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On Tuesday, November 12, 2013, Institutional Investor and SumZero, the world’s largest online membership community of buy-side investment professionals, hosted an idea competition at Columbia University Business School’s Uris Hall Auditorium. Nineteen emerging managers were selected from within the SumZero community on the basis of strong performance and high-quality peer reviews. Each manager gave a three minute pitch on their best idea to an audience of analysts and investors who rated their pitch for validity of the thesis, strength of the argument, feasibility of the trade and originality. We invite you to view these ideas and register to download each presenter’s bio and full pitch paper. If you’re a professional investment officer or analyst, we invite you to register to vote for the winning idea.
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Scott Miller Age: 42
Greenhaven Road Capital
Title: Portfolio Manager
Location: Rye, N.Y.
Education (Undergrad/Grad/Certifications): University of Pennsylvania (Political Science), Stanford University Graduate School of Business – MBA, Stanford University Graduate School of Education - MA Previous Employers/Positions: I have held a variety of operating positions from managing a paper bag factory to cofounding a service business that employs 1,000 people across five states. I have also worked for an education-focused private equity fund as an associate and a long/short hedge fund as an analyst. Bio: Unlike most fund managers, I have extensive operating experience growing a business as a cofounder, expanding from three employees to more than 1,000 people and generating annual revenues in excess of $50M. I have served as Chief Financial Officer, Chief Technology Officer, and software developer. To quote Warren Buffet, “I am a better investor because I am a businessman, and a better businessman because I am an investor.” I have also worked in private equity and a long/short hedge fund which provided foundational skills for due diligence, industry analysis, and financial modeling. Favorite Investment Book: You too can be a Stock Market Genius by Joel Greenblatt Favorite Quote/Author: Why do you think the same five guys make it to the final table of the World Series of Poker EVERY YEAR? What, are they the luckiest guys in Las Vegas?” —Mike McDermott from the movie Rounders, explaining to his girlfriend that poker is not all luck. I feel the same way about investing. Most Attractive Area of the Market Right Now: Small cap technology companies with strong balance sheets, reasonable valuations, and limited to no analyst coverage. Least Attractive Area of the Market Right Now: U.S. 30-year treasuries – I am not lending our current government money for 30 years at sub 4%. Languages Spoken: English and Spanish
Best Past Investment Made: I bought Apple in 2000 at $8 split adjusted and held. It has been a 60 + bagger. Worst Past Investment Made: I owned Pinnacle Airlines all the way into bankruptcy. I mistakenly believed that the board and management would be fair to common shareholders and Delta would honor their contract. Both assumptions proved false. Common shares are no longer worth the paper they are printed on. Personal Investing Style: Concentrated with low turnover, willing to accept volatility for long-term returns Areas of Personal Expertise: I invest almost exclusively in equities with a preference for technology and business services that are U.S. or European listed. I am very comfortable with small cap companies that have limited to no analyst coverage.
Fund Description: Greenhaven Road Capital Fund 1 is a concentrated, value-focused long/short fund. The portfolio consists of high-quality businesses with high free cash flow yields and special situations such as spinoffs. The fund can invest in all geographies and market capitalizations, but primarily invests in small and mid-cap U.S. listed companies and has historically been 80%+ net long with minimal use of leverage. AUM: $5 million Past Ideas Submitted on SumZero: Fortress Investment Group (FIG), AIG Tarp Warrants (AIG WS), ChipMOS (IMOS) Firm Focus: Greenhaven Road was created as a vehicle for friends and family to invest alongside me. I invest the fund like it is my own money – because it is. The structure is based off of the early Warren Buffet partnerships where I only make money when my investors make money. Firm Strategy: The fund is engaged in primary research and operates under the premise that fundamentals matter and the market is inefficient. The general partner of the fund has a very substantial portion of his liquid net worth in the fund and manages the fund as if it is his own money – because it is. Fund Disclaimer: Please see section 16 of appendix.
Ticker ZIXI Asset Class Common Equity Recommendation Long Expected Timeframe 1 year to 2 years Country United States Situation Growth at a Reasonable Price Price At Recommendation $4.12 Price Target $6.00 Diluted Shares (MM) 62.5 Market Cap $257 Cash & Equivalents (MM) $33 Debt (MM) 0 Non-controlling interest (MM) 0 Enterprise Value $224 Catalyst Type Growth & Spinoff of subsidiary
ELEVATOR PITCH Zix is a high quality business with 95% + customer retention rates, regulatory tailwinds, in a four player industry with one of the players exiting. There is optionality on two new products that are transitioning from only expense to profit contributors over the next two years as Zix cross sells to their 9,000+ existing customers. THESIS ZIX Corporation is a small, growing, mission critical, high-quality business with very high customer retention rates (95+%), contracted revenue, high gross margins, regulatory tailwinds, and the ability to cross-sell new products to their 9,000-plus customers. The current GAAP financials mask the true profitability of the business as new product development temporarily depresses earnings. ZIX has a solid balance sheet with no debt and 12% of the market capitalization in cash.
70 Greenhaven Road, Rye NY 10580 (917) 880-2051
PRIMARY PRODUCT Established in 1998, Zix was originally in the healthcare business, providing an e-prescription platform to healthcare organizations. Gradually, the business migrated away from prescriptions towards encrypted e-mail and fully exited the prescription business in 2010. The Zix Corporation e-mail encryption system emphasizes ease of use. The person sending the email does not have to actively encrypt the e-mail by remembering to press a certain button. Instead, the e-mail encryption product has a series of filters that are set by the client and determine if an e-mail needs to be encrypted. A very basic example is that words such as “confidential” will trigger encryption. The company has spent several million dollars a year on R&D and has built more complex algorithms than encrypting “confidential.” Once an e-mail is sent, it is routed through Zix’s $50M data center. If the intended recipient is registered in the Zix directory, then they will receive the e-mail and be able to read the content without any action on their end. There is never any additional action required by the user. Sending an encrypted e-mail is the same as sending a regular e-mail. All of the work is done by the filtering technology. Only recipients not registered in the Zix directory have to do anything to receive the e-mail. With more than 38 million registrants in the Zix directory, more than half of received e-mail requires no action by the recipient. As the Zix directory grows, this percentage will continue to increase. BROAD BASE OF CUSTOMERS Zix currently provides e-mail encryption solutions to 9,000 organizations, including the U.S. Treasury, all U.S .banking regulators, the SEC, 32 of the Blue Shield healthcare organizations, 20% of U.S. banks and 20% of U.S. hospitals. Customers typically sign multi-year contracts (the average length is 2.5 years) with a per user fee (average fee is $21 per user). No customer accounts for more than 2% of revenue. SAFE CHOICE FOR PURCHASERS Zix has a 90+% retention rate of customers and a 75% win rate on new contracts because of the ease of use for senders and recipients, low cost, and installed base of customers. For the IT manager that selects the e-mail encryption platform, Zix is a safe choice. It is the same e-mail encryption that government regulators use. You will not be fired for selecting or renewing Zix. E-mail encryption is not the first place managers go to save money or be heroes/innovators.
70 Greenhaven Road, Rye NY 10580 (917) 880-2051
Given that Zix passes the cost, uptime, ease of use, and industry standard criteria most managers use, the one area where Zix is vulnerable is on the breadth of offering. Zix’s e-mail encryption is effectively a stand-alone offering. CORE BUSINESS IS GROWING AND A PRIMARY COMPETITOR IS EXITING THE BUSINESS Zix has had 19 consecutive quarters of increasing revenues. YTD 2013 revenues are up 13% versus the previous year. Historically, Zix has cited Cisco as one of its three primary competitors along with Proofpoint and McAfee. Cisco, as part of its corporate realignment, has been re-emphasizing routers and deemphasizing e-mail encryption and other ancillary businesses. E-mail encryption, which was never a significant business for Cisco, has become even less so. To quote Zix CEO, Rick Spurr, on the second quarter 2012 conference call, “Cisco announced they are no longer selling their high end encryption solution and they put a notice in the marketplace that, like I said, they quit selling and they are going to drop support for their product in the 2014-2015 timeframe. So customers will have a little runway but it's obviously a signal that they are going to quit investing and most customers see that as a red flag to do something different. We don't know the rate at which that will play out but that high-end encryption appliance is being used by a number of large corporations. So that's good.” NEW PRODUCTS CREATE SHORT TERM HEADWINDS BUT LONG TERM OPPORTUNITIES Zix has a very scalable model with gross margins in excess of 85%. Their largest variable expenses are sales commissions. As a result of their cost structure, the economics of any incremental revenue is highly profitable. To increase long-term profitability, Zix has been steadily increasing its R&D budget to fund the development of two new add-on products which have just been launched. The Zix 2013 R&D spend will be approximately $10M, which is twice the 2011 spend and three times the 2010 spend. The company is spending somewhere on the order of $3M to $5M or five to eight cents per share in what could really be considered growth capex. Eventually the new products should be strong financial contributors, but given the combination of their young life and subscription accounting, they are virtually all cost and no revenue to date. The first investment is in a product for Data Loss Prevention (DLP), which was released in March 2013. The DLP product uses the same filters as the e-mail encryption to determine if e-mail content and attachments should be sent. In the event that an e-mail has content that should
70 Greenhaven Road, Rye NY 10580 (917) 880-2051
not be sent, the system will quarantine the information and send the proper alerts. The company has provided no guidance on the number of expected users. To date, the market acceptance of DLP appears tepid. There have been fewer than 8,000 seat licenses sold in six months. The company is releasing a version 2.0 in 2014 which they claim will address several feature requests from the marketplace. If Zix can achieve a 10% attachment rate at $7 per user and 85% margins, the company is looking at two cents per share in contribution and two cents per share in decreased development spending. For a company with YTD run rate GAAP earnings of twelve cents per share, this is material. The second product Zix is developing and introducing is also a derivative of the core product, and relates to BYOD – Bring Your Own Device, a growing problem for IT departments where employees want to use their own iPhone/Blackberry/laptop for work. Bringing your own device is a very practical request, but can be challenging for the preservation of e-mail encryption and other security measures such as DLP. The BYOD product allows IT departments to encrypt mail, control devices, and delete mail in the event a device is lost. BYOD was released in September 2013, just 27 days before the quarter ended. The ASP for BYOD is expected to be in the $30$35 per user range. Similar to DLP, the financial impact of BYOD to date has been all expense. If Zix can convert 10% of users to also purchase BYOD at a $35 ASP and 70% gross margins, it can contribute eight cents per share in earnings and another five cents per share in decreased development spending once the product is mature. For a company with YTD run rate GAAP earnings of twelve cents per share, the combination of BYOD gaining traction and decreased future expenses is material. GAAP FINANCIALS UNDERSTATE EARNING POWER Zix Corporation’s accounting is all legal and conservative, however, it can be misleading during times of growth and investment. The company has three practices which depress short-term earnings that are not clear from looking at the income statement. The first practice is that even though contracts have a typical duration of two to three years, all commissions are paid in the first year, even though the revenue is recognized over full timeframe. The net result of this policy is that the first year, with all of the commissions loaded into it, is less profitable than the subsequent years. The impact of this can be seen in orders, which are on a run rate of almost $9M. All commissions will be expensed this year even though the revenue will be recognized over the next 2.5 years.
70 Greenhaven Road, Rye NY 10580 (917) 880-2051
The second accounting practice that can obfuscate true profitability relates to the company’s accounting for product development. All software development expenses are incurred during the period that they are expensed. As previously discussed In the case of the development of the DLP and BYOD products, the company is incurring significant R&D expenses for which there is almost no revenue coming in yet. These expenses are an investment in future growth that depresses current earnings. R&D has increased by $5M from two years ago, or eight cents per share in depressed earnings. Lastly, the company recognizes revenue on contracts only as services are provided. If the company were to sell a $300K contract with a duration of 30 months ($10K/month) with each year paid up front, it would receive $120K in cash to start services for the first year. The company would pay commissions of approximately $20K and would recognize only $10K per month in revenue. Over the 30-month lifetime of the contract, it will be profitable; from a cash perspective, because they are paid up front, the contract will be cash flow positive over the course of the contract, but from a GAAP earnings perspective, the contract will not be profitable in the initial quarters where the commissions are paid and only a fraction of the revenues are recognized. Again, over the life of the contract, this sorts itself out, but during periods of growth, the revenue recognition and commission expense practices serve to depress short-term earnings. GAAP FINANCIAL STATEMENTS UNDERSTATE BALANCE SHEET General Accepted Accounting Principles (GAAP) understate the balance sheet of Zix Corporation as well as the earnings power. This understatement can be seen in two primary areas. The first is that Property Plant and Equipment is valued at $2.5M on the balance sheet. In the late ‘90s/ early 2000s, the company spent in excess of $50M building a data center, which it is still operating today. The data center is still fully functional, processing more than 100 million emails a month and would cost tens of millions of dollars to replace, yet effectively does not appear on the balance sheet because of its age; it is fully depreciated according to GAAP. This situation exists because the useful life of the data center is longer than the period that GAAP allows for depreciation. The second area of understatement is that the balance sheet does not reflect the company’s “backlog.” The backlog represents signed contracts for which payment has not yet been received (but commissions have typically been paid). The value of the backlog is currently $64M. This appears nowhere on the financial statements, but would clearly be of
70 Greenhaven Road, Rye NY 10580 (917) 880-2051
value to an acquirer. The backlog has the added benefit of providing visibility into revenues since more than 90% of the coming year’s revenue is typically already contracted and often already prepaid. VALUATION Zix has a market capitalization of $257M; when the $32M in cash is backed out, there is an enterprise value of just $225M. Given that the GAAP financial statements understate the value of Zix, I believe a more true value of the company comes from looking at the cash flow statement. In the last reported quarter, Zix reported YTD run rate free cash flow of just over $11M. When you add back in inflated R&D of $4M, and the understated impact of $9M in new contracts, there is normalized free cash flow of more than $16M + per year before any contribution from new products or continued growth in the core business. If the company continues to grow the core business at double-digit percentages per year, reduce share count at single-digit percentages, and launch high margin new products, this will be a very successful investment over the next three years. The quickest path to realizing true value may come through being acquired. Most logical acquirers are much larger organizations with existing sales forces and infrastructure. As a result, they can increase the profitability just by stripping out another $2M in general and administrative expenses they would no longer require (CFO, etc.). An acquirer should ascribe value to the $64M in contracted revenue, the $50M data center, the potential of the future high margin products, and the technology. Given that Google and Symantec have both chosen to partner rather than build, there are data points to suggest that somebody may choose to buy over build. Symantec, which is going through a strategic review under new CEO Steve Bennett, would be a logical acquirer. A $6 per share valuation would imply less than $330M enterprise value for a $50M data center, 9,000 customers, 3 product lines, and $60M in backlogged contracted revenue and a 5%+ FCF yield before stripping out duplicative expenses. In other words not a stretch. BARRIERS TO ENTRY The e-mail encryption business is not a great business, but is a pretty good business with reasonable barriers to entry. Of course it is possible for a competitor to build a data warehouse and hire engineers. It would be harder to replicate the Zix directory. This is a directory of 34
70 Greenhaven Road, Rye NY 10580 (917) 880-2051
million e-mail users and addresses such that if a user is in the Zix directory and receives an encrypted e-mail, it will automatically be decrypted – thus greatly improving the ease of use. The last piece of the Zix puzzle that is hardest to recreate is the customer base and reputation. Who would you buy encryption from – the people who provide it for the Federal Reserve or those who don’t? Certainly, there are a number of potential entrants with credibility in the security market that could win customers and are potential new entrants, and this will never be a monopoly. I do however, take some comfort in the fact that two logical entrants into the email encryption business, Google and Symantec, have both decided to partner with Zix and resell their products rather than developing their own. CATALYSTS Zix is an attractive business with recurring revenues, barriers to entry, high gross margins, a market leading product, and a reasonable valuation. It has had these attributes for years while the stock price has languished below $5. There are two potential catalysts. The first is that if the BYOD product can demonstrate any traction in the marketplace, it would provide support for multiple expansion. The second potential catalyst is a change in the composition of the board of directors. The largest shareholder, Meldrum Asset Management, threatened a proxy fight while seeking three board seats. The company agreed to forgo the fight and award Meldrum two board seats as of January 1, 2013. Meldrum has not been explicit in its agenda, but increasing the share buyback and pursuing the sale of the company would be two potential paths to value realization. If Zix can continue to profitably grow sales, expand its customer base, and expand product offerings, there is plenty of opportunity to compound growth for years to come. RISKS Zix is a small cap company that is off the radar screen for most investors. They are covered by no bulge bracket firms. The four analysts that cover Zix are Craig-Hallum Capital, Imperial Capital, LOM, and Topeka Capital markets. Market indifference to Zix could persist for years. With short term R&D for new product development masking growing profitability, the market may remain inefficient. There is also the possibility of new entrants to the market. In particular, instead of partnering, Google, Symantec, or others could enter the marketplace competing in part on cost and driving down the overall profitability.
70 Greenhaven Road, Rye NY 10580 (917) 880-2051
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This is not an offer to buy or sell securities. I am not endorsing the buying or selling of this security in any way, shape or form. I may or may not own this security at any time. Please make your own decisions regarding investments. This investment write-up in no way incorporates any non-public information and/or unsubstantiated rumors or misrepresentations and does not involve any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person in connection with an investment. I have obtained all necessary approvals from my employer to submit this investment write-up to the SumZero Idea Database and it complies with all applicable policies of my employer. This submission does not violate any agreements to which I may be subject (including, without limitation, any confidentiality agreements), insider trading regulations, SEC regulations, and/or other applicable laws, rules and regulations. My fund and/or I have a position (long or short) in this security and may trade in and out of this position without informing the SumZero community. Note: if you click this checkbox, this sentence will be displayed at the top of your write-up.
70 Greenhaven Road, Rye NY 10580 (917) 880-2051