MSFT - Gen Digital: Cybersecurity Yes But Moving On
Summary
- Gen Digital, relative to the global cybersecurity market, holds a market share of ~ 1.83% 2022A (down from ~ 2.49% 2018A).
- Following the competition of the merger, Gen Digital's interest-bearing debt now stands at $10.12B ( ~+197%) or a net debt/EBIT of 9.78x.
- I rate Gen Digital shares as Hold with an estimated fair value of $21.4/share, which would represent a 5.0% downside from the current price of $22.49.
Description
Gen Digital Inc. ( GEN ) ("the company") is a large-sized company that provides its customers with all kinds of cyber safety services, namely: cybersecurity protection, identity protection, and privacy protection (e.g., VPN). It operates under a broad portfolio of well-known brands, including Norton, Avast, LifeLock, Avira, AVG, ReputationDefender, and CCleaner. The company's business model spans from free-to-use to pay-to-use products, with direct-to-consumer business ("DTC") as the main channel.
Below, you can see how the company did recently.
The Company, relative to the global cybersecurity market, holds a market share of ~ 1.83% 2022A (down from ~ 2.49% 2018A).
In fact, while the overall market grew at a CAGR of 11.0% over the 2018A-2022A period, the company's revenue grew at a CAGR of 2.2% (0.2x the market's CAGR) over the same period. This is a negative trend that I expect to continue in the future driven by the growing competition with highly innovative solutions, a much better competitor's UX (user experience), and all of that at an affordable price.
Company Valuation
Competition
The company operates in a highly competitive market with new entrants focusing on delivering not only a high-quality solution but also a high level of UX at an affordable price (e.g., Surfshark Antivirus).
The competition is represented by well-established companies like, for example, Microsoft ( MSFT ) (e.g., Microsoft Defender), Intego (one of Kape Technologies PLC subsidiaries), and Surfshark.
Valuation
The company is trading at an EV/SALES of ~ 8.32x TTM, which is in line with the peers' median EV/SALES of ~ 8.32x TTM.
I believe that Gen Digital Inc. company is fairly valued.
The company is highly profitable with paid direct customer count at ~ 38.6M TTM, or +65% QoQ post the merger with Avast . However, on the churn side during the last quarter, as stated during the 2Q23 earnings call , we saw a decline in both NortonLifeLock and Avast:
Paid direct customers count declined by roughly 60,000 quarter-over-quarter on the NortonLifeLock side and 190,000 on the Avast side, our short-term focus and opportunity coming out of the acquisition is to work on the increasing -- on increasing the value for millions of our customers and consequently their satisfaction and retention rate.
A negative net churn but still above the street expectations that were mainly based on the trends in PC shipments. In addition to that, the annual retention rate dropped from 85% pre-merger to 75% post-merger (Avast retention rate was 65%). However, the management seems to have a positive view on this side as it expects this number to move up thanks to the synergies the merger will bring to the table.
On the merger side, the management expects to deliver around $200M of revenue synergies and $300M of cost synergies over the next 18 months. However, this merger came at a big price: long-term debt. In fact, following the competition of the merger, the company's interest-bearing debt now stands at $10.12B ( ~ +197%) or a Net debt/EBIT of 9.78x. The debt can be decomposed into:
- Term loans at $7.6B: consisting of $3.91B due in 2027 and $3.69B due in 2029, and bearing interest at a rate equal to Term SOFR plus credit spread adjustment plus a margin. As of September 30, 2022, the interest rate was 4.77% .
- Senior notes $2.6B: consisting of 6.8% senior notes due in 2027 and 7.1% Senior Notes due in 2030.
And as many of you know, debt is expensive nowadays. In fact, the rising rate environment eats into some of EPS accretion and it represents a point of concern for the street.
Overall, I do not see good reasons that make me willing to invest in this company. It's a good company but it is also at a mature stable growth stage and with the Avast merger, I believe that Gen Digital Inc. lost its track, and instead of focusing on growing organically and investing more heavily in R&D, the company chose to do it inorganically at a very high price with various challenges and risks that will come along the road.
Having said that, and in line with the current macro environment and company-related trends, I expect the company to lose strength and to converge to an EV/SALES closer to that of Check Point Software ( CHKP ), or an EV/SALES of ~ 6.59x TTM.
In terms of downside risks , here are a few:
- Competition , If the competition will be perceived as being a key driver of slower growth, it would negatively affect the company's share price.
- Recession, a recessionary environment, especially a "hard landing," will negatively affect business growth.
- Long-term debt, the rising cost of debt puts downward pressure on the company's bottom line and it represents a big issue since the company is exposed to interest-rate fluctuations. On this matter, the company stated:
We will drive a balanced and disciplined capital allocation approach between targeted deleveraging and opportunistic share buybacks.
Final Remarks
I rate shares as HOLD with an estimated fair value of $21.4/share , which would represent a 5.0% downside from the current price of $22.49.
Having said that, even if I do like the sector, especially as a long-term investment, I do not believe that Gen Digital Inc. is the right one to bet on (if you are looking for a high-risk and hopefully a high return company). However, Gen Digital Inc. may be a good investment for those investors seeking stable income since the company rewards its shareholders with a forward dividend yield of 2.28%.
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Gen Digital: Cybersecurity Yes, But Moving On