.  As noted, Zix's clients are concentrated in the healthcare and financial services industries. Because these clients often e-mail each other, everything works seamlessly. Anyone wishing to change provider will suddenly be faced with the need to access some emails via the Zix web interface, which is a pain.  

Put another way, the winner take all dynamic is present, and Zix has won in their tiny niche.  Zix claims its service is used by all U.S federal financial regulators, one in four banks, and one in five hospitals.  Humana, Anthem, Cigna, and numerous Blue Cross/Blue Shield organisations are all customers.  Zix's niche is also too small for bigger players to really bother with, unless it's via an acquisition of Zix.  Zix’s 2015 revenue was $55m and no single customer accounted for a significant proportion of revenues.  This is too small a market to entice larger players to notice it.  Zix does compete with firms such as Microsoft and Proofpoint, but clients often utilise multiple service providers.  It’s hard to imagine Microsoft dedicating a sales force to specifically target hospitals in an attempt to win $50m of additional business.

Capital allocation is good

Historically, Zix’s capital allocation wasn’t fantastic.  Zix entered the e-prescribing business (aiming to leverage its relationship with hospitals) in 2003, acquiring a small firm for $1.5m and investing in the business.  Unfortunately, the business was a failure and after reporting segmental losses of ~$7m annually between 2004 and 2009, the firm finally closed the division.

Luckily, the company learned its lesson.  Since 2005 (when the former CEO took leadership), the company has spent zero dollars on acquisitions.  Over the past five years, share repurchases have averaged ~$15m annually.  The most recent quarter saw another $5m in buybacks (during the call, the company also disclosed buybacks continued during 2Q with a further $4m completed by April).  While management have experimented with very limited investments in internal projects (two projects, ZixOne and ZixDLP, launched in 2013; both have been failures but have consumed minimal capital) have attempted to build upon the existing client relationships and in my view were fairly rational experiments.  I expect capital allocation to continue to be devoted almost entirely to repurchases.

Management & board

One minor wrinkle in the story is that management has recently changed.  Richard Spurr was CEO and chairman of the board from 2005 to 2015, when he stepped down. The CEO role was taken up by David Wagner.  Wagner comes from Entrust (a PE-owned firm that was sold in 2013), where he was CFO (and later president, after the acquisition).  The PE-based background suggests he will be fairly disciplined.  Wagner acquired 60k shares in open market purchases in February, at a price of $3.57.

The six-member board will include 4 independent directors, in addition to Wagner and Spurr.  These boardmembers include:

Robert Hausmann - boardmember since 2005 and now chairman after Spurr stepped down from the role.  Hausmann previously co-founded a firm (TetraSun) which was sold in 2013.  

Mark Bonney - CEO of MRV Communications, where he was appointed to the role after a fairly protracted history of proxy battles.  See a recent VIC write-up on the stock for some background, but Bonney is one of the good guys in the pretty dreadful history of the firm. He also has a background selling firms.

Taher Elgamal - CTO of security at Salesforce.com.  Pretty senior level of expertise for a $250m market cap company.

Maribess Miller - Accountant from PwC.

Financials

Revenues were $56m in the last twelve months, growing at a CAGR of 9% since 2011 (with no major change in trend; 1Q16 growth was 10%).  FCFF margins averaged 22% over this time (again with no trend; 1Q16 margins were 24%).  FCFF margins (defined here as CFO minus capex minus stock-based comp) are the right way to look at the firm due to the deferred revenue accounting.  The only other difference from EBIT figures is the lack of taxation thanks to the NOL, discussed below.  There growth and margin patterns are stable, reflecting the stable business, and unlikely to change.  There's an order backlog of $75.5m (up 7% YoY), so revenue visibility is good.

There are $250m in NOLs.  I don't have the sophistication to fully analyse the section 382 implications, but I don't think you need particularly generous assumptions to make the equity undervalued.  Either Zix continues to utilise the NOLs as a stand-alone company, or an acquirer is able to monetise some fraction of the NOL.  The sophistication of management and the board make me believe this is achievable.  

Catalyst

Acquisition