By Joseph Hogue, CFA
The loss of credit card information for 40 million Target (NYSE:TGT) customers in December is just one in a growing list of high-profile cyber-crimes. The increase in these attacks, both financial and politically-motivated, is on the rise and is one of our megatrends for the next decade. Symantec (NASDAQ:SYMC) has lagged peers in the industry but looks poised to surprise higher on the completion of its reorganization. Higher margins and a focus on new products could drive earnings over the near-term while growth in the cyber-security market should drive long-term returns.
This article is part of our megatrend series, a look at the trends that will drive markets over the next decade. Within each megatrend, we will focus on two companies with the potential to outperform. The idea is that, even if the individual companies fail to execute on their strategic plans, the overwhelming force from the megatrend should drive strong returns.
Cyber-Crime is only getting started
Hacking has been around even before Matthew Broderick made it cool in 1983's WarGames, but high-profile attacks have made cybercrimes a top corporate priority over the last couple of years. The National Counterintelligence Executive estimates U.S. financial losses in the tens of billions a year and economic losses to R&D secrets as high as $398 billion. Research firm Gartner Inc. (NYSE:IT), estimates that the worldwide security market could grow to $86 billion by 2016, a compound annual rate of 8.5% from $67 billion last year.
Despite increased attention and higher spending, the problem will not easily be controlled and budgets will need to be continuous. As mobile devices increase internet penetration globally and more information goes online, the need to protect that information will be pervasive and continuous.
The market has not missed the potential in the cyber-security space. Shares of pure-play companies have surged on each new cyberattack; FireEye (NASDAQ:FEYE), Barracuda Networks (NYSE:CUDA), KEYW Holdings (NASDAQ:KEYW) and Palo Alto Networks (NYSE:PANW) all feature six-month returns over 60%. The acquisition of SourceFire by Cisco Systems (NASDAQ:CSCO) last year, for an enterprise value of 12.1 times sales, boosted valuations and many of the smaller firms now trade with expensive buyout premiums.
With a market cap of $14.9 billion, Symantec is by far the largest pure-play security software company and one of the few that does not trade at a significant buyout premium. The company reports in three segments: user productivity and protection (43% of FY2013 Revenue), information management (38%) and information security (19%). The company books 52% of its revenue from outside the United States.
Shares slid 6% late January when the company forecast fourth quarter sales between $1.62 and $1.66 billion, slightly lower than expectations. The disappointment is nothing new to investors with the shares down nearly 9% over the last year and underperforming the broader market since the end of the recession.
The problem at Symantec is that it is a legacy security company in a world where legacy systems have not evolved to meet new cybercrime challenges. Santosh Rao, analyst at High Alert Capital Partners, describes the environment in a recently completed sector report on cybersecurity,
"Secular shifts in technology like the growing practice of BYOD (bring your own device and the adoption of cloud services, combined with the modern network infrastructure with its widely-dispersed multiple end points has made legacy signature-based security technologies obsolete. Today's attacks can appear harmless to legacy systems by coming through as file formats other than .exe (executable) and can be initiated through the system's random access memory instead of being written to the hard drive."
Revenue has grown at a compound annual rate of just 3.3% over the last five years, even as high-profile cyberattacks drove faster growth across the industry and opened the door to smaller competitors. Revenue is expected to decline by 4% this year even against a 9% increase in the market for security software spending.
What the market missed on the quarter
Despite the disappointing fourth quarter guidance, operating results were surprisingly positive. With the megatrend of cybersecurity as a tailwind, Symantec is poised to outperform as it manages through a reorganization and a strategic transformation under the relatively new leadership of CEO, Steve Bennett. The company cut about 5% of its worldwide employment last year and reorganized the sales division to focus on new business and new products.
CEO Bennett commented during the conference call that the reorganization had been completed which should mean that costs savings could drive earnings higher over the next few quarters. The company increased its operating margin to 30.4% over the last quarter, beating expectations of 26%. Shares outstanding have decreased every year since 2006 as the company returns money to shareholders.
The shares trade for an enterprise value of just 1.8 times 2013 sales, well below the 10.8 average multiple among pure-play IT security companies. The price multiple of 17.3 times earnings is well under the shares' five year average of 22.6 times trailing earnings.
I think management is being conservative on guidance and the company could see revenue of $6.75 billion in FY2014, a decline of 2% from the year before. Modeling a 19.4% net margin and a reduction of 3.5% in shares outstanding brings my estimate for $1.94 in earnings. A turnaround in operations should drive investor sentiment and the price multiple could increase to the 18 - 20 range. Applying a price multiple of just 18 times earnings leads to a target of $34.92 per share, more than 60% above the current price.
Symantec is not the fastest growing company within the cybersecurity megatrend but completion of a restructuring program and strong market growth should lead higher revenue and margins in the years to come. Over the short-term, the shares should benefit from a trough in investor sentiment and better execution. The company's size and scope enable it to adjust to the evolving nature of the industry and the shares should not be as volatile as peers in the space.