This firm was once at the forefront of a new industry, but commoditization of its core product and lack of innovation has resulted in management’s attempt to re-invent the company through acquisitions. Profit growth expectations embedded in the stock price are likely unfeasible in light of current financial performance and formidable competitive challenges.
We think execution risk is high and the probability of upside to already high expectations is low. The firm lacks a clear competitive advantage amidst a sea of well-established rivals. Carbonite, Inc. (CARB, $19/share) is this week’s Danger Zone pick.
Carbonite Background
Carbonite Inc. (CARB) offers cloud-based data storage and back-up solutions to businesses and consumers. CARB was among the first to offer cloud back-up services to the masses and went public in 2011 at $10/share. Since the IPO, the proliferation of cloud storage options and lack of timely innovation has resulted in the loss of first mover advantage and a deteriorating competitive position.
CARB’s legacy consumer data back-up business is in decline. The company is now repositioning itself through acquisitions to target the business continuity and disaster recovery markets. The two original founders remain on the Board of Directors, but their focus appears to be on outside endeavors. The duo has raised capital for a cloud data storage start-up, called Wasabi, to compete directly against Amazon Web Services (AWS).
Slowing Growth Gives Way to M&A
CARB has grown revenue 24% compounded annually since 2012. Over 60% of this growth (in dollar terms) has come since the end of 2015 by way of two acquisitions, which totaled $80 million in deal value. Revenue growth had slowed to 11% in 2015 before jumping to 52% in 2016 and 29% over the trailing twelve months (TTM).
Most recently, revenue growth slowed to 10% in 2Q17 vs. 2Q16. This increase was mainly driven by the recent Double-Take Software acquisition. Without this acquisition’s $5-$6 million quarterly revenue contribution (per company guidance), it appears CARB generated little-to-no organic revenue growth over the TTM.
Figure 1: CARB’s Revenue Growth & NOPAT Margins
Sources: New Constructs, LLC and company filings
Profits Remains Illusive
CARB has not achieved consistent profitability since going public. The company posted a break-even 0% NOPAT margin in 2014. Profitability then swung between -7% and +2% NOPAT margins over the next two years. CARB’s current NOPAT margin has dipped to -2% (TTM) due to expense growth. 2Q17 total expenses increased 23% vs. 2Q16 while 2Q17 revenue increased only 10% vs. 2Q16.
In addition, free cash flow (FCF) swung to -$76 million TTM from $10 million in 2016 due to the decline in NOPAT and capital investment in acquisitions.
Per Figure 2 below, management’s focus on non-GAAP metrics creates an illusion of profitability. Specifically, management’s definition of ‘non-GAAP net income per share’ allows for the exclusion of: purchase accounting adjustments, stock-based compensation, litigation expenses, acquisition expenses, intangible amortization, non-cash convertible debt interest expense, and the tax effect of non-GAAP adjustments at a 13% effective rate.
Removing so many expenses relevant to the operations of the business, especially with the new acquisition-driven strategy, is suspect.
Figure 2: Non-GAAP EPS vs. Economic EPS
Sources: New Constructs, LLC and company filings
Poor Return on Invested Capital
CARB’s return on invested capital (ROIC) has averaged -5% over the past two years. The current ROIC of -9% (TTM) is in the bottom quintile of our coverage universe and well below the median 5% ROIC generated by 230 companies in the software and services sector.
The main impediment to higher ROIC is NOPAT margin as the balance sheet is relatively efficient. CARB’s capital turnover ratio (revenue divided by invested capital) is 2.6 compared to an average of 1.3 for the software and services sector. For the company to earn an adequate ROIC above the cost of capital, it would need to earn a 3% NOPAT margin on TTM revenue without growing invested capital.
This hurdle appears manageable given the software sector’s median 5% NOPAT margin. However, a low single-digit profit margin provides little room to maneuver, while invested capital seems more likely to balloon than remain flat given the investment in new business lines and acquisition-driven strategy.
Executive Comp Aligned with Misleading Metrics
We know from numerous case studies that changes in ROIC are directly correlated to changes in market value. Accordingly, we favor compensation plans that use ROIC to measure performance to ensure executives’ interests are aligned with shareholders’ interests. Revenue and non-GAAP performance targets can be an incentive to sacrifice profitability for volume, or worse, engage in acquisitions that destroy shareholder value.
