Short Zix Insurmountable Competition

Short Zix: Insurmountable Competition|Must Read Sep. 30, 2015 9:31 AM ET3 comments

by: Lester Goh

Summary• At 4.4x EV/sales, shares of Zix Corporation are expensive on an absolute

basis. Relative to close comp MobileIron, they are dramatically overvalued.• Following MOBL's Q1 warning, the firm fell 35% due to fears of increased

competition from heavyweights such as Microsoft and VMware.• Zix did not follow MOBL's lead - shares continued rising after MOBL's

warning, and only fell slightly due to an analyst downgrade and a poor Q2.• The market appears to be ignoring the fact that Microsoft and VMware are

also Zix's competitors. Low-ROI R&D/meager growth indicates intensifying competition/growth is unlikely to accelerate.

Short Zix: Insurmountable Competition - Zix Corporation (NASDAQ:ZIXI) | Seeking… Page 1 of 22

http://seekingalpha.com/article/3542476-short-zix-insurmountable-competition 1/8/2016

• The Google deal/Cisco's exit & collaboration seems unlikely to yield the benefits expected. If Zix trades in-line with MOBL, shares would see 70%+ downside from current levels.

ThesisShares of Zix Corporation (NASDAQ:ZIXI) are a compelling short at current levels. Specifically, it is my view that shares are an enticing short because:

• Earlier in April, MobileIron (NASDAQ:MOBL) issued a Q1 warning announcing that results would clock in lower than guidance and cited increasing competition from tech heavyweights such as Microsoft and VMware. Zix's management has cited MOBL as a competitor, which makes Microsoft and VMware Zix's competitors as well. Given their dominance in the enterprise space, it would be extremely difficult for Zix to compete effectively. EMM ("enterprise mobility management") growth for Microsoft and VMware outpaced Zix's by a wide margin.

• Although Zix has kept up R&D/marketing spending, these efforts do not seem to be bearing fruit. Considering the entry of tech giants such as Microsoft/VMware, you would be hard-pressed to convince anyone that Zix can compete effectively against these players, given the sheer differential between their R&D/marketing budgets.

• The bull case for Zix - the procurement of Google as a reseller/the exit of Cisco and eventual collaboration - seems misguided. If Zix could benefit from the above, one can argue that said benefits would have already been shown in its results. Nothing in the company's recent performance indicates any acceleration or momentum.

• Insiders have been selling shares aggressively. Notably, in the last 12 months, insiders have only sold, never bought. This speaks volumes of management's confidence in the firm.

• At 4.4x EV/sales, shares of Zix are expensive on an absolute basis. Relative to close comp MobileIron - who trades at 1.1x EV/sales - they are significantly overvalued. The overvaluation is even more absurd when one considers that



MOBL possesses a much stronger growth profile and an arguably more complete offering (and thus better competitive position) when compared to Zix.

• Given the unlikelihood of acceleration in operations, any potential for shares to move up drastically is substantially reduced. Moreover, given its weak growth profile, small size, and increasing competition, the probability of an acquisition of Zix by a larger tech company should be close to zero. However, Zix currently has a share repurchase program (~$15m) in progress, which could mean a slight appreciation to shares/a floor to the current share price is not out of the question.

Ultimately, my thesis essentially boils down to this - the bull case is misguided. Zix trades like a high-growth stock despite mere single-digit growth. Increasing competition would result in limited opportunities to grow and investors should not expect a substantial acceleration in the top-line to stem organically given the company's history of product flops (ZixDLP/ZixOne).With limited probability of being bought out by a competitor, and high unlikelihood of results exploding positively, it is my view that potential for shares of Zix to move parabolically higher is severely reduced. Couple this with the fact that a much faster-growing peer (MobileIron) trades at a ~3 turn EV/sales discount, shorting Zix seems compelling here.Company DescriptionGiven the presence of large amounts of publicly-available research on Zix and its industry (EMM/security is a very hot industry at the moment given the numerous data breaches experienced by many organizations recently), I will keep my description brief.Zix operates in the high-growth (though the firm does not seem to be benefiting from this growth) EMM/security industry. The company's main product is email encryption. Given the fact that email is the communication medium of choice for businesses, and that Zix's email encryption offering does not require user authentication, customers tend to be sticky and revenues highly recurring. In addition to email encryption, the firm also has additional offerings such as email data loss prevention ("ZixDLP") and other BYOD ("ZixOne") solutions.



MOBL's Q1 warning led to a massive selloff, but Zix barely moved following the reportIn April, MOBL issued a Q1 warning, trimming guidance slightly. Given the relatively small haircut (guidance was ~3-5% lower), one could have justified a small selloff. Yet, shares fell 35% following the warning. MOBL cited increasing competition from a number of large players, notably Microsoft and VMware, but the list includes other tech mammoths such as IBM and SAP as well. Clearly, the reason for the huge selloff (instead of a small one) was due to increasing competition.Following a weak Q1 was a soft Q2. Despite beating Q2 estimates, guidance was once again slightly trimmed, and increasing competition was once again cited. Shares of MOBL fell ~8% following the Q2 report.Why does this concern Zix? Simple. As seen in Zix's recent investor presentation, the company cites Proofpoint, VMware and MOBL as competitors.Notably, VMware/MOBL are only cited as competitors in the BYOD market, which is not Zix's crown jewel. This may be a factor contributing to the stock's mispricing - investors could have possibly reasoned that although Zix faces competition, this competition is in one of Zix's smaller offerings.Moreover, the slides do not mention Microsoft/VMware as a competitor within email encryption (Zix's crown jewel). As the reader will learn in the next few paragraphs, the situation is much more dire than implied by the company.Bad news for MOBL is equivalent to bad news for Zix. Yet, shares of Zix soared following MOBL's April Q1 warning (possibly aided by its share buyback program) and have only recently retreated due to a weak Q2 and an analyst downgrade.It is important to note that Zix's email encryption offering is its crown jewel - the offering accounted (and continues to account) for a majority of the top-line (numbers to illustrate this will be provided in a later section). Though the company frequently alludes to the massive market opportunity, it has little growth to show for it (revenues have been growing at mid to high single-digits, not exactly exploding), leading one to wonder - if the opportunity is so large, why can't Zix capitalize on it?



One word: competition. Microsoft and VMware, with their entry into the EMM space, have also created their own email encryption offering. Microsoft's offering is known as "Office 365 Message Encryption" (it seems to be integrated with its cloud productivity suite and Azure platform) while VMware's offering is called "CipherMail Email Encryption Gateway". A brief reading of their descriptions reveals striking similarities with Zix's email encryption offering.Here is how Microsoft describes Office 365 Message Encryption:



Office 365 Message Encryption is an online service that's built on Microsoft Azure Rights Management (Azure RMS). With Azure RMS set up for an organization, administrators can enable message encryption by defining transport rules that determine the conditions for encryption. A rule can require the encryption of all messages addressed to a specific recipient, for example.When a user sends an email message in Exchange Online that matches an encryption rule, the message is sent out with an HTML attachment. The recipient opens the HTML attachment in the email message, recognizes a familiar brand if that's present, and follows the embedded instructions to view the encrypted message on the Office 365 Message Encryption portal. The recipient can choose to view the message by signing in with a Microsoft account or a work account associated with Office 365, or by using a one-time passcode. Both options help ensure that only the intended recipient can view the encrypted message."Source: Microsoft

And how VMware describes CipherMail Email Encryption Gateway:



CipherMail gateway provides an easy-to-use solution to securing your email without requiring additional client software. The centralized policy based encryption engine can be setup to automatically encrypt email based on regulatory compliance or business rules thereby minimizing human errors which might result in a data breach. The gateway seamlessly integrates with existing anti-virus, anti-spam and archiving products. For additional security, all private keys can be stored on a tamper proof hardware security module (HSM). The CipherMail gateway supports S/MIME, OpenPGP, PDF encryption and TLS.Ciphermail email encryption gateway can be installed as a virtual appliance for VMware and can be installed on most Linux and Unix based systems. Installation packages are available for Ubuntu/Debian, Red Hat/CentOS and OpenSUSE."Source: VMware

And finally, here is how Zix describes its email encryption offering:



"Whether your company has 10 or 10 million employees, ZixGateway is your solution for easy email encryption. Employees simply click 'send.' We do the rest. With full content scanning of the subject line, message body and attachments, ZixGateway can encrypt, route, block or brand outbound email based on corporate policies.Receiving encrypted email is just as easy. When a ZixGateway customer sends encrypted email to another ZixGateway customer, the email and replies are delivered securely and transparently. No extra steps or passwords are needed. Just in case your receiver isn't a ZixGateway user, we use the Best Method of Delivery to deliver the encrypted email in the easiest manner."Source: Zix

Considering Microsoft's and VMware's dominance in corporate productivity/virtualization respectively, I believe it is safe for me to assert without fear of being refuted that Microsoft and VMware are likely to dominate the email encryption space going forward.These players have client bases that dwarfs Zix's, much more widely-known brand names, and drastically higher R&D and marketing budgets. In case the reader is unconvinced, Microsoft's EMM customers jumped 90% y/y to 17K+ while VMware's AirWatch (its EMM offering) rose 60% on a constant currency basis. Contrasting this with Zix's paltry single-digit/low double-digit growth, the story does not look good.



The sheer differential between their growth rates suggests that clients are simply looking for a complete solution (email encryption with a productivity suite in Microsoft's case and email encryption with virtualization in VMware's case), not a point product (ala Zix). This certainly explains why Zix is unable to grow past single-digit rates.Low-ROI/relatively small-scale R&DZix has consistently been spending ~$9m-$10m annually on R&D. This spending has resulted in the development of two new offerings: ZixDLP (email data loss prevention) and ZixONE (BYOD). Despite new product introductions, their contributions to revenue have been minuscule.From the Q4 FY14 conference call (emphasis mine):



In terms of customers and licensed seats we now have a total of 84 DLP customers and approximately 155,000 licensed seats, with nearly 90% of these in large enterprise accounts. The average per user subscription price for these 155,000 seats is $3.69 reflecting a large concentration in enterprise accounts. We continue to see DLP as a highly complementary offering to our core email encryption business and our sales teams, both corporate and enterprise offered us a package solution to accounts new to Zix. Slightly more than half of our ZixDLP sales have come in this manner and the other half have been upsells to the existing base.We had an exceedingly strong quarter for ZixOne adding a record high 96 new ZixOne customers during the fourth quarter. This surpassed the previous record of 56 set in the third quarter of 2014 and represents a sequential increase of 71%. This addition of 96 new ZixOne customers grew our lifetime ZixOne customers by 57% to a total of 264. Of these 264 customers approximately 40% have been new accounts to Zix and 60% have been additions into our installed base.



The average number of seats across all ZixOne customers was 68 and the new seats sold during the quarter increased approximately 120% from the third quarter with the addition of more than 7,700 new seats. This brings the total number of ZixOne licensed seats to more than 18,000 from approximately 10,000 last quarter, a 75% increase. The average price per user for year looking at all ZixOne customers at the end of the quarter was $27."Source: Zix's Q4 FY14 Earnings Call Transcript

Fast forward two quarters to the most recent quarter (Q2 FY15, emphasis mine):



Also the price per seat in Q2 for these new DLP customers was higher than our average and was a little over $5 per seat, bringing our lifetime price per seat up a bit to just over $4. In terms of customers and licensed seats, we now have a lifetime total of 119 DLP customers and approximately 186,000 licensed seats, with approximately 84% of these seats in large enterprise accounts. We continue to see DLP as a highly complementary offering to our core email encryption solution and our sales teams, both corporate and enterprise, offer it as a package solution to account new to Zix. Slightly more than half of our sales come in this manner and the other half have been upsells to our existing base of email encryption customers.We had our second best new customer quarter ever for ZixOne, adding a near record 82 new ZixOne customers. This represents an 82% increase year-over-year. This addition of new ZixOne customers grew our number of lifetime ZixOne customers 26% to a total of 393. Of these 393 total customers, approximately 40% are new accounts to Zix and 60% have been additions into our installed base. The number of new seats sold during the



quarter was nearly 4,800. This brings the total number of ZixOne licensed seats to nearly 26,000, up from approximately 21,000 last quarter, a 23% increase in a single quarter. The average price per user per year, looking at all ZixOne customers at the end of the quarter, was $33; no change from the prior quarter.The average number of seats per customer across all ZixOne customers was 66, which highlights the opportunity for expansion within these customers, similar to what we've seen occur with our DLP product. In terms of new first year orders, ZixOne contributed 50% more to our results in the first half of 2015 versus the same period last year."Source: Zix's Q2 FY15 Earnings Call Transcript

From the above commentary, the unsuspecting reader would probably be thinking that the company is experiencing huge momentum. However, if we put the above numbers into perspective, it appears that this "momentum" is nothing to write home about.From Q4 FY14 to Q2 FY15, ZixDLP customers grew from 84 to 119 while seats grew from 155,000 to 186,000. Over the same period, ZixOne customers grew from 264 to 393 while seats grew from 18,000 to 26,000. If we put these growth numbers in percentages, it seems like these offerings are growing very quickly. However, these numbers are infinitesimal compared to Zix's core email encryption offering.



Per the July 2015 investor presentation, the email encryption offering had a customer base of 12,000 and ~2.7m seats (paid end users). Any way you slice it, revenue contribution from ZixDLP/One is immaterial.Notably, average seats per customer for ZixOne (the highest price-point offering: $33/seat for ZixOne vs ~$20/seat for the core email encryption offering and ~$4/seat for ZixDLP), actually decreased from Q4 FY14 to Q2 FY15 (68 to 66, data sourced from the quotes above), suggesting at the very least that the company's client base does not seem to be too excited about deploying its solution enterprise-wide. This trend is also present for Zix's DLP offering (data sourced from quotes above) - in Q4 FY14 Zix had 84 DLP customers and 155,000 seats or 1845 seats/customer on average. Two quarters later (Q2 FY15), Zix had 119 DLP customers and 186,000 seats or 1563 seats/customer on average.The above trend suggests one of two things (likely both):

• Zix is selling to much smaller customers than before, which will clearly result in lower revenue contribution given that its offerings are priced on a per seat basis.

• Larger customers (measured by number of seats) are leaving Zix and are being "replenished" by smaller customers.

Either way, the Zix story does not look good. The narrative becomes even more dreadful if one considers the fact that Zix's R&D/marketing budget is a fraction of that of its competitors (Microsoft, VMware, etc). Talk about bringing a knife to a gun-fight.The apparent bull case for ZixThe curious reader would then wonder: if the story is so bad, why are shares priced so highly?The bull case for Zix is fairly apparent. The company has strategic partnerships with OEM leaders such as Google, Cisco, and Symantec. The firm clearly considers these names as their best partners given that they specifically list them in their investor presentation (slide 28).



These players have huge networks and client bases. With Zix partnering up with them, it is not hard to come up with the case for owning Zix. To illustrate the bull case in numbers, Zix claims that Cisco has a distribution network of 68,000 resellers while Zix has a network of only 300 (per Q1 FY15 earnings call transcript).Additionally, Cisco was originally a competitor to Zix, but has exited the space in 2012. In July of that year, Cisco announced the end of its IronPort encryption solution but promised to continue to issue maintenance releases until July 2015. Couple this with the firm's partnership with Zix (in early 2015), one can assert that it is likely that Zix will be able to capitalize on former Cisco's customers' need to migrate over to the new provider.Following these developments (largely occurred during 2014/early 2015), shares of Zix rose substantially from $3 to $5. Clearly, investors were pinning their hopes on Zix's partnerships with Cisco, Google, and others.Reason for the mispricing - the bull case is misguidedDespite the positive developments listed above, Zix does not appear to be benefiting much, if at all, from any of them. Year-over-year revenue growth rates remain in the single-digits quarter after quarter. What's more revealing is that revenue was flat sequentially (at ~$13m) over the past 5 quarters (per Morningstar data). Clearly, nothing in Zix's recent results suggests any near-term explosion in growth.In addition, the firm attributed poor growth at the end of Q4 FY14 to a delay in ramp-up from Google resellers. Q1 FY15 was the first quarter where the company experienced a full 3-month contribution from Google resellers (emphasis mine):



As most of you know the resumption of sales of our email encryption service through Google's resellers did not take effect until last October. This quarter Q1 is the first quarter where we're reporting a full three months of Google sales since that announcement. We anticipated that we take the reseller's time to get trained and reengage but given what we now know we underestimated that ramp up time."Source: Zix's Q1 FY15 Earnings Call Transcript

Yet, revenue barely budged on a sequential basis - Q4 FY14 revenues were $12.9m while Q1 FY15 revenues were $13.1m. Clearly, even with the aid of Google's reseller network, Zix did not perform at a level that would justify the rise in shares ($3 to $5) in 2014.Despite the apparent poor contribution from strategic partnerships, management comments continue to be upbeat overall, with numerous claims alluding to the possibility that the top-line is on the cusp of exploding. From the Q1 FY15 call (emphasis mine):



Now the big news, on March the 5th, we announced a new strategic partnership with Cisco. It was too long ago that Cisco was our largest competitor. Now we are approaching the market as partners combining the strength of their world class distribution and our technology. The partnership will focus on two solutions in 2015. First of all as we've noted before, the announced end of life of the current Cisco IEA product has created a number of large potential opportunities with Cisco's install base between now and the end of the year. The partnership agreement is designed to allow these customers to move seamlessly to a new IEA product that we are building using the original Cisco IEA code base.The update version of Cisco IEA will include new hardware as well as software patches to protect against the latest security threats. Encryption capabilities reporting and end user interaction will remain the same in the new version, so customers will have a seamless transition.



We will provide the technical support for this new IEA product and Cisco will begin to accept orders ones the product is released scheduled to be later this quarter. We expect that this first phase of our Cisco partnership will allow us to maximizes our sales to this base of large accounts and will position us well for potential future upgrades."Source: Zix's Q1 FY15 Earnings Call Transcript

Notably, the company mentioned that it will begin accepting orders from Cisco's installed base later this quarter (the Q1 FY15 quarter). To ascertain their progress, we need to look no further than the second quarter numbers (or the most recent quarter). The numbers are underwhelming to say the least: new orders grew to $2.5m or a mere 5.5% y/y. Despite this poor performance, management continues to be very positive about the company's future (per their comments on the call).In sum, I believe that the bull case (that the Cisco/Google partnership will result in an explosion in the top-line) is misguided. Probably the two best validators of my bear thesis are as follows:

• The company increased the number of VARs (value-added resellers) and MSSPs (managed security service providers) from 97 to 240 and 94 to 131 over the 2012-2015 period respectively (slide 29 of investor presentation). Said another way, VARs nearly tripled while MSSPs grew by about a quarter. Yet, the firm's top-line grew from $43m (2012) to ~$52m (on a LTM basis). This suggests that Zix's offerings may not be as highly demanded as investors hope they will be. In sum, the Google/Cisco partnership is unlikely to result in the surge of the company's top-line that investors hopes it will.



• Management's upbeat comments about the company's future is not reflected in their actions. Per Nasdaq/Finviz data, insiders have aggressively sold shares (on both a 3-month and 12-month basis). Notably, there were zero buy transactions during the period. This raises the obvious question: if management is so confident (apparent from their comments) regarding Zix's future, why sell shares?

My theory as to why Zix's top-line has been unable to gain traction is rather simple.The company offers point products - products that are meant to address a single problem. Its email encryption offering, ZixOne and ZixDLP are all centered on solving a single problem - email security.However, the data (flat revenue sequentially, single-digit top-line growth rates, declining average seat/customer, etc) suggests that enterprises are not looking for point products, they are looking for solutions.This view is supported by the fact that Microsoft and VMware (who most certainly offer solutions, not point products) have managed to grow their EMM offerings by high double-digits (90%+ for Microsoft and 60% for VMware on a constant-currency basis), far outpacing Zix's meager single-digit growth.Furthermore, Zix is clearly continuing to focus on email - the recent release of ZixDLP is evidence of that. By continuing to myopically concentrate on just email - a small segment of the overall EMM space - Zix will likely be unable to compete against competitors which provide more complete EMM solutions. In fact, it will be nearly impossible, considering the level of Zix's R&D/marketing budgets compared to its rivals.Relative valuationAt ~$50m in annual revenues and ~$28m in net cash, Zix currently trades at ~4.4x EV/sales. In contrast, MOBL currently trades for 1.1x EV/sales (~$130m in revenue and ~$100m in net cash). Both companies share striking similarities: they are about the same size (~$250m) and both operate in the high-growth EMM space (though out of the two, only MOBL seems to be benefiting from the growth trend). MOBL's



stock has been thrashed recently, largely due to weak guidance and increasing competition. Given my above commentary regarding Zix, I see no reason Zix will not eventually follow the path of MOBL as increasing competition would also harm Zix.Although one might attribute the valuation discrepancy to the difference between the company's offerings, this assertion does not hold merit. MOBL is arguably much better positioned competitively compared to Zix, given that MOBL provides a more complete solution (unlike Zix, it is not simply focused on email) than Zix. Due to this, MOBL has enjoyed much higher growth rates (20%-30%) compared to Zix (6%-10%). One can reasonably make the case that MOBL should trade at a premium multiple to Zix, not the other way around.One other bone of contention the reader could raise is as follows: Zix is profitable while MOBL is not. While true, this argument does not hold water as one needs to consider that as these companies operate in a high-growth industry, it is very likely that they are priced basedon their growth profile, not their profitability.I believe a reasonable base case is that Zix trades in-line with MOBL. At MOBL's EV/sales multiple, Zix would see ~75% downside from current levels. As alluded to above, there is no reason why Zix can't trade lower, given its weaker growth profile and poorer competitive position.CatalystsThe main catalyst that would push shares lower would be a continued single-digit revenue growth rate going forward (i.e. no explosion to the top-line).Shares of Zix rose sharply (from $3 to $5) as a result of the announced Google/Cisco partnerships. In prior sections, I have detailed why it is highly unlikely Zix would reap much benefit from these partnerships.I expect continued single-digit growth in the following quarters to be proof of this and result in investors adjusting their growth expectations for the firm, which would lead to a drop in Zix's share price.Risks & conclusion



• Acceleration of operations which would push shares higher - Unlikely.Although one can credibly make the case that Zix's results would accelerate meaningfully as a result of the Cisco/Google partnerships, the data clearly shows that such a scenario is unlikely to materialize.Furthermore, the acceleration of operations would have to be very pronounced to result in shares appreciating higher (companies trading at 4.4x EV/sales simply do not continue trading at that multiple if sales are growing at single-digits, or even low double-digits).

• Zix gets acquired - Unlikely as well. Zix offers point products (and thus is poorly positioned competitively). The firm is growing at single-digit rates (not exactly a coveted growth rate to an acquirer) and is extremely small (~$250m in market cap). Given the above, the rationale for a larger player to acquire Zix seems weak.The fact that Zix offers point products would not allow an acquirer to gain a meaningful foothold into the EMM space (a more complete EMM offering would). In addition, Zix's small revenue base and single-digit top-line growth rates would hardly move the needle for any potential acquirer.Further, Zix clearly trades at an elevated multiple, which is likely to deter potential buyers. In fact, Zix's competitor, MOBL, is a much better target for an acquirer (much higher growth rates, depressed valuation, and a much better competitive position given its more complete EMM offering) compared to Zix.Finally, potential acquirers such as Microsoft, VMware, IBM, and SAP already have their own email encryption offering, making it pointless for them to acquire what they already have.

• Continued share repurchases - while this is very likely (Zix already has an existing share buyback program of $15m), average daily trading volumes of Zix's shares are in excess of $2m. Thus, it would be difficult for a repurchase program to push shares significantly higher from current levels.

Essentially, my bearish view on Zix is based on the fact that the company trades at a sky-high valuation despite a sluggish growth profile, something that is unlikely to continue going forward.



Its growth profile is likely to remain weak given increasing competition from very large players (Microsoft, VMware, etc). The company's small R&D/marketing budgets relative to the aforementioned tech giants places it at an insurmountable disadvantage. Although management continues to be optimistic about Zix's future, their aggressive selling of Zix's shares contradicts their upbeat comments.With little reason for operations to accelerate, poor competitive positioning, and a stratospheric valuation, the likelihood of Zix getting acquired is substantially mitigated. Shares are unlikely to rise further as well for similar reasons. With limited downside and huge upside potential (75%+), shares of Zix seem like a compelling short.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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Short Zix Insurmountable Competition