Carbon Black Painted Red, So We Committed Some Green

About: Carbon Black, Inc. (CBLK)
by: Quad 7 Capital

Another quarterly beat but guidance just below expectations set this name up for a trade.

We discuss our trade but note that upside remains as positive free cash flow is likely going into the future.

Slight disappointments and management changes can create havoc in shares short-term, allowing us to acquire shares to capture rapid reversals as part of our investing approach.

Carbon Black (CBLK) was on our radar after reporting quarterly earnings and year-end results that beat estimates, but shares were down 22% as guidance was a bit worse than expected, and there was a management change announced. We pounced on this opportunity at BAD BEAT Investing and want to share with you our trade, but also why we also see possible further upside.

Source: Carbon Black

This is an interesting company that operates in a niche we have't covered much here at BAD BEAT, though have started touching upon recently. By that we mean tech and data security. Carbon Black was initially known as "Bit9." Upon founding it was set up to provide next-generation endpoint security solutions. The company still operates in this niche. Carbon Black's predictive cloud platform continuously captures, records and analyzes unfiltered endpoint data to help deliver security capabilities to its customers. They assist customers by predicting, preventing, detecting, responding to, and fixing cyber attacks before they result in damaging data breaches.

Source: Information age

So what kind of so-called 'endpoints' are addressed? Well the devices protected range from personal devices such as personal computers, laptops and mobile phones to large scale business devices. These large scale business devices include things like servers, virtual machines, cloud workloads, ATMs, point of sale systems, and many more.

Here is what we like about the company, aside from the stellar revenue growth we will discuss below. Carbon Black's platform is of course proprietary, but we like the approach. The platform essentially uses unfiltered data from the customers devices and deploys a 'data-shaping technology' that smooths bursts of endpoint data activity, optimizes bandwidth demands, compresses data, and delivers a graph-like custom model for endpoint data for further analysis. From here it then evaluates and classifies a continuously updated series of events to identify risk and viable solutions to attacks.

The customer base is quite wide. In general much of the revenue comes from enterprises and government agencies, and the company's reach is spread across multiple industries. We see opportunity for continued growth in the name moving forward.

So what is happening to the stock? Well, it's getting hammered, and beat up hard. This catches our eye:

Source: BAD BEAT Investing

From a chart perspective it looks like just above the $12 mark is a solid entry point in this name. But the fundies will drive the action here. You see, it is not so much that the stock is getting slammed. That's not a BAD BEAT per se. What we like about it is that the fall comes on the heels of a better-than-expected earnings report, with guidance that, yes, was indeed below expectations, but not terribly so. The selloff was also being driven by a management change.

So we feel this management change was driving some of this action. The company announced that CFO Mark Sullivan will resign, and this was effective March 11. The Street hates changes like this. Stephen Webber, former CFO and COO for BackOffice Associates, will step into the role. Sullivan will remain with the company until June 30th to help with the transition. We believe this is a shoot first and ask questions later setup, combining with the disappointing guidance. While the company is losing money, it's setting up for solid earnings in the future with ongoing revenue growth.

Discussing performance

Carbon Black earns revenues through a subscription and license fee model for its product and by providing other support services. It has seen strong financial growth in the recent past, but the operational expenses have widened, eating at the bottom line. Let us delve further.

Top line

So how does the top line look? Well there is growth and this is promising. Total revenue was $56.9 million in Q4 2018, an increase of 27% year-over-year. Subscription, license and support revenue was $54.4 million, an increase of 31% year-over-year. There was however some weakness in services revenue which were just $2.5 million, a decrease of 17% year-over-year. However, this is a small portion of revenue, as you can see.

Total revenue was $209.7 million for the full year fiscal 2018, an increase of 30% year-over-year. That is stellar growth. Subscription, license and support revenue was $198.5 million, an increase of 33% year-over-year, while services revenue was $11.2 million, a decrease of 6% year-over-year.

Source: Data from SEC filings, graphics by BAD BEAT Investing

Profit and EPS

Gross profit remains strong. Gross profit was $44.3 million in Q4 2018, representing a 78% gross margin, in line with the year-ago period. Adjusted gross profit was $44.9 million, a 79% adjusted gross margin, in line with Q4 2017. For the year gross profit was also solid. Gross profit was $164.0 million for the full year fiscal 2018, a 78% gross margin, the same as 2017. Adjusted gross profit was $166.2 million, representing a 79% adjusted gross margin, the same as last year.

There are, however, significant down line expenses in operations that have led to losses. Loss from operations was $19.5 million in Q4 2018, compared to $14.0 million in the year-ago period. Adjusted loss from operations widened to $15.0 million in Q4 2018, compared to $11.3 million in the year-ago period.

For the year losses also widened. Loss from operations was $74.6 million for all of 2018, compared to $52.6 million for the year-ago period. Things on an adjusted basis were a bit better, but losses still widened. The company saw a loss from operations of $55.5 million for 2018, compared to $42.1 million a year ago

So it all boils down to the company losing money right now. Net loss was $18.6 million in Q4 2018. Net loss was $0.27 per share based on 68.8 million weighted-average shares outstanding. In the year-ago period, net loss was $14.8 million and net loss attributable to common stockholders was $27.1 million, or $2.51 per share based on 10.8 million weighted-average shares outstanding. Adjusted net loss was $14.1 million, or $0.20 per share versus $1.04 per share a year ago.

Net loss was $82.1 million for the full year fiscal 2018. It lost $5.82 per share versus a loss of 53.2 million or $7.83 per share based on 10.4 million weighted-average shares outstanding. Adjusted net loss was $54.2 million, or $1.12 per share versus $4.03 per share based a year ago.

Cash and Cash Flow

At the end of the quarter, which was December 31, 2018, Carbon Black had $160.6 million in cash, cash equivalents and short-term investments. During the three months ended December 31, 2018, Carbon Black used $9.2 million of cash in operations and $1.1 million in capital expenditures and capitalized software development costs, leading to negative free cash flow of $10.3 million, compared to positive free cash flow of $3.6 million in the year-ago period.

Source: Data from SEC filings, graphics by BAD BEAT Investing

During the year Carbon Black used $37.3 million of cash for operations and $8.4 million for capital expenditures and capitalized software development costs, leading to negative free cash flow of $45.7 million, compared to negative free cash flow of $13.7 million for the year-ago period. Overall, the company has plenty of cash at present, and we are unconcerned.

Disappointing guidance?

We take you through key performance to understand where the company has been. But it also matters where it is going. It is here that we think the Street has grossly overreacted and you will catch a sizable rebound if you play the name here. The guidance led to the Street seeing analysts downgrade the stock a price target of $15. That is still 25% upside from our preferred entry point. So what was so bad? Mixed 2019 guidance had pegged downside revenue from $240 million to $244 million. The consensus was $257 million. However, the earnings per share guidance was better than expected. It sees a loss per share from -$0.64 to -$0.61, while the Street was looking for a loss of -$0.69. We believe this was underappreciated.

The play

We believe that astute investors will take note that this revenue guidance calls for around a 15%-20% increase in the top line, with an improvement of nearly 50% in the EPS figures. This seems to us like the company is moving in the right direction, but we do share in the concern a bit that the pace of revenue growth slowing is a risk factor. However, considering price targets were in the $20-$30 range before this announcement on a consensus basis, we contend that there is ample opportunity for us to come in and scalp a point or two at these levels for around a 15%+ gain

Target entry: $11.90-$12.30

Target exit: $13.90-$14.30

Stop loss: $11.25

Estimated time frame: 2-4 weeks

Results--The trade worked to perfection

Looking ahead for the company

So we saw the guidance, but we think for our long-term investors that are faithful to the BAD BEAT Investing philosophy, we need to give you a bit more of a compelling reason to get long the stock, for more than just trading purposes. This trade worked to perfection. But there is more upside ahead, we believe. You see, the cloud is the future of Carbon Black. That is where the company and the tech world is headed, and has been this decade. In a little over two years, Carbon Black has transitioned from an almost entirely on-premise business to building an $80 million revenue run rate cloud business that grew 133% year-over-year in 2018. Increasing market awareness of Carbon Black as a cloud security company will be instrumental in increasing sales.

In the latter half of 2018, the company built out an 'enablement team,' which is now fully staffed and trained as part of the enablement process the enterprise field sales team is now focused on leading with the cloud versus a mix of on-premises and cloud solutions. That has been a reason expenses were out of line versus revenue growth. With the growth outlook for 2019, we expect Carbon Black to moderate the growth of its expense structure to reduce operating loss and cash burn. The company continues to target generating positive free cash flow by the fourth quarter of 2020. This is critical.

We believe that getting to positive free cash flow will be a bullish signal for investors to bid up the stock, as improving EPS is a natural next step. As the company continues to improve, we believe you can comfortably stay long the name, beyond a trade.

Take home

The bottom line here is that we view the progress made in 2018 toward transitioning Carbon Black to a multi-product cloud company was a major achievement. It was costly but will begin to bear fruit in 2019, while expenses will be a bit more in check. With the real excitement set for 2020 and beyond, we believe there is a compelling reason for long-term investors not only to have considered our BAD BEAT trade on the company and the stock at $12.25, but to consider entering the name currently for growth into 2020.

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Disclosure: I am/we are long CBLK. 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.