Is Zix Corporation Stock (ZIXI) Undervalued?

ZIXI stock has shown up on many of my screens before and every time it did not make it to the Value Stock Guide Watch List. At a first glance, the stock indeed looks undervalued on many levels but a deeper look reveals a different picture. I want to outline my reasons on why I do not consider this stock undervalued below.

Zix Corporation Background

Zix Corporation provides secure email and encryption services to law offices, government agencies, health care provides and insurance companies, financial services industry and SEC. This service is provided using Software as a Service (SaaS) model. The company is based out of Dallas, Texas.

There are many other competing service providers for secure email including the open source PGP encryption technology, Cisco Systems, McAfee and Trend Micro.  The barriers to entry in this industry is relatively low, patents notwithstanding. Some of the competitors are large enough to materially erode Zix’s market share if they wish. Zix however looks appealing at the first blush due to its reported PE ratio of 4.49 and what appears to be a trailing 12 month EPS of 0.66. This EPS though translates to a total net income of $42.49 million. Zix’s ttm revenues only amounted to $37 million. So what explains this abnormality?

Tax Benefits

Zix has accumulated $75.35 million in accumulated US deferred tax assets. These are a result of its historical losses. These deferred tax assets are recognized if it is more likely than not that they can be used to offset future earnings. In Dec 2010, Zix chose to recognize a large portion of these assets. $35.5 million was applied right away as a benefit on the income statement, and another $34.3 million was moved to the balance sheet as deferred tax assets. As a result, this has added $0.53/share in EPS to its ttm earnings.

Without the use of these tax assets, Zix’s EPS for the trailing 12 month is $0.12/share which gives it an adjusted PE ratio of 23.82.

This of course, is a far cry from the reported PE ratio of 4.49 at popular financial sites.

Balance Sheet Strength

Currently Zix sports a Price to Book ratio of 4.46. It has $22 million in cash out of the total assets of $63.66 million. With a market value of $191 million, Zix shares are terribly over priced based on its balance sheet strength. One can argue, that for a software company that relies much more on its intellectual capital to generate revenues (rather than factories and equipment), it is to be expected that P/B ratio will be high. I will accept this argument but we should also consider the following.

Zix reported negative shareholders equity until Mar 2010 quarter. Subsequent to that the equity turned positive due to improving business conditions. However, the equity got a quantum boost in Dec 2010 quarter when $34.3 million in deferred and unapplied tax assets were moved to the balance sheet. Excluding this asset, the P/B ratio is 22.

(in millions) Sep-30-2011 Dec-31-2010 Dec-31-2009 Dec-31-2008
Cash 22.03 24.62 13.31 13.24
Total Assets 63.66 66.85 19.75 19.36
Total Liability 20.73 19.96 21.74 20.66
Equity 42.92 46.89 -1.99 -1.3

 

But then, an asset is an asset and if business continues to improve this asset will retain value. This is just a cautionary insight to illustrate the fact that one must look beyond the numbers to understand what is really going on in the business.

Earnings are Rising

(in millions) ttm Dec-31-2010 Dec-31-2009 Dec-31-2008
Revenues 37.11 33.07 26.41 22.6
Gross Margin 81% 80% 83% 82%
Operating Margin 25% 16% 9% 7%
Adjusted EPS 0.12 0.08 0.04 0.03
SGA 42% 49% 60% 63%
R&D 14% 15% 14% 12%
Rev Increase (over prior period) 12.22% 25.22% 16.9%  
EPS increase (over prior period) 50% 100% 33%  

 

The table above is adjusted to net out the deferred tax income from the Dec, 2010 and ttm columns. As you can see, the company has been consistently improving its operating margin over the years as its SG&A costs are spread over an increasing revenue base. The R&D expense has been consistent as a percent of sales. Whether the company is able to increase its net income depends on whether it is able to keep its sales growing as well as how much SG&A leverage it still has left.

As a value investor, I tend to be a bit skeptical of a company’s future growth. In this case, next 5 year growth is estimated to be at 20.83% which still gives the shares a PEG ratio of 23.82/20.83 = 1.14. This shows that the stock is fairly valued based on the expected growth rate. However, as the table above shows, the EPS is fairly sensitive to the revenue growth and even a slight decline in revenue will have a disproportionate effect on the EPS. This is largely due to the fact that in a highly competitive market like this, Zix has to continue investing in R&D to keep its market share.

Share Repurchase

Improvement in the balance sheet and the outlook for future business has given the management confidence to announce a $15 million share repurchase program that expires in Jul 2012. For a $191 million market value company that is NOT undervalued by most measures, I believe that this share repurchase program is ill advised and will have very little to no effect on the stock price when completed.

Bottom Line

The stock is fairly valued to over valued and therefore I have no interest and cannot recommend a purchase of ZIXI stock. The future may be rosy, but the historical losses do not inspire much confidence in the management’s ability to keep executing. Neither does the level of competition in the industry.

Avoid at current levels. Purchase when the stock falls to $1.5 or below.

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