Data backup company Carbonite (NASDAQ: CARB) has several of the characteristics that I look for in a possible investment – a thoroughly clean balance sheet, an undemanding valuation, insider ownership and the presence of a founder, and 2 segments that have vastly different outlooks (making screening/consolidated financials not necessarily useful in understanding the future of the business). Whilst the company is best known for its consumer offerings – dollars to donuts you’ve seen the commercials – its SMB business, built out via various acquisitions, is now above half of revenue.
Unfortunately, after digging into the market plus the financials, I don’t come away impressed by the quality of Carbonite’s product offering or its management. I also think the consumer business may decline quicker than expected given the significantly “good enough” nature of cheaper/totally free sync and backup products for consumers. While I see upside to $11 or $12 (from the current share price of $8) if management executes reasonably well, I don’t think it’s a lay-up, and thus view Carbonite shares as a show-me story rather than a compelling investment opportunity.
Consumer Doing What Everyone Expected… SMB Is The Question
While Carbonite’s consumer business ended 2015 up slightly, the outlook for a -10% decline isn’t really all that surprising. While Carbonite’s backup offering is technically a different product than the plethora of cloud-sync or backup products like Box (NYSE: BOX), Google (NASDAQ: GOOG) (NASDAQ: GOOGL) Drive, Microsoft (NASDAQ: MSFT) OneDrive, Dropbox (Private: DROPB), Amazon (NASDAQ: AMZN), and so on, the differences in consumers’ minds are likely to continue to fade over time as they increasingly become the same thing from a functional perspective.
Data relating to PCs from HP (NYSE: HPQ), Intel (NASDAQ: INTC), et al have hardly been robust, and the ongoing move towards thin-client continues (as an increasing percentage of devices are packaged with faster but lower-capacity SSDs, with data-hogging photos and music stored in the cloud). With that, the decline of the consumer business is really more a matter of when than if from my point of view. Given the low double-digit churn, in the absence of significant marketing investment, high single-digit declines don’t seem unreasonable over the medium term, although it could be much faster (or slower) depending on how much Carbonite wants to put behind it in terms of resources and how rapidly consumers actively choose to cancel in favor of other, cheaper services. PRO TIP, dont forget we offer coupons and deal for new carbonite subscribers right here
The SMB business, on the other hand, is now over half of bookings (thanks to the EVault acquisition). Parsing through forward guidance, one factor that jumped out at me is that organic growth in SMB bookings appears to be decelerating meaningfully. In contrast to the consumer market, the SMB market is growing at a rapid clip; commentary from industry analysts as well as peers like Barracuda (NYSE: CUDA) suggests that >25% growth over the medium term should be in the cards. Against this, Carbonite grew SMB bookings at 35% in 2015, although the organic rate was lower backing out the benefit from the late-2014 acquisition of Mailstore.
Looking ahead to 2017, while the headline bookings growth number is impressive – the midpoint of $105 million in SMB bookings implies 90% growth y/y – the largest chunk of this is derived from the acquired EVault business (which I’ll discuss extensively in the next section.) Backing out the ~$42.5 million midpoint of guidance for EVault, organic SMB bookings from the “legacy” Carbonite business only look to increase at around 15%, from $54.5 million in 2015 to $62.5 million in 2017. (Even at the high end of the company’s range, I only get to around 20% growth – still a marked deceleration.)
This is a rather surprising number to me, especially in light of the company’s success in building out its channel partners. Given his background, the new CEO has been focused on building out the indirect channel, and the company ended 2015 with more than 8200 resellers, up over 40% y/y. You would assume that this would help maintain or accelerate sales growth, but that’s just not happening.
The question of whether this is a competitive issue is a worthwhile one. Going back to the consumer discussion earlier, the trends are similar on the business side – backing up endpoint devices is viewed as less critical as backing up servers and applications. While EVault should help here, integration will take some time. Either way, since this is the future of the business, its growth rate is important for investors to follow.
EVault Acquisition: So Many Questions
As I referenced, the big story in 2017 will be how the company integrates the EVault business acquired from Seagate (NASDAQ: STX). Strategically, the deal fills a gap in EVault’s product portfolio – while its simplicity-focused solution works well for the “small” end of the SMB space, it lacked critical features offered by competitors such as Barracuda and Veritas that larger businesses need. EVault brings many of these capabilities, although competition is still fierce. (For those who put stock in Gartner quadrants, Seagate was categorized as a “Visionary.”)
Incredibly, management didn’t know basic details about EVault’s business on the call. At the time of announcement, for example, they didn’t know how fast the business was growing. In response to an analyst question about the growth rate of EVault, CFO Anthony Folger replied:
I guess what I would tell you is EVault really is a division of a division within Seagate, and so we have got to carve these financial statements out. So we are being a little bit cautious in terms of the guide and talking about some of the forward-looking numbers.
Management’s credibility in terms of meeting expectations isn’t the highest to begin with (or the stock wouldn’t be trading for 50% less than the buyout offer a year ago). That said, even if you take Folger’s explanation for their uncertainty about revenue growth at face value, CEO Mohamad Ali followed up with this doozy on the Q4 call in February (see transcript) in response to an analyst question about seasonality:
First of all, we should say that we’ve owned the business for two weeks now. So I still think we are learning about the patterns and seasonality and so forth.
If the answer about revenue growth didn’t make sense, this one just jumps the shark. How can you buy a business, and three weeks after closing, not know, at least vaguely, which quarters are stronger and which ones are weaker? That is pretty much Business 101. That is something literally, anyone on the sales team could tell you if you asked them. “Summer’s slow, but year-end is big,” or vice versa. You’re the CEO. It’s literally your job to know these things.
On the one hand, given Carbonite’s balance sheet and the fact, at $14 million, that this wasn’t a “transformative” deal from a financial standpoint (though it’s hoped to be from a product/go-to-market standpoint), you can argue that it’s not so financially significant as to be a big deal either way. On the other hand, I am viewing this more through the lens of process than outcome – whether or not the deal ends up working out, it does not sound to me like the company did enough diligence here.
Ali is no dilettante when it comes to corporate management – he was formerly the Chief Strategy Officer at HP and a senior executive at many other organizations including IBM (NYSE: IBM) – and it’s frankly inexcusable to do a deal and try to figure out what you’ve bought after the check has already cleared. My concern is that he may have brought the HP/IBM M&A mentality along with him – i.e. who cares how much we spend, let’s just go buy ourselves growth. That’s all well and fine when you have functionally limitless discretionary cash flow to throw around, but with substantially more limited resources and a more precarious competitive position, Carbonite requires a much more judicious approach to capital allocation.
I would also point out that Seagate sold the business for basically nothing, continuing the trend of purchasing somewhat flamed-out businesses. (Zmanda, which forms a lot of the basis for Carbonite’s server product, clearly wasn’t a hit for its VCs either.) Chris Mellor of The Register wrote a great timeline – while you should hit the link and review it in full, basically Seagate futzed around with the business for a decade and then sold it for less than a tenth of what they bought it for. Given that it did ~$50MM or so in bookings (guidance for $40 to $45 million excludes a few months of European revenues) at mid-60s gross margins (per both Seagate and CARB management), Carbonite paid less than a third of bookings and half of gross profit. If the company is able to extract meaningful synergies from data-center consolidation (a questionable proposition, in my view), you can certainly model a scenario where deal consideration was an absurdly low-to-mid single-digit multiple of post-synergies EBITDA.
A transaction at this sort of price would not have occurred if EVault was knocking it out of the park. In my experience, putting two somewhat challenged businesses together usually does not magically solve the problems of either one, although this isn’t to say that EVault is a bad asset in the right hands.
The current stock price around $8 values the company at an enterprise value of around $165 million. I’m adjusting the balance sheet for cash outflow relating to the closing of the EVault deal.) That certainly doesn’t put a high multiple on the company – less than 1x forward revenues, or less than ~2x the value of the SMB segment,. That’s (The difference between my number and the one you may see quoted in your preferred data provider. It’s certainly not hard to justify putting a >2x revenue multiple on that segment of the business and more or less ignoring consumer if you assume that CARB can grow the SMB segment at 20% or higher over time. I’ve read various bullish angles that take this approach.
As a cautionary note, I would point out that the revenue multiple of Barracuda (one often-mentioned comp) has compressed pretty significantly, taking away some of the juicy upside opportunity, at least in the near term – particularly since Barracuda is executing a lot better than CARB.
Carbonite just isn’t very profitable,. That is the problem, for me. If you exclude the impact of the CEO hire, free cash flow is inflated by stock-based compensation that is very generous even. Even on a non-GAAP basis, the high end of 2017 EPS guidance is merely 15 cents. Given that the SMB business is not going to organically grow at 30% this year per guidance, I also am not willing to give management credit for effective return on customer acquisition cost.
Finally, i would point out that the real value in the backup market appears to be in the “M” rather than “S” part of SMB, and in the server rather than endpoint segment of the backup market. To supplement my earlier discussion, two different organizations I worked for in the 50-100 employee size range, for example, used Google Apps for all internal documents with limited (if any) meaningful data to back up on employee devices, and the same goes for the fund I used to work for. Would have use for server backup, although the larger organizations would have no use for endpoint solutions.
With that assessment, as well as Carbonite management’s own acknowledgment that they basically weren’t very competitive in that space prior to the EVault acquisition, it’s hard to assign them a big multiple. Their SMB business has, more or less, been patched together via various acquisitions of not-particularly-spectacular companies over the years, and I don’t see any indications that they’ve been improved so much as to now be worth premium multiples (as opposed to the fairly low multiples they were sold for).
In particular, it’s hard for me to mark EVault (nearly half of the SMB line) up to a high multiple of revenues when it was literally just sold for .3x – if the hoped-for synergies and growth materialize, that’s one thing, but it’s way too early to tell.
Combine that with the fact that one year in, I simply don’t like the CEO or have much confidence in his ability to manage this business, and it’s hard for me to call Carbonite compelling (although it is cheap.) I do think there is plenty of upside opportunity for shareholders here if management executes – if they could post teens GAAP EBITDA margins, and continue to consistently grow the top line at a high single or low double-digit rate despite the drag from consumer, then I could justify a price around $11 or $12 (good for 40-50% upside from the current stock price).
Setting aside the margin issues, this would require growing the SMB business at 20% every year while keeping Consumer segment declines to high-single digits at most. Other investors with a more favorable view will likely see value here, even though i don’t personally have enough confidence in either Carbonite’s product or its management to view that upside potential as likely to be achieved. Having watched other similar situations play out, I’m also cautious about the assumption on Consumer – often, it seems like there’s a “tipping point” and the rate of decline ends up being higher than anyone initially expected.
Finally, I suppose a takeover is still a possibility, although this also seems unlikely. The company has rebuffed multiple takeover offers at much higher prices and I don’t think the third time will be the charm.
Wrapping It Up
The market is tough, the consumer business may decline even more rapidly than expected, and execution is necessary to succeed, though carbonite has interesting potential, and you certainly don’t have to use aggressive assumptions to justify a price higher than $8. I would view shares a lot more constructively if Carbonite achieves the hoped-for synergies with its EVault business and demonstrates clear traction in the server backup market for medium-sized enterprises. I’m on the sidelines despite the valuation, even though until then.
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