Symantec (NASDAQ:SYMC) has rallied since the turn of the year, returning 26% YTD largely based on future growth potentials. I have been bullish on Symantec over the past few months due to its strategic acquisitions, which, I believe, will soften the blow from the declining consumer security segment which drives profitability and FCF yield.
The driver for my new short thesis is a tripod which rests on three legs, namely:
- A recent multiples expansion which has driven Symantec’s near-term valuation into undefendable territories.
- A low likelihood of more multiples expansion, given that the stock is now pricing more growth and EBITDA margin expansion than management will guide for in the coming earnings season since we are at the tail-end of the share buyback program, which has been the tailwind for the first leg of the gains which started 1H’2016.
- A host of negative news which might drive up cost as Symantec will have to beef up its IP; hence a ramp-up in OPEX. I project existing customers pulling back on added services off the back of the negative news and I see Symantec spending more on sales & marketing to win new logos.
Melding the legs of the tripod firmly on a bearish turf is the moderation in synergy expectations, which might drive lower-than-expected gains from new acquisitions, most importantly, LifeLock.
Here is how to play the coming earnings season.
Symantec’s past earnings report have managed to come slightly above guidance to a narrow beat.
This, coupled with back-to-back raised guidance, has driven more multiples expansion towards unsustainable territories. Fundamental metrics, including EV/EBITDA and EV/Sales, have gained from Symantec’s ability to meet back-to-back growth estimates based on recent acquisitions.
As highlighted severally by Paulo Santos, a sudden dearth of the growth story will blow out the synergy narrative given that the denominators (FCF, EBITDA, Sales) for most valuation metrics have been mostly overlooked.
Since Symantec is currently trading at a valuation above guidance, we need to ask what institutional and retail investors know that management isn’t aware of.
I priced Symantec at a fair value of $28/share for 2017, and in the absence of a major catalyst, I believe any upward ramp in valuation is only inviting unnecessary short interest.
Therefore, pre-earnings, a short position in Symantec will offer more reward as it will be hard for management to carry on the growth narrative stripped out of bottom line profitability or FCF yield, given moderate competitive moat/advantage on the demand side.
Analysts are somewhat bullish on the stock. According to Morgan Stanley:
Symantec gets an over-weight rating with a PT of $37 due to deep dive which increased confidence in high-single-digit revenue growth for FY18/FY19, via stronger Enterprise assets garnering a higher percentage of the mix and LifeLock driving growth in Consumer.
The analyst sees an opportunity for operating margins to improve to 36% by FY19 from 28% Dec15.
Despite the 27% stock appreciation over the last 3 months, current valuation continues to undervalue SYMC’s enhanced market positioning and significantly improved profitability.
On the contrary, I expect Symantec to announce a growth in OPEX, which won’t be supportive of the FCF yield the market is pricing as it will need to beef up its brand advantage, given the recent scandal with its SSL certificates amidst other growing concerns that might arise from cross-selling LifeLock in the consumer security segment.
Also, given the small deal sizes of the consumer security segment, I expect that to cap marginal upsides, putting more pressure on the enterprise security segment to sustain the growth narrative.
Given management’s guidance for its top line (fiscal 2017 revenue to be up 11% to 13% to $4.040 billion to $4.120 billion), putting unneeded pressure on the enterprise segment to drive more multiples expansion will come at more cost to operating and profit margins.
As a result, I feel the upcoming earnings season will provide mixed results as management faces the dilemma of moderating the growth narrative via the synergies versus addressing the issue of declining profit margins, which is now pressurized from unwarranted multiples expansion in recent months.
Given that the market prices the stock on growth and not profit margins, I feel management will, in the least, uphold the growth story. This might cause an earnings surprise to the upside, jeopardizing the pre-earnings short thesis.
However, post earnings and CC, any upward rise in valuation or multiples expansion will only make Symantec a big fat floating bubble. This only means one thing. A pressure on management to deliver unactualizable earnings. At this point, the institutional owners will have no choice but to unwind their bullish positions as the potential gains from 2018 will now be overpriced in the stock. In an attempt to pick profit that hasn’t been realized, short interest will stifle the bullish narrative and there will be no support for more upward valuation. At this point, the risk/reward will be heavily tilted towards heavy multiples compressions, and the fear of an inevitable earnings miss will precipitate a sell-off.
Pre-2H’17, a short position in Symantec will prove profitable especially call options expiring by Q3 earnings as any marginal upside post upcoming earnings will only make it cheaper shorting Symantec, meaning investors have little to lose holding a short position. At that point, all that will be required for a sell-off will not be more than a bearish rumour.
Risk to the thesis
Blue Coat is capable of achieving an annual run rate of $800MM by 2H’17 based on its contribution to sales in the last quarter. Since the enterprise division now comprises +60% of sales, LifeLock’s ability to balance the decline in the consumer segment means Symantec can achieve $5.25 billion in sales for FY’18, in line with analysts’ projections. This will not only sustain the current valuation, it also has the potential to expand valuation multiples.
Currently, the stock is priced for perfection given that Symantec is yet to earn these lofty numbers. Therefore, any soft or narrow miss would have a detrimental effect on current valuation as analysts will have to rerate for softer earnings.
Furthermore, a comparison with competitors (Palo Alto (NYSE:PANW), Fortinet (NASDAQ:FTNT), Check Point (NASDAQ:CHKP)) in the cyber security sector reveals that Symantec is slightly undervalued on both growth and profit margins. This might delay any near-term correction in the absence of macro headwinds.
Large bullish positions will most likely suffer more from headwinds than Symantec’s valuation can currently accommodate. Therefore, I believe the risk/reward is tilted towards more downsides and the current bull market, which has favored equities is the vital bolt preventing Symantec’s current acceleration from grinding to a halt.
I reiterate my PT of $28 with a downgrade from HOLD to SELL.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.