SPECIAL SITUATIONS: New Issue
Endurance International Group (EIGI) is a leading provider of cloud-based solutions for small and medium sized businesses to establish, manage and grow their businesses by harnessing their web and mobile presence. Endurance was founded in 1997 and has over 3.4 mm subscribers through a family of brands including BlueHost, Hostgator, Domain.com, Fatcow, A Small Orange, iPower and iPage. The company's strategy is quite simple, but highly effective. In their own words, "Our company's strategy is based on two simple principles: adding more high quality subscribers to our platform and then selling our subscribers more value added solutions."
It's not often that individual investors get to play the same type of ball as some of the most well-known and successful private equity and venture capital investors - the likes of KKR, Warburg Pincus, Goldman Sachs Capital Partners and Accel Partners. That changed a couple of months ago with the quiet Initial Public Offering of a relatively unknown firm called Endurance International Group - a company that survived the technology bust in the 1990's and grew under these investors as a private company. A couple months ago the company offered its shares to the public. The stock seems to have been abandoned as it wasn't growthy enough for the growth investors and wasn't cheap enough for value investors. While not a busted IPO by any means, Endurance offers a rare opportunity for the individual investor to play a similar game as some of the most successful private equity investors in history. Notably, KKR still owns one of its larger competitors in GoDaddy, and Warburg Pincus/Goldman Sachs are still majority holders of EIGI. The stock still trades in the $14-$16 range that the banks had initially valued the company; however it has moved up slightly from its offer price of $12 since reporting a strong Q3. We still think that the market is offering investors a rare opportunity to pick up this publicly traded LBO at a substantial discount to its intrinsic value.
It is not surprising that EIGI has been owned by private equity/growth investors for the past decade as it checks off all the dream characteristics of a great private equity investment.
- Large addressable market with significant growth. There are 25mm and 76m small and medium size businesses (SMBs) in the US and internationally that are expected to spend billions of dollars on technology annually for the foreseeable future. With only 3.4mm subscribers, EIGI has a small fraction of the market with ample runway for growth. EIGI has over 150 products catered to these entities from basic web services to more advanced tools in cloud, mobile, security and storage that can help these companies with a full suite of services. The growth of the market is evident as even without significant investment in marketing this past quarter, EIGI reported a strong 10% organic CAGR over the past 8 months in their subscriber base. The company also stands to benefit as one of the main SMB service providers for Google's business customers - the market seems to be underestimating the power of this relationship.
- Powerful economic model and repeatable playbook. EIGI has a standard playbook that has allowed them to survive and grow through difficult market cycles. Once the customer is on their platform (through organic growth or acquisitions) typically paying a few dollars a month, they begin to provide them with higher value added products that result in a substantial increase in ARPU through the life cycle of the customer. The most recent ARPU was $13.14, which was a 9% organic increase without a significant push in moving its recent subscribers up the value chain. Over a 3 year period, new ARPU for new subscribers ramps almost 40%. This incremental revenue stream will fall to the bottom line at very high incremental margins since typically there is not a lot of cost associated with providing the customer with these additional services.
- Sticky customers and recurring revenue. Once EIGI's SMB's become customers they typically are customers for the life of their businesses - lost contracts are often to do M&A or businesses shutting down. Hence, in the past quarter EIGI reported a 99% monthly recurring revenue retention rate. This is not surprising given the high value, low cost proposition that EIGI offers and the challenge and disruption of changing technology platforms once a company is a customer.
- Cash Flow Generation. While the company generates a significant amount of free cash flow given the high margin (approaching 40%), low capex profile (~5% of revenues) of the company, still another aspect of the business often overlooked is the large deferred revenue on the company's balance sheet. This is effectively a negative working capital business where most customers typically pay upfront (12 months or more in advance) and the company recognizes this revenue over the life of the contract.
- High ROIC business. While the company hasn't disclosed its subscriber acquisition costs, industry estimates are in the mid $60's. If you assume an average ARPU of $13 and a fully loaded margin of 50%, EIGI has a 9x return on its investment over the life of a typical customer. While the company must continue to innovate and broaden its product suite, the incremental costs to servicing are minimal, and combined with a sticky customer that is typically increasing spend with the company, the returns are very high.
- International growth. With the recent acquisition of Directi, based in India, 30% of the company's revenues are now international. This gives them a great platform to geographically diversify their growth and continue a high growth trajectory in faster growing economies.
- Deleveraging story. While many investors may balk at the leverage (~5x adjusted EBITDA), we think that a company with the type of recurring revenues and growth is appropriately capitalized. Management has recently reduced and refinanced this debt which has brought interest expense down over $35M and will continue to use the ample cash flows to reduce debt. That said, we would rather have them invest capital back into the business given the ROIC profile.
- Acquisitions masking true growth. The Company made 2 large acquisitions that closed earlier this year in HostGator and Homestead, which accounts for over 20% of their total subscribers. As is typical of their playbook, they took most of 2013 to integrate these acquisitions and have only started ramping up these subscribers to higher value added products. While management will still need execute, we think 2014 is going to set up as a better year than sell-side analysts are currently projecting given their ability to monetize these new customers. Further, most of the analysts have not factored in the Directi acquisition which is set to close in the coming weeks. Management hinted at this in their Q3 call - "So, as we go into 2014, we have high hopes again that with the migration completed at the end of Q4 that we'll be able to execute on the playbook like we have in the past."
- Management/Private Equity. Ultimately, this is a show me story given the acquisitions that company has made recently which has temporarily disguised the company's powerful growth. That said, clearly some of the most successful investors have backed this management team (Accel-KKR in the past and more recently Warburg Pincus) and the CEO has successfully been leading the company for the past 16 years.
- Consolidation. EIGI has been an acquisitive company; however, we would not be surprised to see this as a possible acquisition target for large technology firm looking for growth and a strong customer base to sell into. We note Oracle's purchase of Responsys a couple weeks ago as evidence of this.
The key risks to the investment are that this is a competitive industry with a constant need to innovate to drive customer growth and some of this growth will come through acquisitions, which carries the risk of integration and customer turnover. In regards to the stock, we think that the company has yet to find a stable shareholder base given its recent IPO and we expect the private equity players to monetize their investment in a secondary. This will create volatility in the stock in the coming months.
So why is Mr. Market offering up this stock at such a discount to its intrinsic value? We think there are 2 main reasons. First, the company just became public two months ago so like many lower profile companies, investors want to see a couple quarters of good execution. While the company did not give formal guidance for 2014 in the past quarter, they did have strong 3rd quarter and we think they will come out with strong guidance for the fiscal year 2014 when they report Q4 and 2013 results. They should easily beat their guidance for 2013 given their performance through 9/30. Second, we don't think this new issue found a stable ownership group when it became public. It does not screen well on earnings given its high debt levels, a bit pricey for traditional value guys, and growth investors were on the sidelines as the strong growth trends in the business were masked by the 2 large acquisitions that they had just made. These 2 acquisitions should fuel a strong growth trajectory for the company in 2014 and beyond.
It is important to note that the bankers initially valued EIGI and expected to price the public offering at $14-$16, but subsequently had to cut the price to $12 due to demand. That said, investors now have an additional quarter of positive results and these results exceeded all the analysts' expectations so it is not surprising to see that the company is now trading in the initial IPO range. In fact, we are surprised that it hasn't surpassed this range. Given the high debt levels we think that using a DCF based and multiple of EBITDA approach are the best ways to value EIGI. For simplicity, we will lay out the EBITDA approach here (but note that the valuation is supported by our DCF approach) and keep the math as simple as possible - as our main point is to illustrate that the company should easily be able to grow north of 20% EBITDA in 2014 - not surprising since they laid out a high teens long term growth plan for EBITDA in their q3 presentation. (See income statement below). Based on our modeling, EIGI should be able to hit 20%+ growth in Adjusted EBITDA. The two key drivers to this number are the same drivers management points to as the keys to the business: 1. Subscriber growth 2. ARPU growth. Our 2014 estimate is driven by 10% growth in organic subscriptions (keep in mind they just already posted a 10% growth without any significant sales and marketing to the new customers that came on board this year) and an average ARPU growth of 5%, well below the 9% organic growth achieved in the last quarter). Hence, we think our numbers are very conservative.
With 20%+ growth in 2014 EBITDA to $250MM (from management's 2013 estimate of $205MM) and a business model that supports high teens long-term growth, the market would easily put a mid to high teens multiple on the stock. With the median comp set trading at 16x growing at a lower growth rate, we will give EIGI a slightly higher multiple of 17x EBITDA. This equates to a $24 target price on the stock, or 65% upside from current levels. In the low probability scenario that the company doesn't execute the playbook they've been executing on for over 15 years, the stock would probably trade down to near its IPO price. We like the asymmetric risk reward here which is why the company's 2 large private equity buyers haven't sold a single share. By the way, while as value investors we like to be contrarian, this one already has the support of the leading tech analysts at MS, Goldman and Credit Suisse, with the latter putting a $23 price target on the stock. That said, we do think analysts' estimates for 2014 are too conservative.
10% growth consistent with past quarter in 2014
Cost of rev
Estimate base on historical deferred/revenue