LogMeIn: A Lesser-Known, Small-Cap Value Story Now On Sale

| About: LogMein, Inc. (LOGM)

Summary

LogMeIn's shares have fallen by almost 20% in little over one month.

LOGM has exceptional levels of non-GAAP operating margins for a SaaS software vendor.

Essentially all of the company's growth comes from areas that are not tied to the remote access space.

The company has a nascent offering, Xively, in the emerging Internet of Things (IoT) space that can potentially transform the company yet again.

The company has a strong and experienced management team.

Introduction

LogMeIn's (NASDAQ:LOGM) shares have dropped by about 20% in a bit over one month with most of that decrease occurring in the last two weeks. Like many cloud companies, the shares of LogMeIn are controversial with articles in Seeking Alpha decrying both valuation and the company's market position. On the other hand, consensus analyst opinion regarding the company's shares is a respectable 2.1 on a scale of 1 to 5 with 1 according to Thomson/First Call, with a 12-month price target averaging $82, from the 11 analysts who cover the company. While most investors rightfully take price targets with several grains of salt, the average price target is more than 43% above present levels.

Investment Thesis

I believe that the current share price decline affords investors with a decent entry point. While the company is reasonably followed given its size, there are still many popular misconceptions that surround the company's business and competitive positioning. LOGM's shares are the closest thing to a value play in the world of cloud based, Software-as-a-Service (NASDAQ:SAAS) vendors. That doesn't mean that the shares are a value play in the classical investing world. EV/S is still over 4 and the non-GAAP P/E based on consensus 2016 non-GAAP EPS estimates is about 32X.

But the company does offer certain metrics that may appeal to value investors. It is achieving significant operating leverage, and it has been able to produce non-GAAP operating cash flow margins of almost 40%. In addition, the company has seen a significant increase in deferred revenue which suggests that contract signings are growing significantly faster than reported revenues. Deferred revenue reached $137 million last quarter, up 33% year over year and flat on a sequential quarter basis during the seasonally slower summer quarter.

LogMeIn is basically identified as a company selling desktop, remote access solutions to PCs and laptops that are used in the home or remotely. While that is a significant part of this company's revenue stream and provides its name, its success in recent years has come from providing users with software that facilitates remote maintenance of both IT products and software as well as products that allow users to conduct remote meetings.

While the traditional remote desktop market is not expected to show much growth going forward, the other markets in which LOGM operates are markets that are still under penetrated and have years of significant growth ahead of them. In addition, the company has an early entry into what is forecast to be a very large market opportunity, the Internet of Things (IoT). The company's IoT offering, Xively, is not going to contribute to revenues or earnings in a material way for a few more years; when and if it does, it has the possibility to transform the financial basis of the company. IDC in its industry analysis suggests that IOT revenues will surpass $7 billion by 2020, and while I think the accuracy of longer-term industry forecasts is questionable, I do think that it is reasonable to believe that Xively will be a meaningful contributor to growth and profitability for this company over the longer term.

Analyst estimates for 2016 for EPS growth are relatively modest, in the range of 10% or so to around EPS of $1.80 per share, up from the $1.60 expected for 2015. The relatively modest growth expectations are, in part, due to an anticipated higher tax rate accrual. I expect that the company is likely to continue to exceed consensus earnings and revenue forecasts for at least another couple of years and that the current consensus earnings growth forecast of 25% for the next five years will likely be significantly exceeded.

As detailed below, the company has a couple of unique twists in its business/technology model that make it both more profitable and much abler to generate cash than most SaaS-based high-growth vendors. That doesn't mean the company has or is likely to have the kind of high operating margins that some investors seek among the companies in their portfolio. Non-GAAP operating margins are likely to have been around 21% for 2015 which is up sharply from the 15% non-GAAP operating margins in the prior year but far below the operating margins that large, traditional software companies can achieve.

Background

LOGM is one of the smaller public companies that has a completely cloud-based offering. It is a bit unique in that some of its offerings are sold to consumers and its single hottest product, called join.me, which facilitates remote access meetings, is a desktop offering as opposed to an enterprise solution. Although the company in recent years has moved much of its sales effort to the enterprise side of its business, it will be a long time before the company is not best known for its desktop solutions. That being said, because of the product mix of what the company sells, it collects most of its revenue on credit cards and thus has exceptionally low receivables. Days sales outstanding (DSO) are just 22, far less than comparable levels of most other software vendors. By comparison, Salesforce.com (NYSE:CRM) has a DSO of 60 and Splunk (NASDAQ:SPLK) has a DSO of 66. Low DSO has allowed LOGM to reduce its capital intensity significantly. As a concomitant, low DSO also has been a factor in the company enjoying an operating cash flow margin significantly greater than its reported net income. The growth in receivables which is a significant capital expenditure for most software companies has a far lower impact for LogMeIn.

In addition, the company's capex for infrastructure build-out is significantly less than other cloud companies. Capex for this company will probably be about less than $15 million in 2015. Just as a comparison, Splunk, which is just a bit larger, albeit growing revenues somewhat faster than LOGM, will have capex that will probably exceed $40 million in its current fiscal year. As a result, while Splunk is recording depreciation charges of nearly $20 million for the fiscal year that ends 1/31, LOGM is likely to have just $13 million of depreciation allowing the company to achieve higher levels of operating cash flow, free cash flow and EBITDA than might be anticipated from a cloud-based software provider of this size. Analysts expect that non-GAAP operating cash flow margin for the full year for LOGM will be close to 40%.

Overall, the combination of low DSO and a far smaller infrastructure build out per dollar of sales than comparable companies has created a business model where operating cash flow for this company is substantially greater than reported non-GAAP income. The company's non GAAP operating cash flow during 2015 was probably in the range of $100 million. The company's reported non-GAAP profits will probably be around $40 mil. The company has a current market capitalization of just under $1.4 billion with an enterprise value of about $1.1 billion. LOGM's revenues are anticipated to have been around $270 million for 2015. Non-GAAP EPS for the period is estimated at $1.61. While this company is not one of those deep value software vendors featuring little or no growth, at 4.3X EV/S and with operating cash flow running at almost 9% of enterprise value, this company probably has among the lowest valuations amongst profitable cloud-based software vendors.

One thing that investors might note is the relatively high gross margin the company enjoys. Most vendors that offer enterprise software via the cloud have gross margins in the range of 75-85%, reflecting the costs of creating the cloud infrastructure and the expenses of providing users with some level of customization. For example, CRM has gross margins of about 76% while SPLK has gross margins of 83%. LOGM gross margins are significantly higher at between 87-88%, reflecting a unique technology that minimizes storage requirements and computing requirements compared to those of other cloud application vendors. While most observers do not think of software vendors as having differentiated cost structures, this is one of the rare exceptions to that rule. While it's difficult to compare gross margins exactly with the two companies seen as LOGM competitors, Citrix (NASDAQ:CTXS) and Cisco (NASDAQ:CSCO) through its WebEx offering, it would appear that LOGM has significant cost advantages that it has used to enable price competition in competing against its two much larger rivals in the specific spaces where they coexist.

LogMeIn, despite its relatively small size, has several unique and differentiated product offerings that are of significance in trying to determine the outlook for the company in the short term. In addition, the company has a major initiative in a space which is called the Internet of Things. Its product offering Xively is not a significant revenue producer currently but it has the potential to significantly transform the size of LogMeIn at some time in the next several years.

Product Overview

Connectivity - 32% of Revenue

LOGM as the name says was founded as a company to provide users with remote access to their PCs when they are working either at home or on the road. Simply put, by using the LogMeIn product and those offered by competitors such as Citrix, users can login remotely and they can access all of the files on their "base" PC and they will be able to work remotely. There are very few distinguishing characteristics regarding the products in the space. Having used the Citrix product Go To My PC for many years, and having also tried the LOGM solution, it's very difficult to distinguish between the two with regards to functionality. The main difference is that the LOGM product is far less well known than the Citrix offering and in turn costs far less.

The market was pioneered by Citrix some years ago and penetration rates for the application have probably reached a peak. In addition, with the decline in PC shipments and the advent of tablets, opportunities to sell to new users or to add the application to new hardware are limited. When LOGM first started its business in this space, it actually gave away the base functionality of its product with the belief that it would be able to upsell a significant cohort of the free users who would subscribe to its premium service. As the market matured and as the scope of the company's target market diminished, management did away with the so-called "freemium" model last year with little apparent impact on the business.

At this point, it seems that concerns regarding the potential for Citrix to crush LOGM in a price war are dramatically overblown. Given the relatively modest market share that LOGM has, the economics of a price war are seemingly heavily weighted against any Citrix action. In addition, the pending restructuring of Citrix, in which its traditional product families including all of the "Go To" suites are to be spun off into an independent entity also would seem to militate against CTXS taking any significant negative pricing action that would hurt its profitability.

A few years ago, LOGM launched a product that it calls join.me. join.me is still marketed using a "freemium" model and LOGM is providing over 1 million free downloads of the software each month. The market for remote meetings is obviously huge and continues to grow at strong rates. join.me has been one of the principal growth drivers for LOGM, and I would be surprised if that did not remain the case for the foreseeable future. join.me costs about half the price of the competitive products from either Citrix or from Cisco (WebEx). Again, it is very hard to draw material functional distinctions between the three products in the space. Indeed, the most telling statistic in terms of overall user satisfaction for join.me is that the average new user doubles its usage of join.me during the first year after it converts a trial to a paid subscription.

IT Management - 34% of Revenue

What LogMeIn describes as its management suite of products is primarily built around three products. One of these, the recently acquired LastPass, is a password manager that has had a very loyal customer following who use it as part of a security solution. Central is a product that automates the access of staff to particular applications while Pro allows instant access to applications, desktops and data from anywhere. The sales strategy here is more or less similar to that of join.me in that free versions of the various products have been available and some cohort of these turn into paid customers who use a premium version with more features. These products have all been around for a considerable period and the growth potential is not huge although they basically are cash cows for the company. While relatively small, the LastPass product suite is a nice tuck-in acquisition that extends the company's footprint into the overall IT security space and which should be synergistic with the other IT management solutions that this company was already selling.

IT Service - 33% of Revenue

The company offers two major products in this category. Its Rescue product is one of the largest selling support tools in the world according to several market research studies. It basically allows for centrally located technicians to take control of remotely located PCs and laptops and to resolve service issues for non-professional IT users. In one form or the other, Rescue has very significant market penetration, and while the market is not in its infancy, it is still enjoying double-digit growth. Growth potential probably is higher for the product that LOGM calls Chat. One sees Chat primarily used on mobile devices to enable sessions where centrally located technicians attempt to resolve service problems with the use of a typed interactive dialog as opposed to using call centers. For many customers, Chat delivers an experience far more satisfactory than that of an intelligent call center. Chat users prefer having an interactive dialog with an IT professional than in trying to use the common fault resolution menus that are typically available on web sites.

Xively - 1% of Revenues

Xively is LOGM's IoT set of solutions that allow customers to build IoT capabilities into their products. IoT is really in its infancy and most users are just experimenting with the technology. The products that LOGM sells will allow users to manage permissions and provide authentication and provisioning and facilitate high-speed communication between millions of devices. Xively has won a few significant design wins including Lutron which makes light switches, and Symmons which makes the Temptrol shower valves. Both of these products have relatively straightforward uses for the software. At what point IoT is going to become mainstream and whether LOGM can convert its technology into a significant business are questions that are not likely to be answered to any significant degree during the course of 2016. Certainly, the product suite has the potential to transform the scope of the company if it achieves widespread acceptance.

Pricing and Churn

LOGM has far greater churn than is typical for many other companies that sell their product via a SAAS model. These days, management suggests that a blended retention rate for all of LOGM's offerings is in the 80% range. Most SaaS vendors have retention rates in the mid-90% range and even higher even when they offer users one-year terms. The company's remote access and remote meeting products are used by workers to some extent in an on-demand mode. Remote access meetings are typically created in an ad hoc fashion, and although the overall concept of remote meetings often is viral in organizations, most of the time users sign up for one or two or three events. Needless to say, the churn of remote access solutions is often based on the churn of the employees in a specific organization. If employees turn over, then so does their remote access status.

LOGM uses highly tiered pricing in order to maximize its revenues with basic versions that are either free or cost very little and more useable versions that sell for quite a bit more. It would be less than objective not to point out that sometimes this kind of approach leads to unhappy users who think that they can solve their problem for a minimal price only to find out during the process that it will cost much more to actually do what they want. Needless to say, the company has and will continue to induce a certain amount of churn due to its aggressive pricing strategy.

As an example, the company's Central product can be had in a minimum configuration for $499/year for 25 users but the Premium capability, as LOGM calls its most featured solution in this space, will cost $1,299 per year for 25 users. Frankly, one of the reasons that this company has achieved the margins it has at the size it has is a function of this tiered pricing which requires far less marketing effort than is entailed in selling massive installations to very large users. Although this appears to be a potential vulnerability to significant user dissatisfaction, there have been no signs that users are more than normally disgruntled. Most users seem to like the product well enough to pay what is required to remain LogMeIn customers.

Investment Summary

LOGM is one of the few profitable small-cap vendors of SaaS solutions. While it has not achieved stratospheric growth percentages when compared to companies selling sexy big data solutions, it has been, for the most part, a consistent growth engine that has steadily extended its product footprint and has come to be a major competitor in one very hot market, that of remote access meetings and the major competitor in remote access service markets. The company has a unique and efficient way of storing user data that has enabled it to minimize its capex and to use "freemium" marketing models where appropriate although its strategy is clearly to transition from that type of sales tactic. All of this has led to consistent 20% top-line growth and cash flow margins that are now approaching 40%. While LOGM's shares do not have classical deep-value criteria within the SaaS space, their EV/S of 4.2X and their P/E of around 32X offer investors a favorable entry point, in my opinion.

Suffice to say that this is not going to be a defensive name, and its share price is going to be volatile and subject to swoons during times of market stress. Although the company certainly has the cash flow and the free cash flow sufficient to pay a dividend, it will almost certainly choose to reinvest its cash into the Xively opportunity. With the founder Michael Simon having essentially retired at the start of 2016, it is conceivable that this company could be acquired although there have been no rumors to that effect in recent months. I would expect the company will continue its past practice of providing modest guidance that it is then most likely to exceed and I have no reason to believe that such a scenario didn't play out that way in the quarter that the company will report in early February. While I can't quite make the case that the shares are overlooked, neither do they have the valuations of some of the more faddish SaaS vendors. I think that the 20% share price pullback provides investors with a good point at which to start to build commitments.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.