NCC Group a Fast Growing IT Security Stock

NCC Group gave interim results last week and they were warmly received by the market. This is a UK based small cap IT company, but before international stock pickers turn away, I suggest taking a closer look. This stock offers a compelling proposition of offering a highly cash generative business model as well as strong secular growth prospects.

Before discussing the results, I want to outline the nature of the company.


A Secular Growth Stock

NCC core business is software escrow. In other words when a company buys some developmental software, it has to carry the risk that the developer could go bust or disappear. Holding the software code in escrow will help to mitigate this risk, because the company can always retrieve it. The defensive nature of this business was put to the test in 2008-10 and it passed with flying colors. NCC was not able to implement the Co's annual price increases, but with this result NCC confirmed that the price hikes are now back.

The second main division is Assurance, and this focuses on the high growth are of information security. NCC have been acquisitive in this area and has built revenues steadily over the years. NCC offers a range of services and cross sells them across the constituent parts. NGS secure sells security testing services. Site Confidence sells web performance and load testing services. SDLC is a UK based testing services provider.
Finally, US based iSEC Partners sells security testing mainly to the US.

The iSEC acquisition is expands NCC presence in the US, where NCC are seeking to also expand software escrow revenues.


NCC Interim Results

I liked these results. Some bullet points

• Closure of the under performing general IT consulting unit
• Group orders and renewals at £41m vs. £30.9m last year
• UK Escrow annual price increases re-implemented with 5% hike
• Assurance growing strongly due to acquisitions, but underlying profits still rising at 6%
• Margins reducing because Assurance (lower margin than Escrow) is becoming a larger share of sales
• High cash flow generation and the current ratio is falling

I think the closure of the general IT consulting unit has been due for some time. NCC reported that

 

The Group's withdrawal from the general IT Consultancy market resulted in a one off exceptional charge of £950,000, of which £450,000 is non cash related.  Total post tax losses from discontinued operations were £1.1m in the period compared to a profit of £182,000 in 2009

This means that the reported results contain losses of £1.1m from attributable profit which makes 3.1p of diluted EPS. The adjusted diluted cash EPS actually rose 24.6% from 12.2p to 15.2 with the trailing EPS at 32.4p giving a PE ratio of 640/32.4=19.7 times.

The disposal is good news because NCC can now focus on growth.

NCC Set for Growth

I've broken down half year historical numbers for Escrow and Assurance here. NCC year end is in May, all data in millions.

	Nov 2007	May 2008	Nov 2008	May 2009	Nov 2009	May 2010	Nov 2010
UK Escrow	7.8	7.9	7.9	8.7	8.5	9.4	9.2
Eur Escrow	.1	1	1.2	1.2	1.4	1.5	1.5
US Escrow	.5	.7	.8	1.2	1	1.2	1.1
Total Escrow	8.4	9.6	9.9	11.1	10.8	12.2	11.9
Assurance	5.8	7	7.7	18.1	11.3	19.5	21.1

Clearly, the acquisition led growth in Assurance is shifting revenues towards a lower margin division. Furthermore, it is interesting to note that non-UK escrow revenues have gone from 7.1% to 21.8% in the last two years. This is partly due to the inability during the recession to implement price rises and from the international expansion plan. Nevertheless, growth has been excellent and few IT companies can boast anything similar over the last few years.

Turning to segment profitability

  

	Nov 2007	May 2008	Nov 2008	May 2009	Nov 2009	May 2010	Nov 2010
Escrow Profit	4.6	5.6	5.5	6.2	6	7.3	6.7
Margin %	55	58.3	56	55.4	55.4	60.1	56.1
Assur Profit	.8	.9	1	2.6	1.3	2.7	2.4
Margin %	14	13	13	14.1	11.8	13.8	11.5
Total Margin %	38	39.1	36.9	29.8	31.6	32.2	27.6

The reduction in margin can be seen in, however, profits are growing strongly. Moreover, this has always been a highly cash generative business. Trailing free cash flow is 12.1m which puts it on a FCF Yield of 5.6% with strong growth due in the second half. Historically, the second half is stronger and NCC expects the same thing this year. 

Consensus forecasts are for £70.4m in revenues, EPS of 36.6p and pre tax profits of £17.2m with a market cap of £214.5m.  I think this stock is better priced at aroud 710-725p.

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Blue Coat Ready to Take on Riverbed in WAN Optimization?

Optimizing IT Performance

Blue Coat Systems International $BCSI is an interesting stock that is focused on some high growth areas in technology spending. The co is well positioned in  providing Wide Area Network Optimisation Controllers (WOCs) , Secure Web Gateway and Application Performance Monitoring. These are set to be high growth areas in future, thanks to the explosion in bandwidth usage and mission critical nature of the Internet and cloud computing.

In summary, Blue Coat is an interesting value type of play. I argue that Blue Coat is in the 'value' category of stock because Blue Coat have some restructuring issues following disappointing European sales in 2010. The company has increased margins over the years with cost cutting by moving workers to Bangalore, however, earnings growth in future will be guided by a resumption to top line growth. If Blue Coat achieve this, than I would argue that they present good value.


Wide Area Network Optimization the Key Growth Driver

The WAN  industry is growing strongly as bandwidth usage expands exponentially. In addition, WAN optimisation provides a relatively short return on investment and can generate growth even in slower economic times. Bandwidth isn't the only issue as the usage of business applications over the WAN isn't linear. In other words, WAN resources might be needed at unexpected times.

The leader in this space is Riverbed Technology and $RVBD appear to offer a superior solution to Blue Coat in terms of WAN optimization. However, Blue Coat's solutions offer an integrated approach which can incorporate security and performance measurement in 'one box'. If a customer wants an integrated approach, he will favour Blue Coat. For pure WAN optimisation, he is likely to turn to Riverbed. It is incontestable that Riverbed has outperformed Blue Coat this year, but if Blue Coat can turnaround execution difficulties the company should have enough of a differentiated offering in order to grow revenues.

The likes of Cisco, Citrix Systems and F5 Networks all play in this market but they tend to offer specific or expensive large enterprise or data center solutions.

As stated in their Q2 results announcement, WAN optimization-rather than Network Security-appears to be their growth focus

'growth in the traditional enterprise portion of the Secure Web Gateway market has slowed. At the same time, we have been too dependent on selling into the company’s substantial installed base and in fact, we are very effective at lining that installed base last year'

 Blue Coat already has a strong market share in Secure Web Gateway with large enterprises and growth is slowing.


Blue Coat European Troubles in 2010

Blue Coat gave a horrible trading statement in May at the final results. Blue Coat's year end is in April.The essence of the problem lies within European sales

 

Region	Q2 09	Q3 09	Q4 09	Q1 10	Q2 10	Q3 10	Q4 10	Q1 11	Q2 11
Americas	61,295	44,110	52,663	53,305	55,255	53,561	58,344	54,612	56,937
EMEA	37,586	43,905	39,731	41,753	44,952	50,531	47,924	42,207	40,889
APAC	20,143	21,581	21,228	20,931	20,229	23,024	26,325	25,661	23,221
Total	119,024	109,596	113,622	115,989	120,436	127,116	132,596	122,480	121,047

 source: Blue Coat

I've put the European sales numbers in red to highlight when growth turned negative on a quarter to quarter basis. Initially, the company blamed the macro economic environment, however after closer inspection it became clear that executive and operational changes needed to be made.

Whilst Riverbed, in Europe, had focused on direct contact with key accounts in Northern Europe, Blue Coat had taken a different approach. Blue Coat Europe is supposed to run their global model of a blend of one and two-tier distribution approaches. Unfortunately, they seemed to be over relying on the two tier model, which caused problems when the slowdown hit. Ultimately, the sales force was focused on selling into the installed base and when their sales quotas proved too high, the sales guys were disheartened.


Restructuring Blue Coat

Blue Coat didn't stand still in dealing with the problems. Brian NeSmith was moved from CEO to Chief Product Officer and industry veteran Mike Borman was brought in as CEO. He promptly inked a two deals. One with Alcatel-Lucent in order to sell Blue Coat's CacheFlow solution to Telco's, ISPs and mobile operators.Similarly, a deal was done with Brocade to co-develop a network health monitoring solution for telco Co's. Given Borman's three decade experience with IBM, speculation is bound to ensue over closer collaboration between the two Co's. Particularly, as IBM is rumoured to be on the acquisition trail.

In addition, the European sales operation has been restructured with Borman recently stating that sales there were stabilising. Blue Coat has new products coming in the new year and this should help drive growth. The focus is on the high growth WAN optimization market, whereby they have to compete with Riverbed.

Another area of growth is Asia, whereby Blue Coat is not strongly established. The management is keen to expand in the region and in particular in China, where there are only ten employees at present.


Exposure to Public Expenditure Cutbacks?

Blue Coat like most other significant IT firms (Riverbed etc) does have exposure here. It is something that I am concerned with, as Governments (particularly the UK) have been cutting back on their IT spending budgets. This area will give Blue Coat exposure to the business cycle, however I think they may fare well due to WAN optimization offering a cost saving solution. Similarly, the network security is hardly an area that is easy for Government to cutback on. Nonetheless, a reduction in growth in public IT spending will result in a knock on effect to the likes of Blue Coat and Riverbed.


Blue Coat Growing Margins

Margins have been growing, thanks to downsizing and shifting employees out to Bangalore. However, I suspect that future growth will come from growing top line revenues as this process appears to be largely complete.

%	2009	2010	H2 2011
Non-GAAP Gross Margin	75.7	76.7	79.8
Non-GAAP Operating Margin	12	17.4	21.1
FCF Margin	6.8	15.9	18.7

source: Blue Coat, Earnings View


To put these numbers into context, the current market cap of 1.35bn with an EV of 1.14bn. Analyst forecasts are for Revenues of 498m and 535m to April 2011 and 2012 respectively. EPS forecasts are for $1.53 and $1.62.

On a free cash flow basis the stock is good value, for example if they play out the H2 FCF Margin and hit 498m forecast (I consider this forecast conservative) they will generate a FCF/EV of over 8.1%  This is cheap for a company growing earnings at double digits.

The question is, will they start to see growth get back to double digits in line with other cloud computing plays?


Blue Coat a Stock to Buy?

Frankly, I'm not sure. Whilst Riverbed looks fairly valued (analysts are starting to make a lot of long term assumptions over their earnings) I think Blue Coat still offers good recovery potential. The WAN optimization market is clearly lowly saturated and looks set for strong growth. Moreover,the restructuring looks to have been carried out in earnest and they do have good momentum in Asia.

On the downside, if Blue Coat don't get back to generating growth, than Blue Coat will have to erode margins in future by rethinking the business. I would look for confirmation of a turnaround in Europe in the next results. Furthermore, the  core business of Secure Web Gateway has slowed and I suspect this is the major cash generator. They are trying to move into the mid-level security market, but this has proved problematic for Websense recently.

I will monitor results.