Carbonite Founders Have Moved On; Investors Should Too

Sources: New Constructs, LLC and company filings

The bull case depends on CARB successfully repositioning from providing consumer cloud backup to providing disaster recovery and business continuity solutions to small/medium-sized businesses.

To establish an enterprise services presence, CARB purchased EVault assets from Seagate Technology (NASDAQ:STX) and Double-Take Software from Vision Solutions (private). EVault assets were purchased from STX for just $14 million. Double-Take’s $65 purchase price was 73% less than the $242 million Vision Solutions paid in 2010. Developing these relatively small investments in discarded assets into an edge over well-established competitors strikes us as a longshot. The current stock price implies it’s a high likelihood.

Bulls assume that synergies from recent acquisitions will cause revenue to accelerate while expense growth moderates. It is far from certain that recent acquisitions will bring the advertised revenue synergies. We also believe the competitive landscape will prove too challenging for CARB to back off expenses. CARB is more likely to be forced to spend aggressively in the near term to integrate acquisitions and pursue revenue opportunities. Under this scenario, reaching the profitability levels implied by current market expectations seems very unlikely.

As noted above, we believe the near-term investment required for CARB to reposition from consumer to enterprise is likely to prolong the current period of losses. As such, we believe that earnings expectations for next year (currently $1.00/share) are far too high and likely to be revised lower as actual earnings are reported.

Market participants have shown themselves to be more than willing to fund operational losses that drive high revenue growth rates, however. Revenue growth, however, is where we believe CARB will truly disappoint investors.

As noted previously, we argue that CARB’s organic revenue growth in 2Q17 vs. 2Q16 fell to near 0% excluding the revenue contribution of Double-Take Software. If the consumer segment was operating within negative 10% to 0% growth guidance and the enterprise segment was growing in line with “bookings” growth of 20%-30%, then CARB’s organic revenue growth (excluding Double-Take) should have been 5%-15% in 2Q17, not 0%.

Given the intense competition on the consumer side and the company’s too-little-too-late entry into enterprise services, we believe that revenue growth is a high risk of disappointing over the coming year.

CARB shares have risen 16% YTD and 46% over the past year to outperform the S&P 500 (+9% YTD, +13% 1Y). This appreciation occurred, despite the steep YTD decline in NOPAT, due to speculation that the company can successfully re-invent itself. Market expectations for 2017 profits (i.e. “consensus EPS”) have increased 33% over the past year to $0.75/per share. However, this estimate reflects company-defined “non-GAAP EPS” which excludes a host of real costs. For comparison, “non-GAAP EPS” has totaled $0.50 over the trailing twelve months compared to economic EPS of -$0.26.

To justify its current price of $19/share, CARB must grow NOPAT by 11% compounded annually for the next 19 years. This scenario assumes CARB grows revenue to $910 million (from $220 million TTM) or 8% compounded annually. This scenario also assumes the NOPAT margin improves to the sector median of 5% (-2% TTM). Achieving this scenario seems highly unlikely given that the consumer half of the revenue base is in decline while the enterprise half has yet to display evidence of sustainable growth at levels consistent with investor expectations.

Even if we assume CARB can grow NOPAT 18% compounded annually over the next decade, the stock is still worth only $13.50 today – a 29% downside risk. This scenario assumes CARB grows revenue to $533 million, or 10% compounded annually. This scenario also assumes an improvement in NOPAT margin to 5%.

Each of these scenarios assumes CARB is able to grow revenue, NOPAT and FCF without increasing working capital or investing in fixed assets. This assumption is unlikely but allows us to create optimistic scenarios that demonstrate just how high expectations embedded in the current valuation really are. For reference, invested capital increased from $39 million in 2012 to $86 million TTM, or 19% compounded annually.

The largest risk to any bear thesis is what we call “stupid money risk”, which means a strategic buyer acquires CARB at a higher price despite the stock already being overvalued. In our view, CARB is not currently an attractive acquisition target due to its questionable competitive position and lack of consistent free cash flow.

We begin assessing acquisition value by adjusting for liabilities that would make an acquisition more expensive than accounting numbers suggest. For CARB, these liabilities equal 7% of market cap:

1. $24 million in off-balance-sheet operating leases
2. $15 million in outstanding stock options.

After adjusting for hidden liabilities, and baking in meaningful revenue growth and margin synergies, CARB is worth less than its current share price even in the most optimistic scenario. As shown below, an acquisition of CARB above the current price is possible only if the acquirer is willing to destroy shareholder value.

Figure 5 assumes an acquirer’s ROIC hurdle in an acquisition of CARB is equal to the software sector’s 6% weighted average cost of capital (WACC). Even if an acquirer can grow CARB’s revenue 20% compounded annually and operate at a 5% NOPAT margin over the next five years, the stock is currently overvalued by 18%. Any deal that only achieves a 6% ROIC would likely be value neutral and not accretive given the software sector’s average WACC of 6%.

Figure 4: Implied Acquisition Prices to Achieve 6% ROIC