Investment Summary
Websense (WBSN) is an interesting enterprise software stock that could provide above-average appreciation potential over the next few years. The company is a leading provider of employee Internet management tools (EIM) to corporations of all sizes.
Since most Wall Street analysts still remain very skeptical about the company’s ability to reignite top-line growth on a sustainable basis, dramatic upside moves in the stock price could be possible if the company continues to deliver greater-than-expected sales results, as was evidenced in last quarter’s financial report.
Basically our view is that notwithstanding the slowdown experienced in 2006, the growth of Internet usage in the workplace over the coming years, especially via mobile devices, makes it highly probable that Websense will hit upon substantial new growth initiatives sooner rather than later. As the market prices in these new opportunities, the stock could advance rather quickly.
At the same time, as investors wait for new growth prospects to materialize, they can take comfort in Websense’s solid cash position of over $300 million (no debt), proven free cash-flow generating capability, and a large, diversified, and mostly repeat customer base. In addition, while not a well-known consumer name, the company has very strong brand recognition in the security software space. All of the above imply low downside risk for the shares on a long-term basis.
Note: The price of WBSN’s stock was about $25.50 as of this writing. The stock price is up from an $18 low this year, but it still down nearly 25% from its high. According to the latest proxy statement, WBSN’s stock had appreciated by over 350% from 2001 to 2005. This is clearly a company that is proven in terms of creating long-term shareholder value.
The People
In January 2006, in effort to position the company for continued long-term growth, WebSense hired Gene Hodges as the new President and CEO. Mr. Hodges received 600,000 option shares on WBSN with a strike price of about $32.
Mr. Hodges was the former President of MCAFEE, INC (MFE) a nearly $5 billion (market value) provider of computer security software products. He became President of MFE in October 2001. Mr. Hodges also served as president of the McAfee product group from January 2000 to October 2001, and from August 1998 to January 2000, he served as vice president of security marketing. Mr. Hodges joined McAfee in 1995 and served in numerous other management positions with the company.
Comments:
Though Mr. Hodges has extensive experience as a high-level corporate executive, WBSN represents his first stint as the CEO of a public company. As such, there is not much to point to in terms of a track record for increasing shareholder value at other publicly-traded companies.
On the negative side, during Mr. Hodges tenure as President of MFE, MFE’s stock price basically moved nowhere, and the company’s financial results were not too exciting. However, since Mr. Hodges was not calling the shots at MFE, it’s difficult to use that company’s performance as an indicator of how Mr. Hodges will fare in increasing shareholder value at WBSN. On the positive side, Mr. Hodges certainly gained a tremendous amount of experience in the security software industry by working at MFE. Current investors in WBSN are essentially banking on this experience to drive renewed growth at WBSN.
Overall, from our perspective, what is important is that at MFE Mr. Hodges helped manage a similar business that was nearly 10X the size of WBSN from a revenue perspective. Therefore, we think it’s a good bet that he has the experience and the knowledge to execute successfully on several growth initiatives at WBSN. As we have noted in the past, when an executive manager of a larger more established corporation is placed at the helm of a much smaller, albeit well-capitalized and proven company, the odds are high that this executive will use his/her experience and more importantly leverage his/her extensive business contacts to drive new business at the smaller company.
In addition to Mr. Hodges, the other key executive worth mentioning is CFO, Douglas C. Wride. Mr. Wride has been CFO since 1999. He holds nearly 260,000 shares of stock, 245,000 of which are issueable upon exercise of options. It appears that Mr. Wride’s latest option grant was 80,000 shares at $25.63 per share. In terms of large shareholders, we note that Barclays Global Investors filed a 13G back in 6/2006.
The Business
Basic Statistics
As of 9/30/2006 Websense had about 46 million shares outstanding, $300 million in cash, and no debt. We estimate 2006 sales of about $180 million and free cash-flow (defined here as operating cash-flow minus cap-ex) of about $80 million. Gross margins for Websense’s software are about 90%.
Notably, Websense generated about $97 million in free cash-flow in 2005, allowing the company to repurchase $48 million in stock. Since 2001, Websense’s revenues have grown from $36 million to $150 million in 2005 and operating income increased from a negative $1.2 million to $55 million in 2005.
It is important to note that Websense’s free cash-flow is significantly higher than net income since the company generally recognizes revenue on the income statement from subscription agreements over the life of the agreement (i.e. 12 to 36 months), even though the company receives actual cash for the subscription within 30 to 60 days of the invoice. The company records amounts billed to customers in excess of recognizable revenue as deferred revenue on our balance sheet.
Business Background
Websense (WBSN), which first released its software in 1996, is a leading provider of employee Internet management tools. Its software enables organizations to analyze, report, and manage their employees computing resources, including restricting access to certain Internet sites (e.g. pornography or gaming sites), and monitoring instant messaging, peer-to-peer file sharing, network bandwidth, and other software applications used by employees.
A core aspect of the company’s software is their proprietary database, which contains updated lists of potential problem websites, including sites containing spyware, viruses and other malware and problematic software applications and executable files. The Websense URL database is currently organized into more than 90 categories and encompasses more than 15 million websites. The software application database has classified over 1.4 million software applications and executable files in more than 50 categories. We also maintain a database of commonly used internet protocols.
Positive Aspects of Websense’s Business
We like the Websense business because it has:
As mentioned above, Websense makes money by selling 12-month to 36-month subscriptions to its software products. This provides a dependable recurring revenue stream.
As of 12/2005, the company reported more than 24,000 customers ranging from companies with as few as 50 employees to members of the Global 1000 and to government agencies and educational institutions. No customer accounted for more than 10% of revenues in 2005, 2004 or 2003.
The above numbers suggest an average revenue figure of about $6,250 per year per customer, which is clearly a tiny dollar amount for even the smallest of companies to pay for proven employee Internet management solutions. This number is of course somewhat misleading as companies pay for Websense’s software based on a per seat basis with larger companies shelling out much more money than $6,250 per year. However, by looking at the very low average revenue number it is easy to understand why Websense’s renewal rates are so high, i.e. supposedly over 80%.
As shown above, WBSN sports 90% gross margins and significant free cash-flow generation. In 2005, free cash-flow was about $100 million on a mere $148 million in sales for a FCF margin of 68% and a whopping return on average equity of over 50%. Clearly this is an unbelievable business.
Given the continued and growing necessity of corporate internet access there is clearly an ongoing significant opportunity for employee internet management and corporate web security solutions, like those offered by Websense, that effectively address the needs of organizations to protect themselves from web-based threats and manage employee usage of the Internet. Additionally, with the growing emergence of internet-enabled applications on mobile devices, there will also be a continued need for software that manages employees Internet activity on these mobile devices.
What Went Wrong Here?
In the case of Websense the only thing that has really gone wrong for the company is that its explosive growth over the last five years has resulted in increased competition and lower average selling prices, both of which have slowed the company’s growth rate in 2006. In addition, the company has clearly already captured the “low-hanging” fruit of the EIM market. As such, the company is in need of new sales strategies and new products in order to maintain double-digit growth and prevent customer attrition.
What Has Changed?
The major change that Websense is currently undergoing is the company’s greater focus on expanded sales via indirect channels. In fact, the recent management change, discussed above, is due to this strategic change and the need for a CEO with greater experience in growing and managing indirect sales channels.
Sales through indirect channels currently account for more than 80% of revenue, and WBSN plans to increase the percentage of this revenue going forward. The strategy is to increase new and renewal customer sales through independent software distributors and resellers and increase the focus of internal sales and marketing force on supporting the channel strategy.
In support of the increased focus on the indirect channel, on August 4, 2006, WBSN announced that Ingram Micro, one of the largest wholesale technology distributors in world, will distribute, market and support the company’s Web security and Web filtering. Ingram Micro will also focus its efforts on recruiting new resellers and building awareness and demand within WBSN’s existing North America channel partner base.
The new program is also intended to expand the company’s presence in the growing small and medium business Web filtering market, and help Websense evolve from a Web filtering company into a comprehensive security provider.
.
Risk Analysis
Aside from the obvious risks Websense faces from customer attrition and non-renewals, the most significant risk for the company is actually quite simple:
There is nothing extraordinarily proprietary about Websense’s software and the high margins and significant cash-flow the company has generated in the past have attracted many competitors. Many of these companies are better capitalized than Websense and could in theory offer the same product for significantly lower prices. The increased competition is part of the reason why Websense’s business has slowed in 2006 and why many on Wall Street are skeptical that the company will continue to deliver extraordinary growth in the future.
Two other major risks the company faces are:
Notably, despite having announced an agreement with Nortel Networks in October 2005, to develop a web content filtering solution to protect GSM/UMTS mobile handsets from receiving and accessing unwanted content, the product has yet to launch.
By relying on indirect sales the company will have little control over sales practices and will remain at the mercy of value-added resellers, distributors and original equipment manufacturers.
It is important to note that even though the above risks are real, we think the company’s stock valuation already reflects some of these risks. More importantly, we feel that despite the increased competition, it is unlikely that current clients will cancel their WBSN subscription given the low-price and trusted nature of the service.
In general, our experience has been that companies are in no rush to cancel important software-based subscription products, despite an ability to save a few dimes, as long as the provider is diligent in its marketing efforts and constantly develops new products.
In terms of larger competitors, we think it is more likely that these companies would rather buy than build and given WBSN’s current valuation the company is definitely a potential takeover target for a larger competitor.
As regards to the replicability of the technology, we almost never invest solely based on technology IP, and we are more interested in customer relationships and management infrastructure. As far as these two factors, Websense’s business is very difficult to replicate and as such has significant value.
Return Analysis
Basically, we believe that the market for all types of employee Internet management software, especially as it pertains to mobile Internet devices, will continue to grow for many more years. As a leader in the industry, WBSN should continue to capture a decent size of this market, allowing the company to deliver strong growth for many more years.
All in all, we don’t think it is inconceivable for the company to grow revenues by over 50% over the next few years. In such a scenario, cash-flow would easily increase dramatically. In addition, with over $300 million in cash, we would not be surprised if WBSN acquired another company in order to accelerate its entry into the wireless market or expand its presence into other aspects of the software security industry.
Valuation: Downside and Upside Scenarios
We think that in a worst case, WBSN would throw off $60+ million in free cash-flow a year. Assigning a 10X multiple to that figure and adding back $300 million in cash, yields a worst case valuation of about $20 per share.
On the upside, if management is able to expand sales channels and markets, the company could easily generate $120 million in cash-flow. Applying a conservative 15X multiple to that number and adding back cash would yield a valuation of $2 billion or $45 per share. Importantly, we think that with renewed growth and an expanded product line, investors will likely assign a much higher multiple to the company’s cash-flow.
Giving each scenario 50% odds implies an expected value of about $32.50 per share, or nearly 30% above the current market price.
Subscribe by RSS
Follow Us on Twitter