Commtouch Software (CTCH) features meet several of the criteria we view as necessary for compelling investments. With a market capitalization of less than $70 million, and little analyst coverage, Commtouch is off the radar of most investors. And yet, its small size belies its potential, as well as its blue-chip customer base. Commtouch's earnings have fallen in 2013 as the company makes aggressive investments in its business, and although it will take some time for EPS to recover and surpass historical records, we see a solid path forward for such a recovery. With double-digit revenue growth set for both 2013 and 2014, as well as meaningful profit growth set for 2014, we believe that Commtouch will not remain under the radar for long, and believe that investors who initiate positions ahead of a pivotal 2014 will be rewarded over the next 12 months. Although Commtouch lowered revenue guidance in August, the company's forward revenue growth is still far above that of its peers (more detail on this later), and we see upside of 57% as Commtouch trades up to levels commensurate with its peers and growth prospects. Unless otherwise noted, the following sources will be cited in this article: Commtouch's 2012 20-F, its Q3 2013 earnings release, or its Q3 2013 earnings call.
Overview
Israeli-based Commtouch (its U.S. headquarters are in Virginia), was founded in 1991 and like many other 1990's companies, shares trade far below historical levels; Commtouch's share price rose to almost $200 in 1999 (the company posted $4.251 million in revenues that year); but shares closed at $2.58 on November 22, 2013 (the company generated almost $24 million in revenue in 2012). However, Commtouch's size belies its blue-chip customer base. The company counts several blue-chip technology companies in both the broader technology and security sector as customers, including Microsoft (MSFT), Google (GOOG), Check Point (CHKP), HP (HPQ), McAfee (INTC), and LG. Commtouch provides its customers with a slate of anti-spam, zero hour virus outbreak detection, and IP reputation products, as well as URL filtering. And in late 2012, the company entered the growing private label cloud security market via the takeover of German-based eleven (which holds 36% of the German managed e-mail security market). Commtouch's customers integrate its products into their own product offerings; Google uses Commtouch's anti-virus products in its Postini e-mail archiving and security service, while HP integrates Commtouch's messaging security products into its Unified Threat Management solutions.
As the company's 2013 results show, Commtouch has been growing sales at a brisk pace, aided in part by its acquisition of eleven, as well as continued growth in its customer base. But, continued investments in its business have weighed on the company's EPS as Commtouch invests in R&D and marketing. However, 2014 is set to be a transformational year for the company in terms of profitability (more on this later), and as Commtouch pivots from mere revenue growth to growth in both revenues and profits, we believe that shares of Commtouch will rise to match its forecasted growth in profits.
Q3 Results & Guidance: Continuing Top-Line Growth
For Q3 2013, Commtouch posted revenues of $8.019 million, representing a 44.28% increase relative to Q3 2012 (revenues for the first 3 quarters of 2013 have increased 40.14% to $23.999 million), and beating estimates by $100,000, partially mitigating the fact that EPS of $0.01 (down from $0.03 a year ago) missed estimates by 2 cents. Part of the decline can be traced to a drop in gross margins as the company moves to expand its customer base; gross margins fell by 292 basis points year-over-year to 81.61% in Q3 2013, but rose sequentially by 130 basis points. When that dip in gross margins is combined with a 42% surge in R&D expenses, and a more than 63% surge in sales & marketing expenses, the roots of the company's earnings decline become clear. Commtouch's customer base continued to grow in Q3; in September, the company announced that Web.com (WWWW) has begun to integrate Commtouch's anti-spam (both inbound and outbound protection) and anti-virus products into its email services infrastructure. In addition to inking a contract with Web.com, Commtouch is also preparing to roll out its next-generation of cloud-based security products, with CEO Shlomi Yanai forecasting that this cloud-based security suite would launch by the end of the year, with revenue to be booked beginning in Q1 2014.
For 2013 as a whole, Commtouch reiterated its guidance alongside its Q3 results; the company continues to expect revenues of $32.5 million at the midpoint of guidance ($32-$33 million), representing growth of 34.85% relative to 2012, when sales grew by just 5% relative to 2011. We note that in 2012, Commtouch saw both anemic revenue growth and a fall in EPS, with earnings falling from $0.26 to $0.16. Although earnings will fall further in 2013, the company is forecasting continued profitability, with pro forma net income of "at least" $1.5 million forecast (versus $3.908 million in 2012). However, despite declines in year-over-year profits, Commtouch's underlying cash flows (excluding changes in working capital) rose year-over-year, as shown in the table below.
Commtouch Software Operating Cash Flows (in Thousands of $)
Net Income (Loss) | ($914) | 19 |
Depreciation | $361 | $155 |
Stock-based Compensation | $329 | $386 |
Amortization | $542 | $102 |
Accrued Interest | $110 | N/A |
Accretion of Earn out Liabilities | $271 | N/A |
Total Operating Cash Flow ex-Changes in Working Capital | $699 | $662 |
Commtouch's underlying operating cash flow rose by 5.59% year-over-year, and although the company posted negative operating cash flow during the quarter (a seasonally weak one), cash burn improved relative to Q3 2012 (the company burned $980,000 in Q3 2013, versus $1.387 million in Q3 2012).
Financials & Valuation: A Compelling Proposition
As it continues to invest in expanding its sales force and customer base, Commtouch's balance sheet, while not the strongest in the industry, remains reasonably secure. The company ended Q3 2013 with $3.972 million in cash & investments, and debt of $3.113 million, in the form of drawdowns to its credit lines to finance the takeovers of eleven, as well as the antivirus business of Iceland-based Frisk Software. After the close of Q3, Commtouch refinanced its credit line with a new $7.5 million credit line from an unspecified United States bank, replacing its previous $5 million credit line from a grouping of Israeli banks. This new credit line will provide the company with further financial flexibility until profit growth resumes in 2014.
For all of 2013, Commtouch is projected to post pro forma EPS of $0.06, down 62.5% from 2012 EPS of $0.16. However, EPS is set to recover meaningfully in 2014, rising to $0.17 (an increase of 183.33%), and far outpacing projected revenue growth of 16.92% (revenues are estimated to reach $38 million in 2014). Commtouch lowered its revenue guidance after posting Q2 2013 results in August, trimming its 2013 revenue forecasts from a range of $34-$35 million to its current $32-$33 million, citing an inability to complete its hiring program within its sales & marketing divisions at the pace it had forecasted at the beginning of the year. However, as we will show below, Commtouch's projected 2013 revenue growth is still far above that of its peers.
With a market capitalization of less than $70 million, Commtouch trades at meaningful discounts to its peers in the security sector, and as the company's profits recover; we believe that this discount will begin to close. In its latest 20-F, the company discloses several publicly traded competitors; Symantec (SYMC) and TrendMicro (OTC:TMICY) are Commtouch's most direct competitors, with IBM (IBM), Google, Intel, and Cisco (CSCO) serving as more indirect competitors (several other competitors to Commtouch are not publicly traded). The table below highlights Commtouch's value relative to its competitors (closing prices and multiples are accurate as of the close of trading on November 22, 2013).
Commtouch Software Peer Comparison
Company | Commtouch | Symantec | TrendMicro | Direct Peer Average | Cisco | Intel | IBM | Indirect Peer Average | Total Peer Average | |||
Share Price | $2.58 | $23.34 | ¥4,040.00 | $21.46 | $1,031.89 | $23.87 | $181.30 | |||||
Shares Outstanding | 1,085,854,383 | |||||||||||
Market Capitalization | $68,228,100 | $16,245,375,443 | ¥534,382,932,120 | $114,738,411,657 | $344,741,456,473 | $118,657,770,000 | $196,865,399,638 | |||||
Last FY Sales | ||||||||||||
Current FY Sales | ||||||||||||
Next FY Sales | ||||||||||||
Current FY Revenue Growth | 35.93% | -3.71% | 14.79% | 5.54% | -4.25% | 18.86% | -1.39% | -3.96% | 2.32% | 3.39% | ||
Next FY Revenue Growth | 16.92% | 2.41% | 3.53% | 2.97% | 4.32% | 16.30% | 1.37% | 0.91% | 5.72% | 4.80% | ||
Last FY EPS | ||||||||||||
Current FY EPS | ||||||||||||
Next FY EPS | ||||||||||||
Current FY EPS Growth | -62.50% | 0.56% | 52.00% | 26.28% | -1.49% | 10.65% | -15.63% | 10.62% | 1.04% | 9.45% | ||
Next FY EPS Growth | 183.33% | 7.87% | 2.16% | 5.01% | 5.53% | 18.36% | 0.53% | 6.76% | 7.79% | 6.87% | ||
Current FY P/S | 2.10 | 2.44 | 4.96 | 3.70 | 2.47 | 5.78 | 2.26 | 1.96 | 3.12 | 3.31 | ||
Next FY P/S | 1.80 | 2.39 | 4.79 | 3.59 | 2.36 | 4.97 | 2.23 | 1.94 | 2.88 | 3.11 | ||
Current FY P/E | 43.00 | 13.11 | 29.06 | 21.09 | 10.78 | 23.42 | 12.63 | 10.75 | 14.40 | 12.47 | ||
Next FY P/E | 15.18 | 12.16 | 28.45 | 20.30 | 10.22 | 19.79 | 12.56 | 10.07 | 13.16 | 15.54 |
Commtouch's forecasted revenue growth surpasses all of its peers, both direct and indirect in both 2013 and 2014, and yet it trades at price-to-sales multiples typically assigned to blue-chip technology companies such as Cisco or IBM. And although Commtouch's earnings are set to fall meaningfully in 2013, the company has solid double-digit revenue growth to show for it. The company's peers are set to grow earnings by less than 10% on average in 2013, but have little revenue growth to show for it. Furthermore, TrendMicro drives much of that earnings growth. Given that over 51% of TrendMicro's sales are outside of Japan, the weakening of the yen relative to other major currencies has contributed meaningfully to the company's earnings growth in 2013. When TrendMicro is excluded, 2013 earnings growth for Commtouch's peers falls to just 0.95% (and revenue growth falls to an average of 1.11%), and only Google can match Commtouch in posting double-digit growth, which comes at a price-to-sales ratio more than twice as high as that of Commtouch. Were Commtouch to be valued at the overall average 2013 price-to-sales multiple of its peer group (3.31x), shares would be valued at $4.07, representing upside of more than 57% from the company's closing price of $2.58 on November 22. Based on 2014 multiples, shares would be valued at $4.47, representing upside of over 73%.
This potential upside does not take into account the potential for an acquisition of the company. Given its size, Commtouch could easily be acquired by any of its competitors, and the company has seen many of its peers acquired over the past several years. In August 2010, Intel took control of McAfee, and in October 2010, Symantec acquired RuleSpace to take control of its URL filtering products, matching Webroot in its July 2010 acquisition of BrightCloud. Cloudmark has also acquired Bizanga, in order to integrate its messaging protection products into its own security offerings. While we believe that Commtouch presents a compelling opportunity on a standalone basis, there is always a possibility that the company may attract the attention of one of its larger competitors, particularly given the fact that its revenue growth is meaningfully above that of its peer group.
Conclusions
Commtouch Software's present valuation does not match its revenue growth in 2013 and 2014. The company has remained profitable through this period of investment, and EPS is set to recover meaningfully in 2014. And yet, shares trade at a meaningful discount to its peers. In our view, such a discount is unwarranted, and as Commtouch demonstrates that it can begin to move profits back to historical levels, all while continuing to grow revenue at double digits, this discount will begin to close, and that shareholders who add to or initiate positions at this point in time will be rewarded in 2014.
Disclosure: I am long CTCH, SYMC, MSFT, GOOG, CHKP, CSCO, IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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