Bill Snyder

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McAfee Hacks Into Success

Bill Snyder

Less isn't always more. But in the case of McAfee(MFE), the No. 2 provider of antivirus software, less has been a winning strategy.

Since shedding its former moniker -- Network Associates -- and three underperforming business units in 2004, the Silicon Valley-based company has seen its stock appreciate by more than 60% while profit and revenue in the first quarter jumped by more than 30% on a pro forma basis. Once a weak player in two of its three lines of businesses, McAfee has slimmed down to focus on its core strength -- Internet security software -- and is getting good reviews from much of Wall Street in the process.

It hasn't all been smooth sailing. Archrival Symantec(SYMC) has been strengthening its hold on the fast-growing consumer market, while Tokyo-based Trend Micro is winning share in the commercial market, according to NPD Group. And privately held WebRoot, NPD says, is making a big splash in the nascent market for antispyware.

What's more, the fight for the $5.4 billion security software market is about to get even rougher.

Symantec shareholders on Friday approved the acquisition of Veritas(VRTS) to form a security and storage software giant. And Microsoft(MSFT), the world's largest software company, is slowly moving into the market for Internet security, leading some analysts to wonder if McAfee can survive the onslaught in the long term.

For now, though, Wall Street is betting that McAfee can continue to grow. Analysts polled by Thomson First Call have a median price target of just under $30, while some targets are higher, including one by Sarah Friar of Goldman Sachs, who sees "upside to the mid-$30s." On Friday, the stock closed at $25.57.

McAfee's transition to a "pure play" flies in the face of an overall trend in software -- away from so-called best-of-breed players, which specialize in a relatively narrow set of skills, toward providing a much broader set of software and services. Giant software companies like Oracle(ORCL) and IBM(IBM) exemplify the trend at the highest level, but even smaller players like Lawson Software(LWSN) are swallowing competitors in an effort to add new tricks to their repertoire.

McAfee tried that in the late 1990s -- with limited success. "Our idea was to become a broad provider of information technology," said Vince Rossi, the company's senior vice president for product marketing. A few years later, the company was caught up in an ugly (and not completely resolved) accounting scandal that led to a change in management and the criminal indictment of several former senior executives.

With a mandate to make major changes, new CEO George Samenuk sold off Sniffer Technologies, its network management arm, for $235 million, and Magic Solutions, its help desk-related product line, for $46 million. (A third and much smaller sale had little effect on the company's business.)

The resulting shake-up focused the company on the fast-growing security market, a segment driven by well-publicized hacker attacks on everything from credit card companies to instant messages. Market researcher Gartner says that license revenue from security software of all types totaled $5.4 billion in 2004, and will likely reach $6.6 billion in 2005 and $11.4 billion by 2009.

At first glance, the divestitures delivered a blow to McAfee's top and bottom lines. Including the former businesses, annual revenue was off by 2.8% in 2004 while pro forma net income dropped 15.6%. But when the divested businesses are excluded, which is how analysts are beginning to look at the company, the story is different.

A year earlier, in the first quarter of 2004, revenue from the company's security business totaled $174 million; this year, that grew to $235.7 million, a jump of 35.5%. (If the divested businesses are factored in to the year-ago figure, total revenue grew from $219.1 million to $235.7 million, a gain of just 8%.)

Similarly, GAAP net income dropped 38% in the quarter, to $35.9 million from $57.9 million. But on a pro forma basis that excludes one-time gains from 2004's results, the company would have earned $45.6 million, or 27 cents a share -- more than twice the $20.9 million, or 11 cents a share, recorded in last year's comparable quarter.

Consumer revenue jumped by 114% with help from digital providers including the AOL division of Time Warner(TWX), Japan's NTT DoCoMo and Spain's Telefonica that distribute McAfee's software to their customers.

McAfee has made a few purchases of its own under the new regime, including Foundstone, IntruVert and most recently Wireless Security, but unlike the buys in the '90s, these deals were carefully focused on security.

"McAfee does a good job of adding more network-oriented technologies both through acquisition and through internal development, and the fruits of this can be seen in the new integrated products rolling out over the next several quarters," says Friar. Goldman Sachs is seeking investment banking business with McAfee.

Now the trick will be to hold off the opposition. Symantec, of course, is already formidable, and has been stealing share from McAfee. According to NPD, McAfee's share of the consumer antivirus market dropped from 22% in 2002 to just 11.8% in 2004, while Symantec's grew from 78% to 88%.

Whether Symantec will be even more formidable with the added firepower of Veritas is unclear. On the one hand, Veritas adds a well-trained sales force that may be able to cross-sell Symantec security products. And it will benefit from the growing customer preference to minimize its list of software vendors.

But Veritas has no direct expertise in security software, so some analysts say the combined companies won't have much synergy and won't be an added threat to McAfee.

A key battle to watch: the shift of McAfee's sales force away from a direct model to an indirect one. In the past, McAfee has not been seen as channel-friendly, while Symantec has been very strong. McAfee's efforts to change its spots appear to be succeeding, but if it fails to make continued headway in distribution, investors will have reason to be unhappy.

Then there's Microsoft. In May, the Redmond, Wash.-based giant did what analysts had been expecting for some time, announcing a consumer-oriented package called OneCare, which will include automatic antivirus and antispyware updates, two-way firewall protection, disk clean-up and defragmentation tools, and file repair capabilities. The company will roll out a beta, or test version, later this year, but has not announced when the software will go on sale.

There's no agreement on how big a threat Microsoft poses. It certainly has the muscle to wage a nasty price war, and will likely make it very easy for users of its Windows software to add the new security products to their computers. But because its own software has had so many well-publicized security holes, it isn't clear how much trust OneCare and other security products will engender, particularly in the corporate market.

Being No. 2 in a consolidating market that is being eyeballed by far bigger fish -- Cisco(CSCO) is playing here, too -- is not the easiest hand to play. Ultimately, McAfee may lack the bulk to compete against its larger brethren. But for now, it looks like it has shaken off the Network Associates yoke and is ready for the next round.