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Why McAfee Looks Like a Secure Play

By Jonathan Rudy, CFA Standard & Poor's believes software maker McAfee (MFE

; recent price, $23) will benefit from the increasing importance of Internet security, with computer viruses and worms being released faster and growing increasingly complex. McAfee is a pure play on Internet security, in our opinion, particularly since it recently sold its noncore businesses to focus on its security offerings. At S&P, we think this strategic realignment has transformed McAfee into a faster growing, more profitable company.

We see McAfee benefiting from a growing market. The security-software market is expected to expand nearly 15% a year through 2008, according to International Data Corp. IDC estimates that secure-content-management software, which includes antivirus software, will grow at a 17% annual rate through 2008.

While investing in McAfee entails risks, most notably the competitive threat from Microsoft (MSFT

; 5 STARS, strong buy; $24), we believe these risks are reflected in the share price. McAfee has a strong brand name in the security-software industry, in our opinion, and we believe that the company will be able to fend off Microsoft's advances, particularly on the enterprise side of the business.

CLASS LEADER. McAfee is trading at a discount to its Internet Security peer group but should increase its earnings faster than peers, in our view, due to a streamlining aimed at concentrating on its faster-growing and more profitable security business. McAfee has also significantly improved its balance sheet, with approximately $925 million in cash and investments and no long-term debt at the end of 2004. With what we see as McAfee's strong brand name, attractive valuation, strong balance sheet, and improving profitability, we have a 5 STARS (strong buy) recommendation on the shares.

McAfee provides best-of-breed security offerings, in our view, that are designed to prevent intrusions on networks and protect computer systems from the next generation of blended attacks and threats. Its products include antivirus and intrusion-prevention offerings.

Its two product families are McAfee System Protection Solutions and McAfee Network Protection Solutions. Its McAfee products include enterprise, small and midsize business (SMB), and consumer products. McAfee's corporate security offerings, which include its enterprise, SMB, and Intrushield products, accounted for approximately 56% of revenues in 2004. Consumer security products, which include its Web site, as well as retail offerings, contributed approximately 33% of revenues in 2004.

GLOBAL REACH. McAfee's enterprise offerings include its Entercept host-based intrusion-prevention products, and its Intrushield network intrusion-prevention products. The company acquired both Entercept and Intrushield in 2003. In 2004, Intrushield's revenue grew 55% year-over-year, to approximately $44 million, and accounted for approximately 5% of McAfee's total revenues.

McAfee derives approximately 59% of its revenues from North America. The Europe, Middle East, and Africa region accounts for approximately 28% of revenues, and Japan, Asia/Pacific, and Latin America contribute the remaining 13%.

McAfee's primary competitor, Symantec (SYMC

; S&P investment rank 3 STARS, hold; $21), is in the process of a $13.5 billion merger with Veritas (VRTS

; 3 STARS; $23). In our view, this planned merger will not only distract Symantec's management from executing in its Internet Security business but will also prevent it from being a pure play on the attractive security-software market. Data backup, recovery, and application-performance management, while solid businesses, in our opinion, are growing at slower rates than the security-software market.

HIGH PRIORITY. Our primary concern regarding competition, however, is Microsoft's entry into the antivirus and spam-filtering markets with recent acquisitions. While we believe Microsoft should never be taken lightly when it stakes out new territory, we see it focusing on the lower-end consumer, someone who wants a free or inexpensive product without a lot of hassle. We continue to view McAfee as having a technology advantage to Microsoft's offerings, in addition to providing a broader suite of functionality. We believe Microsoft will be a threat primarily to McAfee's consumer products.

We see McAfee improving its profitability dramatically over the next couple of years. On an operating basis, we anticipate that operating margin will rise to approximately 25% in 2005, from 13% in 2003. While the 2004 numbers have several moving parts due to the sale of its Magic and Sniffer divisions, we anticipate that operating EPS will improve to $1.05 in 2005, from 59 cents in 2004. We see McAfee earning $1.10 a share in 2006.

We believe Internet security remains a high priority for info-tech departments. Spending in this category held up through the technology downturn as enterprises couldn't afford to justify cutbacks because the risks were, and are, too great. According to a survey by CIO magazine in January, 2005, 56.6% of CIOs surveyed plan to increase their security software spending in 2005, while 38.2% plan to maintain their current levels, and only 4.4% planned a decrease. Overall IT budgets were expected to increase 5.4% in 2005, according to the same survey.

GROWING MARKET. IDC forecasts the security-software market to reach nearly $16 billion in 2008, up from $8.1 billion in 2003, or a compound annual growth rate of 14.7%. Security software is growing faster than the broader software market and the overall IT market, which IDC estimates will increase between 5% to 7% annually from 2004-08.

IDC projectst that secure-content-management software, which includes antivirus software, Web-filtering software, and messaging-security software, will grow to $7.2 billion in 2008, up from approximately $3.3 billion in 2003, or a compounded annualized growth rate (CAGR) of 17%, which is the fastest-growing component of IDC's total worldwide security-software forecast.

Additionally, IDC forecasts the intrusion-detection and vulnerability-assessment market to grow to nearly $1.6 billion in 2008, up from approximately $830 million in 2003, or a CAGR of 13.8%. We believe that this market segment represents the greatest potential upside for McAfee due to its Intrushield product line. Revenues for Intrushield are at low levels currently, but we believe that this intrusion-prevention product has the capability to be very successful in the enterprise market.

TRADING TRENDS. Based on Standard & Poor's Core Earnings methodology, our estimate of 2005 S&P Core EPS is 25 cents, compared to our operating EPS estimate of $1.05 -- a 76% differential. This difference primarily reflects the potential impact of expensing stock options. While this amount remains notable, we're encouraged by what we view as significant improvement compared to McAfee's 2004 S&P Core EPS, which we estimate being a loss of 21 cents per share (a 136% differential from operating EPS of 59 cents).

We believe that with McAfee focused on improving profitability and reducing its stock-option issuance, it will see a further narrowing of the gap between S&P Core Earnings and operating earnings in future years.

McAfee stock is trading at a discount to its Internet security peer group based on p-e-to-growth (PEG) and price-to-sales metrics. The company's peers currently trade at an average PEG multiple of 1.5 times, and approximately 5.2 times sales. McAfee now trades at a PEG multiple of approximately 1.1 times, based on our earnings projection of 20% growth, and a price-to-sales multiple of about 4 times trailing revenues. Based on our

discounted cash-flow analysis, we arrive at a fair value of approximately $32 per share.

Our 12-month target price of $32 per share is primarily based on a blend of these relative metrics and our discounted cash-flow analysis. We believe that a PEG multiple of 1.5 times for a company that's growing faster and is more profitable than its peers is appropriate given our view of McAfee's strong brand name and exposure to faster-growing Internet security markets. According to the Institutional Shareholder Services (ISS) database on corporate governance, McAfee outperformed 50.9% of the companies in ISS' Software & Services group.

MICROSOFT'S SHADOW. Our investment recommendation and target price have some notable risks. Specifically, McAfee recently announced that during its Sarbanes-Oxley preparation, it might have one or more internal-control deficiencies over financial reporting. Accordingly, McAfee has said it will delay filing its 2004 10-K with the Securities & Exchange Commission and that the filing should be completed by the end of March, 2005.

Additionally, the threat from Microsoft can never be dismissed. While we believe it's going to concentrate on the low end, it's always a threat in whatever market it enters due to its enormous resources.

Competition in the security-software industry remains intense, in our view, specifically from Symantec. And with that rival's planned acquisition of Veritas Software, the combined company could offer a broader suite of products and services that McAfee may not be able to compete with on its own or in a partnership.

McAfee receives approximately 41% of its revenue internationally, so any notable weakness in the dollar could have a negative impact. Additionally, as with any tech company, a rapidly changing technology landscape could also change our view of McAfee's current lead over most of its competitors. Analyst Rudy follows shares of systems software companies for Standard & Poor's Equity Research Services

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