When the minnow winds up dining on whale meat!
LogMein (NASDAQ:LOGM) announced the results of fiscal Q2 on July 26th. The results were strong and included a significant EPS beat with almost 30% top line growth as well. In addition, management significantly raised outlook for the last two quarters of the fiscal year. I will discuss some of the details of the beat and the outlook later in this article.
But the big news was not about the operating performance - by far the biggest news was the announcement of a Reverse Morris Transaction which in essence means that LOGM will acquire the "GoTo" properties of Citrix (NASDAQ:CTXS) for about 27 million shares, or about $2.2 billion at current quotations for LOGM shares. In addition, as part of the overall scope of the transaction, LOGM is to pay its current shareholders dividends that aggregate $1.50/share before the transaction closes and Citrix will contribute $25 million to the new company, which is less than $.50/share based on a to-be outstanding share count of 54 million. In my opinion, and detailed below, the transaction will be highly accretive with many potential synergies. Despite the significant appreciation of LOGM shares in the wake of the announcement of the transaction, they remain a buy in my opinion.
Citrix also announced a strong quarter in the context of their expectations. Both revenues and earnings were noticeably greater than the prior consensus expectations. The CFO announced that Citrix had increased its forecast for both Q3 and for the balance of the fiscal year.
Citrix shares fell 3% in the wake of the earnings release although they have since recovered. Part of the knee-jerk drop may have been due to the strength exhibited by the shares prior to the earnings release but much of it was likely to be investor unhappiness regarding the price that was received for the company's GoTo properties. From my perspective, CTXS shareholders are receiving about $2.2 billion for a property that is generating $680 million in run rate sales, all subscription and that is growing at 10%. The specifics of GoTo's financial performance will not be made public for a few weeks. That being said, I do imagine that GoTo properties are reasonably profitable at this point. Inevitably, estimates for CTXS earnings will be impacted to a degree, but without more details it is hard to say how much. But the fact is that this is one of those rare deals in which both of the parties are winners. I think that the value of LOGM shares to be received by CTXS shareholders, coupled with the value of the remaining component of CTXS, is greater than would have been the case absent the transaction.
Management had previously announced that GoTo was not a strategic asset in the company's strategic vision and under those circumstances getting 3.2X EV/S is not such a terrible transaction. Usually, companies having announced that something is for sale and unloved, do not get a really premium price for an asset.
In any event, the balance of this article is about LOGM including the potential impact of the acquisition and the outlook for the to-be combined company. As I will detail below, the shares that will be distributed to Citrix owners are likely to appreciate from current levels and I would advise holding them - but I am not going to cover anything more in detail regarding CTXS and its valuation in this article. I do not think it is necessary to buy Citrix shares in order to get LOGM shares - there is probably an arbitrage to be had but the time frame for the transaction is long enough that I wouldn't like to invest on the basis of the potential premium to be had.
Just how much whale is LOGM going to get to eat?
The contemplated transaction is described as a Reverse Morris Trust merger. Essentially the minnow - that would be LOGM is to acquire and merge with the Citrix product suite known as GoTo, that would be the whale and wind up controlling the new venture. A Reverse Morris Trust merger is used when a parent company has a subsidiary it wants to sell in a tax-efficient manner. The parent company spins the subsidiary it wants to dispose of to the shareholders of the parent company. The former sub then merges with a target company to create a merged company. For this to work, the former subsidiary has to be considered the buyer of the target. Citrix shareholders will own fractionally more than 50% of the new entity. Most unusually, in this case, the surviving entity is to be LOGM whose executives will run the new company. As I will get to shortly, LOGM has gotten a great deal that is already partially understood by the market with the shares up about 20%.
But essentially, LOGM is issuing 27.7 million shares of its stock to buy the GoTo business of Citrix which had revenues of $680 million last year, several times the size of the LogMein products in the space and actually twice the size of the current revenue projections for LOGM as a whole for 2016.
LOGM currently has 25.8 million fully diluted shares outstanding in addition to some amount of stock options. Overall, LogMein's revenues for this year have been forecast to be about $335 million or about $13/share and the new entity will have 54 million shares outstanding with a revenue estimate of at least $1.015 billion or almost $19/share.
In terms of earnings, management chose to focus on non-GAAP EBITDA. Non-GAAP EBITDA for LOGM has been forecast to reach about $86 million for full year 2016 as a mid-point. Non-GAAP EBITDA relates to a forecast for non-GAAP net income of about $51 million. The company accrues a non-GAAP tax rate of 30.5%.
The press release announcing the transaction forecasts that the new company is expected to have a pro-forma EBITDA margin of 35% or $6.50/share and is expected to generate free cash flow in excess of $250 million or more than $4.60/share. EBITDA of $350 million and a tax rate of 30% should yield non-GAAP earnings of $245 million which would be about $4.50 in EPS once the cost accretion has been achieved. The current forecast for LOGM EPS for 2017 is $2.20/share.
What might shares in the new business be worth?
There are obviously many ways to approach that question, none of which are going to be without an element of healthy skepticism and of risk. LOGM shares have had what appears to be a high valuation primarily because this has been a rare company that has been profitable, and achieving rapid organic growth that derives all of its business from the cloud. From time to time there have been articles on this site suggesting that the shares are or have been overvalued.
One of the crucial assumptions is going to be expectations for the growth rate of the new enterprise. No one is going to pretend that remote access technology is a high growth market. The application has been around for a while and whether it is saturated or not, it surely hasn't limitless growth potential. I was surprised to hear from the CEO of Citrix that its GoTo product line was growing at double-digit rates although perhaps the impact of Go To Meeting is sufficient to achieve significant growth.
Most recently, LOGM has traded in the range of about $60/share which had been a market capitalization of about $1.6 billion. With its net cash balance of $180 million, it had an enterprise value of $1.38 billion and its sales had been forecast to be $335 million. So, the shares, in the most recent past had traded at 4.1X EV/S.
The company reported an operating cash flow margin of 31% for the most recent quarter and of 39% YTD. Cash flow margins grew more in Q2 than in Q1. Cash flow margins are significantly greater than the current EBITDA margins, which do not include the increase in deferred revenues. At the moment, looking at the last quarter, that is a difference of $27 million or 16% of revenues.
Again, absent lots more dialogue about the more specific outlook for the combined company which is not currently available, operating cash flow margins could be as much as 50%. CapEx for LOGM is small although it did increase last quarter. It has a run rate that is equivalent to 5% of revenues. (CapEx for LOGM is quite small because it uses a proprietary technology that improves the efficiency of the data centers it operates and is ideal for the kinds of usage engendered by its applications.) CapEx as a ratio will almost certainly be smaller still for the combined company but even using 5% of revenues might yield a free cash flow estimate of $450 million for the period after all the cost synergies have been achieved. A 5% free cash flow yield relates to an enterprise value of $9 billion or more than $160/share.
What ought to be a target free cash flow yield - surely less than 10%. One can get lots of different but positive answers for valuation if a target free cash flow yield is even within hailing distance of levels that are consistent with other SaaS vendors.
An investor would get a far lower valuation using EV/S as a valuation formula. At 4X the expected revenues from the combined company, the potential enterprise value is just $4 billion and that works out to $74/share. At 6X the potential valuation is $111.
Finally, there is the non-GAAP P/E. Again, pre-transaction, the earnings estimates for this year had been about $1.90 rising to $2.20 in 2017. Those are P/Es of 37X and 31X on the closing price prior to the release of the merger transaction news. P/Es in the 30X range suggest a tentative value of in excess of $135/share if my logic trails and company adjusted EBITDA guidance is accurate. Even a 20X P/E yields a $90 price target.
There are many different ways readers might approach the issue of valuation. I think that a range of potential fair value outcomes would be from between $90 and $135. Other readers are almost certain to feel differently, although.
Again, valuation metrics depend on forward growth estimates and the forward growth of the new company will almost surely be lower in percentage terms than would be the forward growth of LOGM as it is currently constituted. How much slower, how profitable and as discussed below, with what potential revenue synergies are not questions that can be dispositively answered by this writer given the information at hand. LOGM hasn't been the best covered name although is likely to change a bit as it reaches over $1 billion in revenues and that will lead to a broad spectrum of opinions regarding the three questions above. And given LOGM's long history of ultra-conservative projections, it stands to reason that when guidance is provided regarding the outlook for the new company it is not going to err on the optimistic side. But I still think $86/share (the current price as of this writing) represents more than the sum of all of the concerns regarding integration risks and transaction risks and gives no recognition of potential revenue synergies.
Writing Wednesday morning in the wake of the announcement I am not going to try to suggest to anyone that I have the kind of specialized skills and knowledge to forecast how LOGM shares might trade today or for the balance of the week. I first wrote about this name in January and then in February in the wake of Q4-2015 earnings. I thought the shares were a buy at that point when they were trading in the $50/share ranges. Obviously the question to be asked is whether or not the shares, now up more than 60% in six months are still a buy or is it time to move on. I believe that the shares still represent outstanding opportunity and are likely to produce positive alpha for the next several quarters to come.
Just What are the Synergies to be had?
Citrix CEO Kirill Tatarinov put it very succinctly and emphatically, this transaction is all about synergies. The ones listed in the press release are specifically $65 million by the end of year one post-merger and $100 million at the end of year 2. Those levels of projected cost savings might seem like quite a bit of a stretch in terms of finding synergies for a company that might be projected to be spending no more than $800 million on opex post-merger. My guess, for what it is worth, is like most of these projections it is probably quite conservative.
There are significant scale economies that ought to be available for a company whose revenues are expected to be 3X greater than the current operations of LOGM. LOGM is a company that derives all of its revenues from subscriptions and has a marginal GAAP profits despite a gross margin of 86%.
LOGM is spending half of its current revenues on sales and marketing. Part of the reason for that is despite the company's relatively small size, it supports numerous products that all need marketing effort. And not all of its product offerings really have the scale necessary to support significant marketing efforts. There is no reason to expect that the combined organization can't reduce the sales and marketing ratio substantially. I wouldn't be surprised to see the sales and marketing expense, just by itself, achieve savings at or in excess of $100 million that is the currently expected cost synergy within two years.
Over the years I have almost never seen a company not surpass projected cost savings over time when putting together a merger of two overlapping products. Although the companies haven't released exact specifics, the Citrix GoTo set of products is almost 10X the size of the competitive LOGM product. LOGM is spending 13% of revenues on general and administrative expenses, and the general and administrative expenses rose 33% on a GAAP basis last quarter. That may not be so visible given that revenue growth accelerated to 28% this past quarter, but it is ratio simply never seen in billion-dollar software vendors.
And LOGM's research and development spend is at 20% of revenues on a GAAP basis and grew by almost 40% year on year. Again, we do not know the detailed specifics, but the fact is that LOGM and Citrix have competed for years in the remote access and meeting collaboration spaces. Although it might sound heretical to say so, the functionality of the competitive products is more or less comparable. Over time, it seems very likely that the new company will attempt to develop a unified set of solutions and eliminate the expenses inherent in trying to sell and support two products that do the same thing.
The synergies that are never discussed in polite company
No part of the synergies identified by the two new partners are those likely to be realized from ending competition between the two major competitors in the remote access space. While there are, to be sure, more than a few other remote access solutions on the market, Citrix has been the market leader since it developed the technology and has been plagued by price competition from LOGM for as long as I have known LOGM. How much the end of competition between LOGM and CTXS will be worth is not knowable for an outsider to analyze and for obvious reasons the companies have not made it a part of their merger justification but it is surely a major factor in the benefits that are going to be achieved. I really don't have a specific idea as to what competitive scenarios are likely to emerge and since the merger is still six months away, none of us, outside of company management, really know what is going to happen when there is one team running sales and marketing. I think it is fair to believe that the two competitors will cease to compete directly on price and will no longer compete directly to try to capture potential enterprise clients. There is almost certainly lots that will be written by users who are complaining that they have to pay higher prices for a service that they have been able to buy for $40/computer - but that's the point it is $40/user.
Citrix and LOGM are also vigorous competitors in the collaboration space where they offer Go To Meeting and Join Me, respectively. The competitive dynamics are the same - sort of - but different as well in that there is a 3rd major player, Cisco, (NASDAQ:CSCO) whose WebEx is the granddaddy and the market share leader. For some years JoinMe was the fastest growing revenue contributor that LOGM offered and it is a significant revenue component for the company. On the other hand, it has a really tiny market share given the size of both Cisco and Citrix in this space. Much of its competitive strategy has been based has, of necessity, been based on price. I will leave it those readers who have used the different technology to evaluate them as alternatives. So far as I am concerned, if one is shown how to launch the sessions, the end result is about the same. There will almost certainly be revenue benefits to go with cost benefits in amalgamating what today are two competitive solutions if for no other reason than ASP's will rise.
It would be a mistake for me to pretend that I have some special knowledge that allows me to understand the likely revenue synergies of the combination in a way that I can offer quantification, but I imagine they will be substantial. The fact is, almost inevitably, the prices received per computer in these spaces by the new LOGM will be higher than has heretofore been the case. I doubt that anti-trust concerns are a significant element in this transaction, given the overall size or lack of size of LOGM compared to many infrastructure software vendors. It is rare to see two direct competitors with significant market shares merge but in this case, where the overall size of the acquirer coupled with the hazy definition of a relevant market makes it hard to imagine anti-trust objections. I just can't imagine that Cisco could argue with a straight face that the combination of JoinMe and Go To Meeting is going to injure it in a visible fashion.
I would imagine the higher prices coupled with more effective marketing and an offering that will be able to tick every box and to fill in every hole is likely to produce more earnings gains than the forecast gains from cost synergies.
Just by the way - How is the dog doing?
Quite well thanks, but he is a mite hard to see given the size of the new tail. What I mean explicitly is that the parts of LOGM that do not have to do with remote access and which have been the heartland of growth for this company for several years are still doing well but their progress is now obscured by the transformation to be wrought through the Citrix transaction. It is ironic that when I first wrote about LOGM for SA earlier this year, one of the significant investor issues at that point was concerns about the company's dwindling growth in remote access and limited comprehension/visibility regarding the outlook for some of the other key products and verticals that have generated much of the company's revenues.
The company offers solutions based on 3 different clouds. It has significant revenues that come from the Internet of Things offering called Xively, from its customer service products, which include BoldChat, Central and Rescue and from LastPass and Meldium, which are password managers. None of these represents a huge market opportunity by itself and as mentioned above the need to support lots of products with significant development and marketing costs has inhibited the growth of GAAP operating margins.
LOGM has been able to grow its top line by 20% or more on an organic basis and that was the case last quarter. It has had a long history of earnings beats going back several years. When conditions have deteriorated for the company, and they have in the past, it was guidance and not current quarter operating performance that has been impacted. So, I have no reason to believe anything other than that the company will continue to print quarters above published expectations until the merger closes and detailed expectations have been completely reset.
But regardless of the outlook for various pieces of the "other" LOGM, the value in the shares and their near-term performance will be dependent almost exclusively on investor outlook for the merged enterprise. At this point the dog is more in the nature of lagniappe rather than being the major driver in either the business or the valuation and investors will need to recognize that going forward.
- LOGM reported its Q2 results earlier this week. The company achieved strong performance and it raised guidance for the balance of the year.
- More important by far than the operating results was the announcement of a Reverse Morris merger in which the end result will be that LOGM will own the Go To operations of Citrix in exchange for 27 million shares in the newly formed company to be distributed to Citrix shareholders.
- The new company, expected to be launched with run rate revenues of $1 billion, will achieve massive cost synergies given that its principle products will be a major overlap between the two prior entities.
- LOGM shares have appreciated sharply in the wake of the earnings release and the merger announcement.
- I believe, based on some conservative projections, there remains significant further upside potential, simply based on cost synergies and cash flow generation.
- It should be noted that the two companies have been the two large competitors in the remote access space for years and have been two of the three largest competitors in the meeting collaboration space.
- It is inevitable that pricing realizations will lift higher in the wake of the merger although how much higher is not knowable.
- And it is equally difficult to determine the growth rate that the new entity is likely to achieve although the comment by the Citrix CEO that the GoTo product line had been achieving double-digit growth was a significant positive surprise.
Obviously, there are many risks in what is eventually to be a complicated transaction. Execution will be key and how this combination is to be consolidated is not known at this point and will certainly not be a simple matter to consummate efficiently. But the upside share price opportunity would seem to allow for risks from execution and to still leave lots of room for positive alpha going forward.
Disclosure: I am/we are long LOGM.
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.