RealMoney Silver - WBSN: Trying to Make Some Websense

WBSN: Trying to Make Some Websense
By Bill Trent
RealMoney.com Contributor
3/13/2008 3:25 PM EDT

Websense (WBSN) seems like a study in contrasts. The stock has shed more than a third of its value over the last couple of years in the face of declining earnings and cash flow. However, analysts covering the company have raised their 2008 earnings-per-share estimate by nearly 8% over the last couple of months, and the stock has recovered by a similar amount.

The big question is whether the latest moves are a head-fake, or represent an opportunity to get in near the bottom before the fundamental changes are widely recognized.

The Promise of SurfControl

Websense provides companies with Internet security tools to mitigate risks associated with malicious attacks, spyware, phishing and spam. It also provides tools for companies to analyze and monitor employee Internet usage. After doubling in size with its October 2007 acquisition of SurfControl, Websense is the category leader with a 21% market share. Websense generates nearly three quarters of its revenue in the Americas.

Facing declining growth rates from its large enterprise customers, Websense expects its growth to come from the small- and medium-business (SMB) market. In July 2007, it launched Websense Express, its first product designed specifically for the SMB category. It appears as though the initiative is bearing fruit, as deferred revenue (license sales that will be recognized in future periods) have increased more than 30% year over year, well ahead of the 17% growth rate in revenue as recognized. Since the deferred revenue will be recognized in the future, the increase in deferreds bodes well for future revenue growth.

Due to the way Websense must account for its acquisition of SurfControl, it will not recognize significant revenue until SurfControl customers renew their licenses, and it will also encounter higher expenses due to capitalized acquisition costs being written off over a four-year period. Cost of sales increased to 14% of sales in 2007 from 9% in 2006, though absent the acquisition-related issues, the increase was to a more modest 10.6%.

Some Concerns About the Future

Not surprisingly, earnings quality as measured by the accrual ratio declined significantly after the acquisition. A combination of higher sales (both through organic growth and the renewal of SurfControl licenses) and stabilizing costs (as the full-year amortization costs in 2008 will not rise further and will eventually go away) should boost the profitability over time unless further large acquisitions are made.

Of greater concern to me is the declining cash flow from operating activity. Cash from operations should be relatively immune to such accounting issues. The culprit is rising working capital, in particular, accounts receivable and "other" assets and liabilities. Since these cash flows are reported net of the acquired assets and liabilities, they can't be blamed on SurfControl.

The security software market, however, is extremely competitive. In addition to the traditional security providers, such as Symantec (SYMC) , McAfee (MFE) and SonicWALL (SNWL) , Websense must deal with offerings from Microsoft (MSFT) , Cisco Systems (CSCO) , Google (GOOG) and others. Maintaining or growing the market share in this environment is likely to become more, not less, difficult.

Showing Caution

The $48 million in free cash flow Websense generated last year equates to a 5.1% free-cash-flow yield, about double the yield on five-year Treasuries. Analysts are projecting a 13% growth rate over the next five years, but 28.4% for this year. Given the growth in deferred revenue, I think this year's growth number will be easily met. That means that the 13% five-year rate only requires 9.5% growth in the remaining four years.

With estimates rising, the growth estimates appearing conservative, and a solid free-cash-flow yield, I like the prospects for Websense over the longer term. However, I'll be approaching an investment cautiously.

On the fundamental side, I'd like to see the earnings quality and cash-flow improvements start to show up. Absent that, the chart could look a bit stronger -- especially given the whipsaw market we've been in lately.

I'd normally look at writing put options here, but the price is too far from any strike price to make the premium sufficiently attractive to me. Whether higher or lower, I'd prefer a different entry point. A pullback to recent lows would boost the free-cash-flow yield above 6%. Alternatively, better price action would give me more confidence that the bottom is really in place.