SonicWall: A Small-Biz Security Blanket

S&P sees good times ahead for the company, which helps small and midsize businesses keep their networks secure

Small and midsize businesses face a growing need for comprehensive network security offerings as they contend with threats such as viruses, spamming, and phishing. Additionally, companies need to protect their data from theft. According to AMI-Partners, a leading IT consulting firm, IT spending for small and midsize business is expected to increase 9% to 10% from 2004-10, more than twice the rate for large enterprises, and security was ranked as one of the highest spending priorities.

We think network-security specialist SonicWall (SNWL) is well-positioned to serve this market. We expect the company to leverage its leadership position by acquiring software offerings that complement its products. In our view, the acquisitions of Lasso Logic and MailFrontier have enabled SonicWall to sell additional offerings to its large installed customer base with minimal additional costs. In addition, we believe the company can increase its market presence in other market segments, such as Web filtering and anti-virus, through this strategy.

We view SonicWall shares as undervalued and compelling for purchase. Although the company doesn't produce a significant amount of earnings, it does generate a much higher amount of cash flow from operations due to its recurring subscription revenue model. The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).

Range of Offerings

SonicWall designs, develops, manufactures, and sells integrated network security, mobility, and productivity packages for small to midsize networks used in enterprises, e-commerce, education, health care, retail point-of-sale, and government markets.

The company sells two families of appliances: TZ and PRO. The TZ family of products is targeted to the small-biz market, while the PRO family targets large enterprises. Every appliance unit includes hardware, processor, and deep packet inspection firewall security, which is designed to protect private networks against Internet-based theft, destruction, or modification of data. It notifies customers if their networks are under attack. The appliance is capable of integrating additional solutions including gateway anti-virus, anti-spyware, intrusion prevention, enforced desktop anti-virus, content filtering, and wireless security. SonicWall generates approximately 49% of its revenue from the TZ family of products, 30% from its PRO products, and 21% from other products.

SonicWall's products are sold primarily through distributors who then resell to resellers and selected outlets. Distributors and resellers accounted for approximately 97% of the company's total revenue in 2005. Its largest distributor, Ingram Micro (IM), generated approximately 18% of total revenue in 2005.

Strength Through Acquisitions

We believe SonicWall is the market leader in network security for the small-biz space, with almost 1 million units shipped. The company's strategy is to extend its leadership position by continuing the transition from a single product firewall/virtual private network (VPN) company to a comprehensive provider of integrated security, productivity, and mobility offerings.

We believe SonicWall has strengthened its market position with several acquisitions. In the past year, the company acquired Lasso Logic, a provider of backup and recovery technology for the small- and midsize business market, and MailFrontier, a provider of secure content management and e-mail security. We believe data backup and e-mail security are two of the fastest growing segments in data security, and we think SonicWall can cross-sell these services to its installed customer base. Revenue from these acquisitions accounted for $5 million in the fourth quarter of 2006, but we project revenue growth of 20% for these businesses in 2007.

We believe another growth opportunity is international markets. International sales accounted for approximately 33% of the company's total revenue in 2006, compared to 34% in 2005 and 30% in 2004. The company witnessed 30%-plus revenue growth in Europe, the Middle East, India, and Latin America, and plans to boost sales distribution in India, China, Europe, and the Middle East by recruiting more channel partners. In addition, it plans to add localization processes and capabilities to its products.

Broadening Its Footprint

We believe SonicWall is well-positioned strategically. Although we view the firewall/VPN market as mature, we forecast growth in the midsingle digits for the small- and midsize business market for the next three to five years, which should provide a solid revenue base due to the company's leading market share. Meanwhile, we believe SonicWall should gain market share, vs. its main competitor, WatchGuard Technologies, which has been acquired by a private equity fund. We also expect the company to benefit from its relationship with Ingram Micro, one of the largest software distributors.

In our view, the security industry is consolidating, because customers are reducing the number of IT vendors in order to lower costs and the complexity of integrating diverse systems—especially in the small-biz market, where companies lack IT resources. We view SonicWall's strategy of broadening its footprint through acquisitions positively, and believe the company, with its large installed base, can enter new market segments by acquiring and cross-selling complementary software offerings.

We estimate the penetration rate of its recently acquired e-mail security and data backup recovery products in its installed customer base to be in the low teens. In our opinion, the company has a significant growth opportunity in merely selling to the current customer base. We project that revenue for these businesses will increase in excess of 20% annually for the next couple years.

Staffing the Help Desk

SonicWall sees an additional growth opportunity in mid-tier and large enterprises, as its products become more robust and more attractive from a price perspective. The company has recently increased its internal support staff in order to provide the more comprehensive help needed to serve large enterprises. While the increased headcount will likely have a negative impact on gross margins in the near term, we believe the increased capability should expand the company's market opportunity.

We estimate total revenue growth of about 16% in 2007, with product revenue rising 14%, reflecting a modest increase in the number of units shipped and a slight increase in the average selling price. We see the average selling price increasing when the company releases updated versions of its TZ family of products in the first half of 2007. By our analysis, international sales should advance to approximately 35% of total revenue, from 33% in 2006, due to increased marketing efforts.

Gross margins should narrow slightly in 2007, to about 70.5%, due to higher investment to develop internal customer support, with most of the costs incurring in the first half of the year. Longer term, we see gross margins rising above 72%. We expect operating expenses to decline as a percentage of revenue to 70% in 2007, from 75% in 2006, as the company achieves operating leverage. As a consequence, we forecast that non-GAAP (generally accepted accounting principles) operating margins will widen to 10.4% in 2007, up from 7.5% in 2006. We expect further expansion in operating margins as revenue increases.

Good Prospects for Growth

We estimate operating earnings per share of 6 cents in 2007, after 23 cents of projected stock option expense, compared to about breakeven in 2006. SonicWall generated approximately $30 million in cash flow from operations in 2006, which correlates to 43 cents a share. Deferred revenue increased 52%, to $67.9 million, at the end of 2006, from $44.6 million at the end of 2005. We forecast that earnings and cash flow will increase significantly faster than revenue.

In terms of valuation, we project that SonicWall will have a low operating margin for the next few years. Therefore, we believe it's difficult to evaluate the company based on earnings. Rather, we value SonicWall on a blend of our discounted cash-flow (DCF) analysis, as well as analysis of sales in relation to enterprise value (EV; a valuation measure representing a company's stock market capitalization plus its net debt).

Our DCF model yields an intrinsic value of $11. We derive a value of $10 based on an EV/sales multiple of 2.2 times our 2007 revenue estimate, a discount to the industry average of 2.7 times, due to our projection of low profitability for the company. We arrive at a 12-month target price of $11 based on a blend of these two metrics.

Pricing Pressure a Possibility

We view SonicWall's corporate governance policies positively. The board is made up of only one inside director, and no affiliated outsiders serve on the board. Additionally, the full board of directors is elected annually. Both the nominating and compensation committees are entirely comprised of independent outside directors.

In the area of takeover defenses, SonicWall doesn't have a poison pill in place. The fact that there's no dual-class capital structure is another governance practice that we view favorably.

On the negative side, in our view, the company doesn't utilize performance-based equity awards with specific performance criteria and hurdle rates disclosed. Also, mandatory holding periods for stock acquired upon exercise of options aren't disclosed.

Risks to our recommendation and target price, in our view, include the possibility of difficulty in integrating prior acquisitions, increased pricing pressure in the enterprise-security industry as the growth rate in the industry decelerates, and significantly larger competitors such as Check Point (CHKP) that may target the small-biz security market. Also, IT spending could be lower than projected due to a slowdown in the overall economy.

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