Symantec (SYMC) recently announced a transformative deal with the multi-billion purchase of Blue Coat, a transaction which has been well received by the market.
Investors seem to like Blue Coat's growth, the new leadership of Symantec and the large synergy numbers. The company is projecting that non-GAAP earnings will rise to $1.80 per share by 2018, but that number seems a bit optimistic in my eyes.
I believe that it is hard to deliver on "general" costs savings as well as deal-related synergies in excess of half a billion in the coming two years. This is certainly the case as the pro-forma revenue base stands at $4.4 billion, implying that these savings are equivalent to 12% of overall sales. Even if these savings can be achieved, the 2018 guidance is still a non-GAAP earnings metric, not taking into account real costs such as stock-based compensation charges.
These concerns, the rich price paid for Blue Coat, and the recent enthusiasm in the share price make me very cautious from this point onward.
The Purchase of Blue Coat
Symantec announced that it has agreed to acquire Blue Coat from a private equity consortium in a $4.65 billion cash deal.
Blue Coat is a leader in web security. It owns a portfolio of cloud-based technologies, used by more than 15,000 corporate customers. The company generated revenues of $598 million in the fiscal year which ended in April, as non-GAAP revenues came in at $755 million.
While revenue growth of 17% is very strong, especially as Symantec's sales are under pressure, the deal multiples look rich. This is even more the case as Blue Coat's growth numbers benefited from acquisitions made in recent times. Based on the non-GAAP revenue numbers, Symantec is paying a sales multiple in excess of 6 times. Based on GAAP numbers, the multiple is approaching 8 times sales.
While growth is a very desirable asset, and is much needed at Symantec, the problem is that Blue Coat is posting large losses. Non-GAAP operating margins came in at 22% of sales, while GAAP margins came in at -42%, implying an operating loss of $250 million.
The Market Is Reacting Positively
In essence Symantec is buying a company which is growing at a solid pace, but it is paying a very steep sales multiple for the business while it posts large losses.
There are a few reasons why one can be upbeat on the deal. For starters is the fact that Silver Lake is doubling its investment in Symantec to $1 billion. Bain Capital, which was the majority shareholder in Blue Coat, will re-invest $750 million into the combined business.
Another reason is the strategic rationale. Blue Coat is strong in networks and cloud security offerings, while Symantec has leading threat telemetry. This gives the new Symantec exposure to e-mail, cloud servers, cloud apps, individual users, networks and data centers, covering essentially the entire security market. This transformation marks a major step given that Symantec originally was focused on online consumer protection.
In essence, Symantec can use Blue Coat as a distribution point for its security offerings, resulting in potential sales synergies which are not yet quantified. The greater R&D base should theoretically boost the competitive offering of the business as well.
The issue is that operating losses of Blue Coat amount to roughly $250 million a year based on GAAP accounting. While these losses were inflated thanks to large impairment charges and some restructuring charges, Blue Coat is far from a profit center. The good news in terms of a contribution to Symantec's bottom line is the anticipation of $150 million in costs savings going forward.
The Pro-Forma Business
Symantec is quick to point out that the pro-forma business posted sales of $4.4 billion in the fiscal year of 2016, although this is based on non-GAAP revenue accounting. By the end of 2018, just two years from now, total cost savings should amount to $550 million a year. This comprises $400 million legacy cost savings projects as well as the $150 million in anticipated synergies from the Blue Coat purchase.
The huge cash portion of the deal will have an impact on the balance sheet. Symantec currently operates with a net cash position of $2.8 billion following the sale of the Veritas data-storage business which generated over $7 billion in proceeds. With the purchase of Blue Coat, Symantec will operate with a net debt load of $1.7 billion, being close to 1 times the anticipated adjusted EBITDA. This leverage ratio is based on the expectation that synergies and general costs savings will be achieved.
With the purchase, Symantec will expand the pro-forma revenue base by some 20%. While Blue Coat is still growing its sales by double digit percentages, Symantec's core business reported a 10% sales decline for the first nine months of this year. In the company's defense, the strong dollar can explain a large portion of these revenue declines. Still, the added growth of Blue Coat can at best halt the revenue declines of the pro-forma business.
The company believes that operational improvements should allow Symantec to post non-GAAP earnings of $1.70 to $1.80 per share by 2018. That seems highly optimistic to me. Back in 2013 when Symantec posted peak revenues of $6.9 billion, GAAP operating margins peaked around 16-17% of sales.
If we assume a generous 20% margins on sales of $4.5 billion going forward, I see operating profits of $900 million. If I take into account an interest bill of roughly $100 million on the gross debt load, and a 30% tax rate, after-tax earnings come in at $560 million. With 650 million shares outstanding at the moment, GAAP earnings come in at just $0.85 per share in this scenario. Even if I add back $250 million in stock-based compensation, at roughly 5% of sales, I only arrive at non-GAAP earnings of little over $1 per share.
The major discrepancy between my predictions and the 2018 guidance of the company relates to Symantec's very aggressive costs and synergy objectives. The $550 million in annual savings are equivalent to 12% of sales, being simply a very high number. In other words, the margin targets of Symantec seem unrealistic.
Even if the company assumes a generous $5 billion in sales by 2018, non-GAAP margins have to increase to new records around 40% of sales. Only in that case can non-GAAP earnings come in around the company's own targets.
Why All The Optimism? Don't Chase Momentum
Investors in Symantec love the Blue Coat deal, as shares have risen from $17 towards $20 since the deal has been announced. This move has added roughly $2 billion in market value on the back of a $4.65 billion cash deal. Clearly investors like the actual investments into the business rather than another round of buybacks.
That being said the 6-8 times sales multiple looks rather rich, even if the business grows by 17% per annum. The purchase price looks especially rich given that Bain bought Blue Coat for just $2.4 billion in March of 2015. In the period of little over a year, Blue Coat has doubled in value. That sounds a bit optimistic, although I recognize that it made a few small acquisitions over the past year.
Publicly trade competitors like FireEye (FEYE) and Palo Alto Networks (PANW) trade at revenue multiples of roughly 4 and 8 times respectively, adjusted for the enterprise valuation of each firm. This means that Blue Coat is valued at a similar revenue multiple as highly regarded Palo Alto Networks, a company which is still growing revenues by nearly 50% year-over-year.
Ahead of the deal, Symantec's enterprise valuation was just $8-9 billion, valuing the business at a modest 2.2-2.5 times sales multiple. Unlike Blue Coat, Symantec was actually still solidly profitable, although it was a value play with many real challenges.
While Blue Coat has the potential to halt (most of) the revenue declines, the cost is relatively steep. Symantec is now operating with some leverage, still has growth challenges, as its costs targets look very ambitious. With the recent momentum run and the unrealistic expectations (in my eyes) for the year 2018, I am not tempted at all to chase shares higher from today's levels.
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.