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Background – Raytheon’s Forcepoint Division

We’ve talked previously about the Forcepoint cybersecurity division lurking in the corridors of Raytheon (RTN). In the context of Raytheon’s overall business, it is a small unit, underperforming, not growing all that much, not generating much operating income, and – we believe – throwing off little if any cashflow. In financial year 2018 the unit achieved $634m of revenues, representing just 2% of group revenue.

Raytheon acquired this business fairly recently. It was formed by the acquisition of Websense from Vista Equity Partners in May 2015, rolling that in with certain lines of business formerly sat in RTN’s Intelligence, Information and Services unit in order to create the new Forcepoint business, and then selling 19.7% of the equity in Forcepoint back to Vista for a consideration of $343m. A couple further acquisitions have been rolled in too. So today Forcepoint is a joint venture with Vista, a software-focused private equity fund, indeed one of the more successful funds in recent years.

Why The Underperformance?

Forcepoint is languishing under RTN’s control. It is barely growing and it appears to make no money. This in a market – cybersecurity – that is one of the highest-growth segments of the software & IT services industry. Why? In a word, because Forcepoint is marooned.

Forcepoint doesn’t – shouldn’t – matter to RTN because it’s 2% of revenue and zero percent of earnings, and it doesn’t – shouldn’t – matter to Vista because their share of Forcepoint represents no more than 1-2% of their assets under management by our estimate – and that is very probably overstating it.

Corporates and private equity funds rarely form joint ventures, for the reason that private equity funds are usually closed-ended entities that need to liquidate their holdings entirely within a 10-15 year period, in order to distribute cash back to investors. Corporates are open-ended entities that do not ever need to liquidate business units unless there is a particular reason to do so (unit has become non-core, leverage is too tight, shareholders are clamoring for cash distributions, etc). Having one shareholder that is likely to own forever, and one shareholder who needs to sell soon, isn’t a recipe for success. In the case of Forcepoint the potential deadlock has been resolved by a shareholders’ agreement whereby Vista can exercise a put option to require RTN to buy out its holding – this has been exercisable since May 2017 – or RTN can exercise a call option to buy Vista out – in each case at fair value as defined by the JV agreement (which we haven’t seen). Finally, Vista has a right to require Forcepoint to IPO at any time after August 2019. (You can read all this in Note 8 to RTN’s Q1 2017 10-Q and indeed earlier filings).

So the underperformance doesn’t entirely surprise us. Nobody in the RTN C-suite or the Vista partnership will make or break their career if Forcepoint hits the cover off the ball or sinks without trace.

There’s another issue too. The bulk of the revenue comes from internet security businesses which were a little long in the tooth even when Vista bought them (this in fact is Vista’s original specialty – reviving legacy software businesses). And whilst a specialist could indeed revive them with re-investment in product development, improved pricing yields, new sales efforts, etc – a corporate like RTN won’t, because it’s not a priority.

In our conversations with RTN management they have all but confirmed that the Forcepoint business is non-core, and at least one tier-1 Wall Street bank has put out a note recently stating the same. So we believe this unit is slated for disposal at the right time.

We think the right time is – now. And we think there’s around $1.5bn of free money available for RTN. Below we explain why and how.

How Valuation Multiple Arbitrage Generates Free Money

Due to its small size, Forcepoint’s valuation multiples under RTN’s ownership are in essence the group valuation multiples. RTN is a federal defense contractor and valuation multiples tend to be muted in this sector, certainly relative to the software sector.

RTN today is valued at 1.9x TTM revenues and 13.1x TTM EBITDA. We’ve used the closing share price on 23 May 2019, and the latest reported cash and gross debt data from their Q1 balance sheet of 31 March 2019. Shares outstanding comes from Ycharts.

Source: Company SEC filings, YCharts.com

Cybersecurity software companies are typically valued much more highly. We’ve selected five of the top names in the sector below – the companies are Symantec (SYMC), Sophos (OTCPK:SPHHF), Carbon Black (CBLK), CyberArk (CYBR) and Zscaler (ZS). Broadly they are split between legacy players (SYMC, SPHHF) and new, cloud players (CBLK, CYBR, ZS).

You can see that valuation is more or less a function of revenue growth. A regression analysis doesn’t work well as the upper ends of revenue growth tend to make software investors go weak at the knees – so the disconnect between sub 30% growth and above 30% growth – and in particular above 50% growth – means that a line of best fit looks like a hockey stick!

No matter. What we are concerned with here is what is Forcepoint worth. It’s more akin to a legacy player than a new cloud player. So let’s use SYMC and SPHHF as comparables. Revenue growth is of the order of 7-9% depending on how you measure it – at the low end, recognized TTM revenue growth from Q1 19 vs Q1 18 was 7.6%; and at the upper end, growth in ‘backlog’ as RTN call it – probably ‘orders’ or ‘deferred revenue’ in software-speak – was 9.1% (source: RTN company SEC reports).

So on a simple revenue multiple basis, Forcepoint is probably worth around 3.3x TTM revenues, which would mean approximately 3.3 x $651m = $2,148m – rather than the 1.9x TTM revenues in the group RTN valuation which implies 1.9 x $651m = $1,237m. So here we have about a billion dollars of free money we just found from nowhere, were RTN to sell the business based on legacy cybersecurity software valuations. The magic of market multiple arbitrage.

But there is more yet to be had.

Taking It To The Next Level – Selling on a Pro Forma Basis

In fact, we believe RTN could realize more value still. Were they to appoint Morgan Stanley, Goldman Sachs or similar to sell Forcepoint, here’s the likely basis of the pitchbook to buyers – particularly to private equity funds who are we believe the most likely type of buyer.

First, the pitchbook might argue – correctly in our view – that the business is starved of attention and funding within RTN and therefore it does not grow as quickly as it should. It might say that in fact despite being unloved it is still growing at nearly 10% per annum. It might speculate that, were it to be run by a dedicated, equity-incentivized management team, that the business could grow in the range of 15-20% per annum, achieved through a combination of price increases in the subscription base, more investment in new name wins, and further product-based acquisitions. So on that basis they will be arguing that in fact it’s worth a revenue multiple of somewhere between that of SPHHF and CBLK above. Let’s split the difference and call it 3.9x TTM revenues.

Next, the pitchbook might say – let’s adopt a “pro forma” mentality, imagining the business today as it could be tomorrow. (For a longer discussion on the use of the pro forma treatment in acquisitions, see our note on the $10bn space-sector acquisition of Orbital ATK by Northrop Grumman here. Used correctly, it’s a perfectly reasonable lens with which to view acquisition valuation.)

On that basis, let’s imagine the business is run by the above top-grade management team. It would be unusual to be making less than 20% EBITDA and cashflow margins if it is achieving only 15% revenue growth. (Note to the uninitiated – software is a wonderful business model. It involves almost no capex and very often you get paid upfront so your working capital is in your favor. A well-run software company growing revenue in the 10-20% range often has more cashflow than it does EBITDA).

Looking through a pro forma lens, let’s say that revenue continues to grow at the current recognized rate of 7.6%. That suggests $700m revenue for the year ending 31 March 2020. Pro forma EBITDA margins of 20% means $140m of EBITDA for the same period. Now, let’s look at what kind of EBITDA multiple should apply. Looking again at the comps above, we can disregard the new cloud players CBLK, CYBR and ZS – they’re either not profitable or so crazily valued on revenue multiples that the EBITDA multiple is meaningless. Let’s turn again to the legacy players SYMC and SPHHF. SPHHF is growing at a similar kind of rate as Forcepoint and it has margins in the same ballpark as the pro forma for Forcepoint. SYMC is going backwards on the top line but has margins precisely where Forcepoint could be. So let’s take the average of the two, for want of a better method. That gives us 20.5x EBITDA as a valuation.

We’re going to apply those multiples to the pro forma revenues and EBITDA at 31 March 2020, because carveouts take a long time to prepare, auction and close – so when the new owner completes the deal, that date won’t be far away.

On this basis, our boundary valuation estimates for the sale of Forcepoint are:

  • 3.9x pro forma TTM revenues of $700m = 3.9 x 700 = $2,730m
  • 20.5x pro form TTM EBITDA of $140m = 20.5 x 140 = $2,870m

Happily these valuations have converged nicely. The multiples aren’t out of line with comps, and they aren’t out of line with the levels being paid by cash-rich, target-scarce private equity firms right now. Even better for RTN, there are a LOT of private equity firms big enough and software-skilled enough to do this deal. Vista itself would be #1 in line we expect – it can buy this from a different pool of money to the one holding its 20% stake, nothing wrong with that if correctly handled by way of a third party valuation; Thoma Bravo would be next in line; then Permira, TA Associates and plenty of others would be at the door. Run correctly, such an auction could well deliver a $3bn sale of Forcepoint.

So if we are in RTN’s shoes, or those of their M&A advisor Morgan Stanley, Goldman or whomever – we see a nice payday ahead.

We can sell a business worth $1.2bn under our ownership today, for at or around $3bn. Hey presto – $1.8bn of free money. As an 80% owner, RTN would take home about $1.4bn of gains.

Lest anyone think the above is creative accounting – it’s pretty much exactly how a tier-1 Wall Street bank sells a business like this, and it’s pretty much exactly how a big private equity firm buys a software business. So the gains we highlight are genuine possibilities for RTN.

What Does One Do With a Spare $1.8bn?

In its Q1 earnings report, RTN stated it had c.$2bn cash on hand – so selling Forcepoint could add around 70% to its cash balances before taxes on the gain. At a time when RTN’s core market is expected to continue to grow, due to the increasing level of geopolitical tensions, we think RTN could achieve a great deal were it to invest the additional funds wisely – in product development or perhaps acquisitions, since they are a serial acquiror. Alternatively, after taxes the funds would likely pay for a full year’s dividends based on the current forward yield of 2.1%, freeing up that cash for re-investment in core business growth.

What We Would Say to RTN’s Management And Board If We Could

Appoint the right advisor. Sell Forcepoint. Now.

Cestrian Capital Research, Inc – 24 May 2019.

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