Zix: The Market Will Soon Give Way
Summary
- Zix's growth metrics are improving. This trend is expected to flow to the bottom line in the coming quarters.
- The market continues to value Zix modestly due to its highly leveraged capital structure.
- There are also worries about the sustainability of revenue growth given its modest cash position.
- These developments continue to make Zix's risk/reward opportunity favorable.
- Assuming double-digit ARR growth in 2021, Zix's valuation will remain cheap at a sales multiple of 3x using the current enterprise value.
Zix Corporation (NASDAQ:ZIXI) is still primed to pull off its growth turnaround. The recent growth momentum has been encouraging. The forward growth guidance is promising. Zix has also demonstrated the ability to effectively manage its liquidity given its highly leveraged capital structure.
The market continues to discount execution worries and pressure from competition. This setup makes the risk/reward opportunity attractive.
Demand (set to keep gaining market share)
I am bullish on the demand for Zix's offerings due to its expanded addressable market, favorable growth trends, improved growth indicators, and sentiments towards revenue growth sustainability.
- Market size (Email, Backup, Archiving, Advanced Threat)
At a high level, the acquisition of CloudAlly expanded our product suite into the cloud backup market, which is a $1.3 billion market growing at 25% according to markets to markets.
Source: Zix
Zix recently expanded its addressable market after the recent acquisition of CloudAlly.
Microsoft Office 365 backup and recovery represents nearly half of that market and was the #1 product extension requested by our channel partners.
Source: Zix
The good thing is that customers actually want this product. This means CloudAlly is immediately accretive to revenue and ARR growth.
With a cloud backup product, Zix adds to its growing roster of cybersecurity offerings which cover capabilities in email security, archiving, and advanced threat protection.
Growth trends (Data breach, cyber-attack, email compromise, cloud migration, regulations)
According to Forrester, 41% of the companies they surveyed between April and May 2020 reported that their organization was not prepared to effectively transition to full-time remote work. That same Forrester survey found that organizations are increasingly leveraging cloud technology to support remote and hybrid work environments and that decision-makers see productivity, security, compliance and resilience as key tenets of a secure modern workplace.
Source: Zix
Beyond the expanded addressable market, it is important to know that the favorable external trends driving the adoption of cybersecurity solutions are still in place. The SolarWinds (SWI) hack has raised awareness for cybersecurity players in general.
Zix also noted during the last earnings that the rapid shift to remote work continues to drive the migration to Secure Cloud. The company also noted that regulations are driving penetration in target verticals like healthcare, financial services, and government.
Other favorable trends include the growing adoption of Microsoft 365 (MSFT) and the need to accelerate backups via Salesforce (CRM).
It is important to explore some of the growth metrics highlighting these trends.
Source: Seeking Alpha
Growth metrics (ARR, Cloud ARR, New Customers, Retention rate, Revenue, Churn)
Revenue has been consistently above guidance over the past five quarters. Q4'20 revenue increased 15% to $57.9 million from $50.4 million in the same quarter last year. Revenue continues to benefit from the recent acquisitions of AppRiver and CloudAlly.
ARR (annual recurring revenue) was $237.7 million (+14% y/y). ARR and ARR growth benefitted from the recent acquisition of CloudAlly. ARR is a good proxy to measure the health of Zix's growing platform subscribers.
Cloud-based ARR grew to $206.6 million (+21% y/y). This represents 87% of the total ARR.
Total billings grew to 56.6M (+15% y/y). Billings benefited from improved revenue/ARR growth.
99% of new customers were onboarded on Secure Cloud. This bodes well for future ARR and cloud ARR growth.
Net dollar retention represents our renewals plus new sales into the installed base divided by the renewals that were available at the beginning of the quarter.
Source: Zix
Net dollar retention was 100.3% in Q4, up from 99% in Q3. I believe this metric is impressive given the anticipated impact of COVID on players with significant exposure to SMBs.
Zix noted that growing macro volatility (caused by COVID) drove higher-than-expected churn, and the trend might continue as it migrates email customers to Secure Cloud. This is going to be a temporary pain as customers tend to expand platform usage after migrating to a cloud platform.
Despite these worries, Zix added 54,800 cloud mailboxes in Q4 2020, bringing the total number of productivity mailboxes to nearly 1.2 million. Lastly, new customers added in the quarter totaled over 4,200.
Source: Seeking Alpha
In terms of guidance, Zix expects Q1 revenue of $58.7-$59.8 million (implies a y/y growth of 12% to 14%). For FY'21, Zix expects revenue of$244.0 million and $248.5 million (+12%-14% y/y).
The Street's forward revenue estimates suggest the market expects growth to continue in the low-mid teens in the coming years.
What are the strategies that will sustain the growth projections?
Business (growing EBITDA to boost financial profile)
I am modestly positive on Zix's business profile due to the potential to expand platform capabilities offset by the relatively low gross margin and stretched solvency ratios.
I expect the cloud migration, which will kick into full effect, to be a temporary headwind to profitability and cash flows due to potential customer churn as customers make the trade-off to continue with Zix or adopt a different vendor.
Zix highlighted some platform updates, including interactions and API extensions, as a part of the growing product investments (organic), which should continue this year. I expect these product initiatives to be accelerated by the new Chief Product Officer.
But the focus for this year is a laser focus on larger MSPs. And so we're building out 2 careful OKRs, one is to attract MSPs who can do meaningful amounts of our IP. The other thing we're targeting is growing our existing MSPs.
Source: Zix
On the sales front, I am encouraged by the updated MPS strategy and the proposed expansion into Germany.
All these initiatives are good. The catch is that margins will remain volatile, and it doesn't help that Zix has a modest gross margin relative to other SaaS platforms. This is a major factor driving a modest valuation despite initiatives to accelerate growth.
Gross margin for 2020 was $105.7 million or 48% of revenues compared with $96.5 million or 56% of revenues in 2019 and $55.3 million or 78% of revenues in 2018. Our decrease in gross margin over the past two years is related to lower margin of revenue associated with Microsoft Office365 and hosted exchange products following the acquisition of AppRiver.
Source: Annual Report
It doesn't help that margins have been pressured in recent quarters. From the growing mix of Office 365 offerings to acquisition-related expenses and investments in R&D to make the platform more appealing to customers, predicting earnings has been tough. Despite this level of volatility, Zix has been able to deliver a double-digit EBITDA margin (adjusted).
Source: Zix
Zix doesn't have much choice here due to its debt obligations. The cash position continues to be under pressure due to recent acquisitions.
In exchange, Zix has a bigger ARR base to grow EBITDA, and this strategy appears to be working.
Adjusted EBITDA guidance for FY21 stands at $56M. With a net debt position of less than $200M, Zix will remain within its permissible leverage ratio using the debt covenant schedule.
Valuation (the market thinks Zix can't grow as fast as possible)
I am bullish on Zix due to the market's average sentiments despite the potential for Zix to keep growing revenue and ARR for a long time.
Source: Finbox
My valuation assumed revenue would be compounded over a long period at a 10-Y CAGR of approx. 12%. The market doesn't appear to agree with this estimate. I guess that the market thinks offerings like email security and cloud backups will be commoditized. It also appears the market expects SMBs to get some of these offerings for free. To offset these concerns, I applied a modest EBITDA margin and a high hurdle rate.
My EBITDA margin estimate is modest at 20% due to the limited leeway provided by the gross margin. Readers will recall that the adjusted EBITDA margin (a non-GAAP metric) for Q4 already stands at 23%.
Besides the contribution from earnings, I expect Capex % of revenue to decline gradually as the upfront cloud investments fade. I am projecting Capex/Sales to fall to 3% by 2025 in line with the range of most subscription companies. In addition to my working capital assumptions, I expect the FCF margin to improve to 15%-18% in the coming years. The cash flow margin guidance for FY'21 stands at approx. 13%.
Source: Finbox
A major factor to worry about when computing the hurdle rate is the debt to capital ratio. Debt continues to represent a significant portion of Zix's total capital. We also have the convertible preferred shares (at 8%), representing about 26% of voting capital stock.
Risks
Risks to the growth story include commoditization of email security offerings, continued EPS volatility, pressured solvency, growing competition, partnership dependency, and market volatility.
Conclusion
Zix's growth momentum remains impressive. Investments to drive growth in 2020 will ensure it outperforms its guidance for 2021. The market is discounting worries about competition, Zix's thin liquidity profile, and the sustainability of revenue growth. Zix's numbers are proving otherwise. This makes the risk/reward profile attractive.
This article was written by
Analyst’s 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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Comments (2)
There are so many small email security offerings out there.
I wonder if they will all be eventually made *redundant* by dominant companies such as Microsoft? As your article mentions;"Microsoft Office 365 backup and recovery represents nearly half of that market and was the #1 product extension requested by our channel partners."
Source: Zix
