PSB Monthly Issue December 2010

Cutting edge technology isn’t always the best place to invest.  Just being the latest and greatest technology is no guarantee of success.

You see, a great idea may never truly reach its financial potential.  Remember, the first pioneers always ended up with the arrows in their back!

A new technology needs to be a great idea… but it also needs to be in a great industry.

What makes an industry great you ask?  One with the potential for exponential growth.  And therein lies the challenge…

We’re looking for a great technology – a real game changer.  Plus, we’re looking for an industry with real growth potential.  It’s a rare combination to identify.

Let’s start off by identifying a great technology.

One of the most promising new technologies is cloud computing.  It’s all the rage right now.

Cloud computing is basically computing over the internet.  It’s a way for shared resources, like software and information, to be provided on demand.

So what makes this technology such a game changer?

With cloud computing, companies don’t need to spend a ton on huge capital expenditures like mainframe computers and fancy servers.  They don’t have to figure out how to set up a complex network in the office or how to secure the data. Someone else is taking care of all those things.

Here’s the key…

It’s much cheaper, easier, and safer for the experts to handle the hardware and setup.  And, it lets the end-users grab what they need when they need it.

More importantly, cloud computing is growing like crazy.  Companies can’t wait to save money and time by adopting cloud computing for their own business.  Major players such as Google and Amazon are already using cloud computing.

But it’s not enough just being in the cloud computing space.  Maximizing the potential for growth is also part of the equation.  And growth depends not just on the technology, but on the industry.

One industry with great potential is internet security.  It’s the perfect forum for cloud computing.

Think of all the data traveling over the internet.  Think of how many emails are sent every day.  The amount of data is astronomical… and we’d love for all of it to be secure.

That’s why internet security is so important.  It’s a part of our everyday lives even if we don’t realize it.  Do you send emails?  Do you shop online?  You’re able to do so because of internet security companies.  Their products make using the internet and email secure and efficient.

What exactly is internet security?

In a nutshell, internet security is a collection of different methods for protecting against attacks over the internet, or having your data stolen.

There are several forms of internet attacks.  They have colorful names such as malware, spyware, Trojan horses, worms, viruses, and spam.  You don’t have to understand what they all are… just realize people and companies don’t want any of those on their computers or networks.

Some of the pieces making up the internet security industry include network security, email security, firewalls, and internet protocol.  These are all widely employed methods of internet security.  Several companies make their living off these different components.

Here’s the thing…

Internet security is being revolutionized by cloud computing.

It may not be the flashiest industry.  Internet security isn’t as high profile as say, a Google application.  But we’re talking about an absolutely vital industry.

Plus, it’s also an enormous industry.  Some conservative estimates put internet security at over a $50 billion industry.  I think it’s even bigger.  The potential for growth is out of this world.

More importantly, internet security companies are gaining extreme benefits from cloud technology.  You see, internet security combined with cloud computing means massive amounts of data can be analyzed quickly and effectively.  And that means safer and faster networks.

But what is really intriguing is the industry’s growth potential.  In particular, the growing need for internet security solutions in Asia is off the charts.

Check out these numbers…

There are roughly 4 billion people in Asia.  According to the latest data, about 700 million of them use the internet right now.  That’s only 18.5% of the population in Asia using the internet.  In comparison, almost 74% of North Americans are on the net.

Do you realize what that means?  There are literally billions of people who will start using the internet in the near future.  And every one of them will need internet security technology of some kind.

Now more than ever, it’s a great time to be a company in the internet security industry.  And one company in particular is using cutting edge technology to make their products the best on the market.

Introducing Commtouch Software (NASDAQ: CTCH)…

THE INTERNET SECURITY BUSINESS

CTCH is a leading provider of email defense and URL filtering solutions.  These solutions include real time anti-spam, zero hour virus outbreak protection, and zombie detection.

Wait… virus outbreak?  Zombie detection?  Is this some kind of Hollywood horror movie? Nope.  Those are just fancy names for ways to protect your network and website from outside attacks.

The company provides these services to internet service providers, networking companies, and even other internet security providers.  Those companies then integrate the CTCH products into their own product offerings.  This arrangement is called original equipment manufacturer (or OEM) distribution.

Here’s the deal…

It may seem like a weird business model, but OEM distribution has several benefits.  It’s a high margin business model with an extremely high customer renewal rate.  There’s very little marketing to the end-customer.  And there’s the ever important ability to cross sell products.

More importantly, the OEM model is obviously working for CTCH… They have over 125 OEM partners.

What’s more, the company just completed an acquisition of the Command antivirus division of Authentium, a privately held internet security firm.  This acquisition provides CTCH major inroads into the antivirus market – a major compliment to their current product offerings.  It also adds $3.5 to $4 million in expected revenue a year.

Here’s the best part…

CTCH has superior technology to their competitors.  By using cloud computing, the company’s technology has the ability to analyze 2.5 billion electronic messages a day.  Most of their competitors have nowhere near that kind of capacity.

And the future looks even brighter…

I mentioned above the huge growth potential of the internet in Asia.  As a matter of fact, only about 25% of the world’s population is on the net.  Obviously, the growth potential in this area is astronomical.  It’s about as extreme as it gets in terms of growth potential.

As the number of internet users grows, the need for internet security products will rise.  That means more demand for internet security products from companies like CTCH.

In fact, CTCH has increased their revenues from Asia by 45% over the past three years.  Clearly, management is targeting this growing region as a key source of future revenues.  Needless to say, it’s a wise decision by those running the company.

Now let’s take a closer look at the company’s financials.

THE NUMBERS

CTCH is a strong, well run company.

The company pulled in $4.6 million in third quarter revenue, compared to $3.9 million in the year ago period.  That’s a solid 18% increase.  And, revenues jumped 12.2% sequentially from the second quarter.  Clearly, CTCH is experiencing strong demand for their products.

What’s more, non-GAAP net income topped $1.5 million for a stellar 31% year over year.  And earnings per share picked up a penny at $0.06.

Even better, the company has an outstanding balance sheet.

CTCH is sitting on a pile of cash topping $12.5 million.  The company also has zero long-term debt.  That’s always a great sign.  What’s more, the company’s current assets are a robust 3.2x current liabilities.  Management clearly knows how to run a healthy company.

Another good sign management’s on top of their game… a share buy-back program.  So far in 2010, CTCH has purchased $3.3 million in shares towards their $5 million share repurchase goal.  Keep in mind, it’s almost always a good thing for shareholders when a company buys back its own shares.

And that’s not all…

Management increased guidance for 2010.  They expect revenues to come in at the top of their $17-$18 million range.  And net income is expected to reach $5.4 to $5.5 million… a very nice increase from the initial $5 million projection.

I probably don’t need to mention increasing guidance is an excellent sign for any company.  Nothing drives a stock better than rising revenue and earnings.

INVESTMENT RISKS

As you know, no investment is without risks.

The company’s growth depends in part on their technology.  If a competitor develops a product using superior technology, it could cut into future sales.

Also, it is possible CTCH’s OEM partners won’t choose to renew their partnership.  OEM renewal rate in the industry stands at over 90%, but there’s a small chance the company could lose some of its partners over time.

Finally, industry security standards could change.  If security standards change significantly, it is possible CTCH’s products won’t immediately meet the new industry requirements.

POTENTIAL RETURNS OF 100% OR MORE

Despite CTCH’s combination of strong growth and adept management, shares are badly mispriced.

At a recent price of $3.50, CTCH shares are trading at 14.6x earnings.  The shares may seem reasonably prices at these levels… but the industry average is at a far higher 28.6x earnings.  If CTCH simply trades at the industry average, the share price would jump 97%.

Trading at the industry average is a perfectly reasonable goal for a technology company with healthy growth and a strong management team.  But let’s use a more conservative 22x earnings to determine price.  That would work out to over $5.19 a share, or a stellar 50% return.

From the chart below, you can see back in late 2007, CTCH shares traded over $7.00. With the economy improving and the company’s sales growing, there’s no reason to believe CTCH can’t get back to those levels.  And I actually expect it to go much higher.

Based on our analysis, we see the stock trading up to at least $7.00.  Buy CTCH now for potential gains of 100% or more.

ACTION RECOMMENDATION

BUY Commtouch Software (NASDAQ: CTCH) up to $3.80 per share.

• Both Ultra Clean Technologies (UCTT) and PLX Technology (PLXT) have stabilized and are moving higher.  With the technology sector rallying, we’re moving UCTT and PLXT from Hold to Buy.  Grab your shares now if you don’t own them already.  They may not stay below their buy up to prices for long. Buy UCTT up to $9.90.  Buy PLXT up to $4.54.
• In our most recent Position Update, we recommended you Sell Omnova Solutions (OMN), Winner Medical Group (WWIN), China Gengsheng Minerals (CHGS), and Tianyin Pharmaceuticals (TPI).  We also moved China Valves Technology (CVVT) from Buy to Hold on price action.

Category: PSB Monthly Issues