Some bulls are incorrectly applying a cyber security multiple to the total revenue base.
Last year only 3% of revenue was commercial cyber security.
At the current stock price investors are actually paying 40x revenue for Hawkeye G, even if you assume generous multiples for the rest of the company.
The Most Expensive "Undiscovered" Cyber Security Company in the Market
In our experience exuberance and enthusiasm for the market tend to peak not when the market leaders are afforded lofty valuations, but when, in desperate search of new longs, the pretenders are given these same, or in some cases, higher valuations. The KEYW Holding Corporation (NASDAQ:KEYW) is one of these pretenders. This is not to say that the company doesn't have a real business that is valuable, but misguided investor enthusiasm and sell side analyst cheerleading has driven the valuation on the company's tiny cyber security business to astronomical heights. In fact, we believe KEYW's cyber security business is being valued more richly than FireEye (NASDAQ:FEYE) despite the fact that the product is completely unproven and FEYE is the unquestioned market leader. Without Hawkeye G, we believe KEYW is worth $6.50 per share even in a premium takeout valuation scenario.
KEYW falls in a somewhat odd category. The company generates 97% of its revenue from government contracts and is covered by analysts that follow government services companies. These analysts are trying to understand commercial cyber security but are not experts. This results in bad analysis and misguided comparisons which culminate in reckless statements like comparing KEYW to Mandiant and saying it is worth $80 per share. KEYW is NOT Mandiant nor is it FireEYE even though it may be trying to be. KEYW has managed to be lumped into the commercial cyber security sector and it looks compelling by comparison on an overall revenue multiple basis to companies like FireEye; however, this is very misleading given that last year only 3% of revenue was commercial cyber security and that product is actually shrinking. We have spent a fair amount of time in an effort to understand the different businesses of KEYW and what they may be worth.
Let's dig into the valuation….
To value KEYW we split the business into four pieces: 1) the Government business mostly related to the NSA 2) Flight Landata, which flies reconnaissance missions mostly in Afghanistan 3) Sensage, which is all of the current revenue of Hexis and 4) Hawkeye G, the exciting new product that has the company's shares flying despite quarter after quarter of lackluster financial results.
To value the government business excluding Flight Landata we use the takeout EBITDA multiple of Six3 Systems when they were purchased by CACI last fall of 13x. Six3 is in a similar business to KEYW (project services for the NSA). We don't expect there would be any objection, even by the most bullish investors in government services companies, to using a 13x EBITDA multiple. Especially considering the business is not growing organically and continues to face headwinds like Obama's current budget proposal which cuts NSA funding by 7% (the NSA is nearly 60% of KEYW's overall revenue). We believe that half of the government EBITDA last year was generated by Flight Landata. This leaves $19.15 million of other government EBITDA. At 13x we value this business at $249 million in an aggressive takeout scenario.
Flight Landata was purchased a few years ago by KEYW for roughly $30 million. This business is reconnaissance flights for Afghanistan. There has been some speculation that this business will eventually go away, but let's assume it doesn't and value the business at $50 million, which is a 67% premium to KEYW's purchase price.
The majority if not all of the Hexis revenue is generated by Sensage, a company acquired by KEYW in late 2012. Our research indicates that Sensage had been thoroughly shopped by its VC backers for a period of time until KEYW finally purchased the company. From KEYW's SEC filings Sensage has actually been shrinking for the last two years: in 2013 they had $9.8 million of revenue, down from $10.1 million in 2012 and from $11.9 million in 2011. We realize that valuations for security software companies are different now than in 2012, even for those with no growth so we will give KEYW a 50% premium on their purchase price of Sensage, which would equate to $36 million. This seems very generous for a cyber security company that has not even experienced any growth, let alone hyper-growth, over the last two years.
This leaves Hawkeye G for the remainder of the valuation. Just doing the simple math you see in the table below we reach an implied value of a little over $600 million for Hawkeye G. This product had essentially no sales in 2013. It is expected to have $10-20 million (some analysts are a little higher) in sales in 2014, but mostly in the second half of the year. Using a midpoint of this revenue range we get a revenue multiple of over 40x 2014 Hawkeye G revenue. Market leader FEYE is trading at a 23x forward revenue multiple. Considering that Hawkeye G has been nothing but disappointing and delayed, we feel investors may be giving too much credit before credit is due. We believe we are using aggressive valuations for the other pieces of the business so you could argue the revenue multiple implied for Hawkeye G is even higher.
|Share Price||$ 22.00|
|Total Enterprise Value||936,912|
|Sum of the parts|
|Total Enterprise Value excluding Hawkeye G||335,000|
|Net Value excluding Hawkeye G||252,480|
|Per share value excluding Hawkeye G||$ 6.50|
|Implied Value for Hawkeye G||601,912|
|Anticipated 2014 Sales of Hawkeye G||15,000|
|2014 Hawkeye G Sales Multiple||40.13|
|FEYE 2014 Sales Multiple||23.77|
The merits of the Hawkeye G product, while debatable, are irrelevant to this analysis. It is clearly unproven and we will all have to wait to see if the company is successful. I would note that most long-time investors realize the challenges of a defense company entering the commercial market. We have witnessed almost every small to moderate size defense company launch commercial initiatives during the last tech bubble that amounted to nothing. It's just not easy for these businesses to make the transition and we don't think buying a less-than-successful commercial company (Sensage) is really the bridge they need. KEYW has a long way to go to be successful and it is surprising that they already have one of the most highly valued cyber security businesses in the market.
We would also encourage all investors to go dig up the Gilder Technology Report from December of 2005. This report profiles Essex Corp (also traded under KEYW) and then CEO Leonard Moodispaw. The news letter profiles a government security business that is developing extremely promising products for the commercial market. Despite the author's extreme excitement for these products they were of little or no commercial success. While the latter focuses primarily on an optical transceiver technology called "Hyperfine" it does make mention of a network security product "that already has spooks excited, detecting attacks the NSA has never seen before." Investors clearly believe that nine years later Mr. Moodispaw will finally have a commercial success.
Below is a brief background on how KEYW was created for those new to the company.
KEYW is primarily a government contractor created from the remnants of Essex Corp. rolled together with a slew of other companies over the past few years. Leonard Moodispaw is the primary architect of this creation. Mr. Moodispaw sold Essex to Northrop in 2007, then in 2008 carved out a group of 60 people from Northrop to launch KEYW. Since then, the company has acquired:
- Integrated Computer Concepts, Inc.
- S&H Enterprises
- Embedded Systems Design, Inc.
- Leading Edge Design & Systems, Inc.
- The Systems Engineering and Technical Assistance team Of General Dynamics Advanced Information Systems, Inc.
- The Analysis Group, LLC
- Insight Information Technology, LLC
- Sycamore.US, Inc.
- Everest Technology Solutions, Inc.
- JKA Technologies, Inc.
- Forbes Analytic Software, Inc.
- Flight Landata, Inc.
- Poole and Associates, Inc.
- Sensage International
- Rsignia Inc.
- Dilijent Solutions, LLC.
With all of these acquisitions the company primarily serves the NSA but also has significant exposure to the Air Force and other government agencies. KEYW does have some product revenue, but the majority of its government revenue is from staffing and from the Flight Landata business that flies reconnaissance planes mostly in Afghanistan. Overall this business appears to grow due to acquisitions, but organically it has been shrinking due primarily to government budget cuts.
In late 2012, KEYW purchased Sensage to enter the commercial security business. The plan was to build on the Sensage platform using the company's cyber security expertise from its work with the government. The company then had the Sensage product and an internal product code named "project G". Project G addresses the Advanced Persistent Threat (APT) network security issue. The company created a separate wholly owned subsidiary for commercial cyber security called Hexis Cyber Solutions. Hexis has now launched their product (Hawkeye G) and has converted two of their four beta customers into paying customers. They have also secured a customer that was not a beta tester.
Disclosure: The fund that I manage is short KEYW shares.
Disclosure: I am short KEYW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.