Teaching users that they need yet another security appliance
The complexities of trying to defend against cyber-attacks continue to grow. There seems no end to the ingenuity and the creativity of cyber criminals and from time to time headlines proclaim that this or that large institution has been brought to its knees by a breach. There are some readers of my articles who have commented that there is no practical solution and that given time and resources the cyber criminals will always get through. That may or may not be the case. Proving a negative over time is more or less impossible. But the issue is not totally the efficacy of the products that are sold but whether users will continue to buy them in increasing quantities.
One of the more interesting companies in the space is a vendor called Gigamon. (NYSE:GIMO). Gigamon is not a security vendor per se, but is a vendor works with most of the major suppliers of security appliances and solutions to give them a holistic view of the data. Salesforce.com (NYSE:CRM) has been a significant user for many years and at one point represented more than 10% of revenues. The company also has a nearly 10% customer with a long term service-provider user. It is also worth noting, I think, that the company had a serious stumble in the first half of 2014. Management said that the stumble was the product of poor sales execution and organizational challenges. The stumble lasted about 2 quarters and was completely over by Q4-2014. It is a risk of investing in small, new companies that when they have operational problems that produce ugly results. there is no place to hide from woeful share price action. Back in 2014 the shares, needless to say, accurately paralleled the company's performance declining from $35 to $10 between March and October of 2014. It has taken almost 2 years for the company to return to its "pre-crisis" level and it has almost doubled in top line and it has become profitable over that period. Revenues for 2014 were $157 million and they are projected to be $295 million this year. So, presumably the current share price is based on much firmer ground than was the share valuation of early 2014.
The company is relatively new and it hasn't always concentrated its technology on the security space. But these days it focuses on what is described as traffic visibility and is able to look at data in an entire network without compromising performance.
Enterprises looking for security solutions these days are typically forced to use multiple products from multiple vendors in order to put together a solution that more or less gives them a reasonable chance to minimize breaches. There are no single security solutions that large enterprises can adopt that solve all of the problems that enterprises have in protecting their data and in shielding their companies from un-authorized penetrations.
Gigamon is not really a security solution per se but that is the market that it addresses. What the company's products do is to provide visibility so that the companies that sell firewalls can actually access the right network traffic in order to insure that they can function effectively. And visibility these days can mean shedding light on insider initiated threats that sometimes develop deep within the firewall.
The company is just more than 10 years old and it has been publicly traded for 3 years at this point. It sells appliances with proprietary hardware and software. And it actually is GAAP profitable although not by some huge amount. It has grown consistently and even managed to eke out some small growth in 2014 the year of its near-death experience. This year, the company has guided to greater than 30% this year by the 7 analysts that cover the company.
The company has 14% of its revenues coming from EMEA, a relatively small amount compared to many other larger technology vendors. If Brexit develops into a European tragedy, this company is not terribly exposed. If Brexit has a lesser effect on the overall European economy, then this company has a significant opportunity to address. I will address valuation later, but on a non-GAAP basis the company has a PE of 33X and its EV/S on consensus revenue forecast for the current year is 3.15X. With earnings, growth, significant operating cash flow and somewhat reasonable valuation I think GIGA is worth a further look by investors. Insiders hold 15% of the shares and institutional ownership is a bit above 71%,
Readers might note that this is a company on a mission to sell its stock. The latest investor presentation has two slides entitled "Now is a great time to invest in Gigamon." The senior management of this company is not made up of individuals who hide their light under bushel baskets. Management has another slide talking about 7 straight quarters of "beat and raise." It has analyzed that which it believes investors desire and has a strategy to provide it. Thus, forecasts of slowing growth that are seen in the analyst consensus are not really credible. The idea is to create an environment in which every quarter is a beat and raise. Frankly, there is a law of diminishing returns when investors understand that lower growth estimates in the out quarters are not much more than polite fiction.
Why the need to go so far down the size scale in order to find investments in the security space?
There are many readers of Seeking Alpha articles who simply want to invest in a stable, dividend paying enterprise that they can own without concern for years. Some reader/investors want exposure to tech but they don't want the risks and the volatility that come tech names that are both highly valued and in a hyper-growth, I think many readers would never desire to play in a market space where companies can and do lose two-thirds of their value and then recover. Cisco (NASDAQ:CSCO) is often written about as an alternative tech investment as are other older, large tech companies. The problem with that approach is that over time, these kinds of companies, and that includes Cisco, which is most relevant to this article, wind up as market share donors. The simple reason for that is that they have enormous revenues derived from what have become slow growing or non-growing sectors and that is the revenue on which they earn the profits that allow them to pay dividends. These days the networking space has a CAGR of all of 2% and it is cyclical at that. And Cisco is never going to quite maintain its market share in networking year after year as new companies arise at the margin whose solutions are cheaper and incorporate more modern features.
I have followed IT for a long time now and before that I worked in the business. For me, investing in IT actually does mean investing in companies that have formidable technologies in emerging spaces. And hence I prefer looking at smaller companies who are, at the least, gaining significant wallet share. Gigamon is one of those companies and as it is available at a relatively reasonable price it is surely worth considering as an investment.
Gigamon has had enjoyed 7 consecutive beat and raise quarters. That alone is a strong suggestion as to the basics of the investment case although given that investors and analysts know that the company has a mantra to produce such quarters, I have to wonder as to just how long this game can last. But I do believe that over time, the consensus forecasts for growth and profitability for this company will increase enough such that what may not look like a bargain actually becomes one.
These days, the company's pivot to the security market is on track. In Q1 60% of transactions were security up from 40% in the year earlier period. Most of the company's larger transactions are based on security deployments. Another growth driver for this company comes from sales to the mobile service provider space. Revenue growth here accelerated to 126% last quarter. There are many ways that service providers have to obtain network visibility; it appears that so far what GIMO is selling is cheaper and more complete than other solutions on the market.
Overall, Gigamon works with all of the better known software security companies including Check Point (NASDAQ:CHKP), Palo Alto (NYSE:PANW), Cisco, Fortinet (NASDAQ:FTNT), LogRhythm and FireEye (NASDAQ:FEYE). A comment coming from Palo Alto seems apt to quote. "…GigaSecure Security Delivery Platform sheds light on Insider initiated threats. It can provide complementary visibility to the network traffic that Palo Alto networks sees." Being agnostic regarding network security providers is a required strategy for a company of this size. On the other hand, it may present a problem should consolidation interest seriously develop.
The other current growth driver for this company is their Federal Systems business. The federal government does not, perhaps, operate the most efficient procurement system in the IT world. And government procurement personnel are always crying about lack of appropriations to do their job. But in this case, Gigamon is part of a group that has won a role in a $6 billion program that is actually funded called Continuous Diagnostic and Mitigation that is being led sourced by the DHS. Part of the initiative includes GigaSECURE so it is reasonable to believe that this will be a visible growth driver for several years to come. Federal represents 16% of revenue which is quite a bit more than the average for IT companies.
Overall, in Q1, Federal grew by no less than 160%; service provider, which is 25% of revenues, grew by 126%; and enterprise grew by 21% this past quarter. It is quite likely that the growth in Federal will not long continue at triple digit rates while it is equally likely that the company can do better in the enterprise space.
On May 10 th Gigamon announced what is said by the company to be the first visibility solution for the public cloud. The product is not in General Availability but is being trialed on AWS. The announcement provided no details on the scope of the trial or when GA might come and needless to say Gigamon has provided no revenue estimates. It is supposed to be the next big thing for this company in terms of driving revenue growth. On the last conference call management described the potential impact of the announcement as "bigger than a big breadbox." Not knowing just how large a standard breadbox is in size, all I can do is repeat the exact verbiage.
A few weeks prior to that announcement the company announced that it had introduced 100GB apliances as well as well as extensions to its product line that enabled 4G/5G mobile operator infrastructure.
Although new products and features often take awhile to gain significant revenue traction, management and some observers feel that these introductions, as well as the others foreshadowed by the CEO during the last conference call are likely to produce a visible growth spurt for this company. That is not at all apparent in the numbers that Gigamon has forecast or that are part of the investor consensus. Whatever these new solutions develop will be in excess of current forecasts.
CEO Paul Hooper went on to say that "if you think this a large launch, then you ain't seen nothing yet…because we have some very significant (additional) launches ahead relative to this one." Part of the noise regarding product introductions relates to the speed of the data that can be processed
While the company does lease some of its products, most product revenue transactions are sales. In Q1 product revenues were about 65% of the total and had GAAP gross margins of 76% up from 72% in the prior year. Some of this is, no doubt manufacturing efficiency and greater overhead expansion at higher volume. Most of the higher gross margins however, relate to both product mix and less price competition. While there is plenty of competition for some of what GIMO sells, the company's newer products have less direct competition according to analyst commentary and more software content. In addition, with high renewal rates, services revenue which has gross margins over 90% is growing a bit faster than product revenue. Overall, gross margins are likely to continue to increase.
The CFO, Mike Burns, said the company was "investing with confidence" which I suppose means that visibility is very good. And hence, OpEx is budgeted to expand at a rate consistent with revenue. Presumably, if revenues achieve another beat, then the EPS upside will be greater than heretofore.
A company called Big Switch Networks which focuses on providing a network packet broker that is designed to create security chains at scale advertises its pricing advantages continuously. Other competitors in that particular market segment include Interface Master, Ixia (NASDAQ:XXIA) and Datacom Systems. Ixia is a relatively large company that has been going through some hard times with revenues decking year on year. Gartner says that Gigamon has and continues to take significant market share from IXIA in the network packet broker space. Overall, GIMO plays in a higher end space and offers more functional products that can scale more readily than companies such as Big Switch. Gartner has described Gigamon as the representative e vendor in its guide for Network Packet Brokers. (Network Packet Brokers is a piece of compact rack mounted hardware that both optimize traffic and the visibility of traffic),
This company, as mentioned earlier does have one of the more reasonable valuations for a company in what appears to be a hyper-growth phase. As mentioned above, the EV/s is just above 3X and the P/E on non-GAAP estimates is 33X. As I take pains to explain later in this article, both of those estimates have a significant probability of being beaten. On the 2017 consensus the EV/S is 2.85X while the P/E is 27X. Those are not unreasonable numbers for a company that has enjoyed a CAGR of over 30% the last 3 years and certainly has the prospect of repeating that record the next 3 years.
The company has historically generated much more cash than it has GAAP net income. Last year GAAP net income was a bit over $6 million, reported non-GAAP income was $29 million after accruing a and operating cash flow was $63 million. The company's free cash flow was $57 million for the year of which $22 million came from the after-tax benefit of stock based comp. The company accrued a 32% non-GAAP tax rate.
In Q1 there were a number of specific puts and takes that impacted reported cash flow. Cash flow from operations was negative by $4 million compared to operating cash flow of $15 million in the year earlier period. The major differences between Q1-2015 and this year were an $8 million year over year change in the effect of accrued liabilities coupled with a $14 million decrease in the change in deferred revenues as well as a $3 million net change in the growth of inventories in 2016. Most of these changes were obviously one-time in nature. The change in product deferred revenues was essentially the value of stocking inventory that had been at various distributor locations and which is now centralized. It has nothing to do with bookings or any other revenue measure. Inventory held at distributors has now been reduced to less than $1 million.
In the last 9 months of 2015 operating cash flow came to $48 million and reported non-GAAP earnings came to $24.5 million for the same period. The consensus non-GAAP EPS forecast for the balance of 2016 is $.85 which is about $29 million in earnings. So, some horseback guess would suggest that cash flow for the balance of the year would be around $60 million. Taking account of the one-time items that were included in Q1 results, suggests that a normalized cash flow for the period would have been $22 million and suggest that the run rate for operating cash flow this year would be about $82 million. That represents an operating cash flow margin of 28%.
CapEx based on Q1 spend is running at around $8 million/year. So that suggests that free cash flow for 2016 would be around $74 million and would produce a free cash flow yield of 7.4%. For a company like this, that is a very handsome free cash flow yield, indeed and suggests that the shares are most reasonably valued.
Why bother looking at a smaller company like this? The succinct answer is that it is likely to be a better investment than large companies in the network security space. I expect that the company will grow rapidly, that it will be able to increase margins and generate significant levels of cash flow and that its technology position is a formidable moat against companies that are trying to enter the market with lower cost/lower function solutions. Given that current valuation is not in nosebleed territory, faster growth and growth in margins is likely to mean superior share price performance.
Is this a reasonable time to buy Gigamon shares?
Most readers are quite reluctant to buy shares of almost anything that are at all-time highs. Gigamon shares today at their current price are just 8% off of their high and that is primarily the impact of the Brexit induced selling in the last several days. The shares remain up by about 8% since the company last reported its earnings on April 28, 2016.
In the June quarter that ends in a couple of days, the company has forecast 36% growth and EPS at the mid-point of $.24 That growth compares to 43% growth in Q1 which saw EPS of $.22. Sequential growth of $3 million, which is 4.5% sequentially is probably what most holders and most analysts really expect. The implied forecast for Q4 of this year would show just 19% growth against what was the slowest percentage growth quarter last year. The implied EPS consensus for Q4 of $.34 compared to the $.29 in 2015 actually implies a decline in after-tax non GAAP margins. The company's long term non-GAAP model is to achieve operating margins in the range of 25%-28%. As Chief Justice Roberts once put it in a different context, "the way to have higher margins is to have higher margins." It really isn't all that difficult to have higher margins for a company growing at 30%+.
As I mentioned earlier, this company is rather clearly on a mission to improve its share price valuations. Not that my memory for such things is perfect, but I am trying to recollect any company ever making an analyst day presentation that comes out and explicitly says that it is" a significant investment opportunity" - twice in the presentation actually! The only short term way that this is "a significant investment opportunity" will be if the quarter reported about one month from now is a significant beat and raise and includes some improvements in operating margin percentage as well as improvements in revenues.
The company CEO, during the last conference call, said, "The reason that we guide the way that we have today is because we've had a very strong start to the Q2 period and so we haven't seen… any failure inside of our business." Another comment worth considering is as follows (I had to edit the transcript significantly to provide a sense of what the CEO actually said):
It is a very different landscape of competitors that we face today. And [the newer competitors are] in the markets where we have the highest [best relative] performance and the highest density solution for the service providers... there are still some competitors that we face. But it's less of a focus for us on an ongoing basis.
The part about the quarter starting strongly is unusual but not unheard of - most CEOs hate to talk about mid quarter trends and simply don't do it. The part where the CEO basically says that the competition has changed from the time of the S1 (before the IPO of 2013) such that competition is no longer a primary focus. Well that is a pretty bold statement, I would say, certainly relative to comments most CEOs are willing to make on most conference calls.
There are, as I wrote above, competitors in certain parts of the market for which Gigamon competes. In those areas, the market share data is pretty strongly in favor of this company. But Gartner simply doesn't have a real magic quadrant for network visibility. Gartner rates Network Monitoring. Indeed if one Google's Gigamon competition that is what comes up for the most part. When one Google's competition in Network Visibility there is basically nothing to be seen and that is probably a good thing at least so far as investors are concerned.
When I write these articles I try to find some bit of objective evidence regarding competition. About all there was to be found was that Gigamon makes the list as one of the 25 coolest network security vendors. I have some basic idea as to what it means to be a cool person. But a cool network security vendor? Cisco was actually on the list as well and how that organization might be cool taxes my imagination. In any event, how being cool is conflated with dominating a market or experiencing strong growth or profitability is not apparent from the CRN article on the subject.
At the end of the day, when it comes to trying to time an investment in Gigamon, the only two things of note are most likely going to be a) beating earnings and raising guidance and b) introducing unique products in spaces with relatively large TAM's. The company has already made two significant product announcements. Now it time for operational performance to advance the valuation paradigm. In my opinion, in the short term the catalyst for share price performance is going to have to be the Q2 earnings report and that report has to be significantly better than both guidance and consensus forecast. It would seem to me that management is quite familiar with the elements of performance that drive valuations and is committed to producing whatever it takes to keep the shares moving up.
Gigamon is not a subscription software company and regardless of what it presents in its investor material regarding its quarterly visibility and its revenue from customers coming from recurring customers it just doesn't have the same economics as subscription software companies. While the current quarter that is going to close on Thursday is apparently not back-end loaded, no amount of presentations is going to allow this company to be valued the same was as a subscription based software vendor. But it can be valued at an EV/s far greater than it has today in terms of comparables with other vendors who still sell rather than lease products.
Is this a good time to make a commitment to Gigamon shares? Again, I am going to ignore the potential issues of Brexit - there are plenty of commentators who have published more than enough articles or participated as talking heads on TV or have written newsletters on the subject. The shares managed a $.02 gain yesterday after falling 8% since Friday.
The shares of this company are as volatile as any. They will most surely go down in a down market. After rallying quite significantly on the Q4 beat that was announced late in January, the shares fell 20% in the subsequent week. Even ignoring what happened to the shares during the 2014 period of underperformance, the shares dropped by 29% in the two months following the July 2015 earnings release. For readers who are intrigued enough about this situation to want to look further or to invest, I would strongly recommend scaling into the name over some period of time. I have no way of knowing exactly how the July earnings season might play out and that will determine the short term course of tech valuations. And the shares of this company will more likely than not rise or fall on how the earnings season plays out and how other companies guide and talk about their outlook in the wake of the Brexit issues.
Unlike some of the companies that I have written about, I think that the company's interoperability with almost all of the prominent networking names might make a consolidation somewhat difficult to realize. The fact is that if Cisco bought this company, it might be difficult for vendors such as Juniper or Palo Alto etc. to want to deal with what would in essence be a division of their arch-rival. I would not be comfortable suggesting that part of this company's valuation might be accounted for by a potential consolidation.
- Gigamon is that odd kind of company-a vendor in the security space who really doesn't develop or sell security solutions.
- Its products are described as offering data visibility to ensure that the firewall appliances that are used to provide security solutions have all of the data they need, both from within and without the firewall to ensure that the end results are as good as they can be with regard to repelling potential breaches.
- This company's solutions work with all of the major security solutions offered by mainstream vendors such as Check Point, Cisco and Palo Alto. It is completely agnostic in that regard.
- The company has recently announced what are likely to be two important product s which include new appliances that support both 100GB and 25 GB though put as well as what is described as the first visibility solution to work with AWS-although that latter product is still operating on a trial basis.
- The company has a fairly comfortable set of valuation parameters given its high growth, its margins and its cash generation capabilities.
- The current consensus forecasts are likely to be consistently conservative. Management has made a point of emphasizing that it has a "bet and raise mantra" and the CEO went out of his way to say that the first month of the quarter was strong and allowed the company to provide upside guidance when earnings were announced on 4/28.
- Based on the product announcements mentioned above, and management confidence during the call as well as with what appear to be an industry trends toward more "intelligent" and more automated security solutions, this company's growth rate appears far more likely to sustain itself above 30% than to slip towards 20%.
- This company has many financial attributes including size, profitability and cash flow that would make it attractive to many strategic consolidators. However, the fact that it need its solutions to interoperate with essentially all of the competitors in the enterprise security space makes it difficult to forecast that they could be consolidators. The same drawback does not apply to private equity.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GIMO over 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.