Zix: Lots Of Potential, Poor Execution

| About: Zix Corporation (ZIXI)

Summary

Cloud email encryption service provider.

Narrow moat stemming primarily from scale, switching costs and network effects.

Growth opportunities are driven by regulatory drivers.

Valuation remains too rich for my liking.

Pop quiz: Name the number one source of data loss among corporations?

Most people would probably come up with an answer that revolves around a device (laptops, mobile phones, USB drives, etc).

Interestingly enough, email is the main source of data loss, according to research.

Email is used on a daily basis by individuals, corporations and governments in order to communicate quickly and at minimal cost. This practice is especially prominent within corporations. In the current technological age, it is safe to say that email remains a mission-critical function for most, if not all businesses.

Therein lies the problem.

If email is not secured once it has left the sender's network, it can be intercepted along the path from the sender to the recipient, resulting in theft, manipulation or redirection, inter alia. In these situations, it is not difficult to imagine the adverse consequences that are likely to manifest as a result.

Zix Corporation

Zix (NASDAQ:ZIXI) has the solution. The firm provides SaaS-based email encryption services to corporations. Its customer base consists largely of organizations operating within the healthcare (51%), financial (30%) and public (7%) sectors.

The company's solution is simple. It acts as an intermediary between sender and recipients. Parties to an email join Zix's network where email is automatically encrypted and decrypted, solving the problem of data loss.

Additionally, it also is extremely convenient. Senders/recipients are not required to input authentication codes or anything of the sort in order to read/send email. This ease-of-use is the company's main differentiator compared to its peers.

The firm's revenue model is rather simple. It charges subscription fees on a per-user basis. More users, more fees. These fees also are relatively small ($20 per user), which could allow the company some room for increases in pricing in the future.

Narrow moat stemming primarily from scale, switching costs and network effects

I opine that the company has a narrow moat. This moat stems primarily from scale, switching costs and network effects, all of which are not particularly significant at the present time, primarily due to the company's small size.

A competitor looking to enter the email encryption space would require minimal upfront capital investment (annual R&D for Zix has yet to breach $15m in recent years) and can simply copy the "intermediary" model that Zix has pioneered, along with the ancillary services that the company provides. Although I'm not a software guru, I submit that it probably wouldn't take years to develop a competitive offering. It is true that a competitor would have to operate at a loss for quite some time before achieving scale, but in absolute terms, the losses would not be that large (probably less than $50m).

Fortunately, switching costs and network effects are present.

As switching to an alternate service provider would result in operational disruption, customers are unlikely to leave Zix for a competitor unless there are very compelling reasons to. Additionally, Zix's solution does the job it is meant to do rather well. Hence, there is little need to even consider an alternative.

As more members are "recruited" into Zix's network, the network becomes more valuable. This is because it is only through using the network can email be encrypted and decrypted with minimal user input/inconvenience. However, I posit that these network effects are probably not particularly significant at the moment.

In a nutshell, we have a business that:

  • provides a mission-critical service,

  • possesses a narrow moat,

  • and generates highly-recurring cash flows.

Now, qualitative discussion is all well and good, but such a discussion needs to be grounded in reality. In this case, the numbers do support the narrative. Perhaps the best manifestation of the above three points are retention rates. Retention rates have consistently exceeded 90% year after year. As the company is still in the growth stage (sales/marketing spend are still rather large), it is not meaningful to form conclusions on the basis of EBITDA margins.

Growth opportunities are driven by regulatory drivers

The astute reader would have picked up on the fact that the majority of Zix's customers are those within the financial and healthcare sector. This is not a mere coincidence. Legislation such as the HITECH, HIPAA (for the healthcare sector) and the Gramm-Leach-Bliley Acts drive the adoption of email encryption services.

Despite the presence of such regulation, the adoption rate remains low in the aforementioned sectors. Only 25% of US banks and 20% of US hospitals use Zix's services. Therefore, the market for email encryption remains largely untapped, presenting an opportunity for Zix to increase its market penetration.

Risks

However, I postulate that Zix faces several firm-specific risks. The primary risk is the company's slowing growth. In the past five years, the company clocked in a mere 9% CAGR. Sales/marketing spend has increased meaningfully but has not resulted in the growth that one would expect.

A simple back-of-the-envelope calculation results in a potential total market size of $5.6b (0.945 x 300 x 20, assuming a 5.5% unemployment rate, population of 300m & $20 per user) in the US alone. With such a large market size, one would think that Zix would be growing revenues at triple digits, but this has not been the case.

Although the firm has partnerships with Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Cisco (NASDAQ:CSCO), which should in theory increase brand recognition and result in an explosion in the top-line, this has yet to occur. The company continues to increase its sales/marketing spend, but I remain cautious as to whether it would result in the top-line growth the company desperately needs. The market potential is clearly present, thus poor execution seems to be the culprit here.

Valuation remains too rich for my liking

Although the cybersecurity industry has been exploding in terms of growth, Zix does not seem to be along for the ride. Investors clearly have high expectations for the company as they have priced the company at 75x earnings.

Zix continues to generate stable free cash flow but does not seem to have any prudent place to allocate capital. The company has an authorized buyback program, but with the stock at such stratospheric valuations, I doubt returns on the program would be significant. Due to a negative retained earnings number, dividends are out of the question as well. Even if the company was permitted to issue dividends, it does not generate enough cash flow to fund even a consistent 3% dividend yield (largely due to its current valuation). The company could very well increase its sales/marketing spend, but such efforts do not seem to be bearing fruit.

Hence, I would advise investors to avoid Zix for a moment until the stock experiences a significant pullback or the company manages to reinvigorate consistent double-digit top-line growth.

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.

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