We are maintaining our BUY rating on NortonLifeLock Inc. (NGS: NLOK) to a target price of $27. This ‘perpetually in turnaround’ cybersecurity company appears to have finally found its footing under new CEO Vincent Pilette. We like the fact that management has set clear goals, executed well, and delivered solid results. The company has no doubt benefited from COVID-19 effects, with rising demand for remote connectivity as masses of workers have moved to work-from-home. While critics might question whether the trend is sustainable, the addition of 600,000 new customers over the last year is an indisputable fact. We have already seen many companies extend work-at-home well into 2021, if not indefinitely, for many employees. It will now be up to Norton management to execute on both retention and expansion initiatives.
Management first set a clear direction for the company by becoming a pure-play consumer cybersecurity business with the sale of the Enterprise Security business in November 2019. Management has also expanded the product line from the venerable Norton security firewall business into personal identity with the LifeLock acquisition, and now is expanding further in personal privacy protection and more with new add-on and stand-alone products. At the same time, NLOK has been converting from a transactional perpetual license model to the typically more profitable recurring fee-based model. In addition, it has begun to invest in both direct-to-consumer marketing as well as in indirect sales through partners like AARP, while also looking to expand overseas.
We see NLOK as undervalued relative to peers given its ability to achieve its clearly stated goals.
NortonLifeLock reported results for fiscal 2Q21 (ended October 2) on November 5 after the close. In 2Q21, the company beat the consensus revenue estimate by $3 million and the consensus EPS estimate by $0.03. Second-quarter revenue rose 3% from the prior year to $626 million, and was up 2% sequentially. Adjusting revenue for the ID Analytics business divestiture in April and negative FX impacts, non-GAAP revenue rose by 5% or $31 million. Billings, a non-GAAP metric that includes revenue plus the quarterly change in contract liabilities, rose 7% or $42 million. Management attributed the billings growth to traction on customer acquisition and retention. The company added 100,000 customers in 2Q21 and 600,000 year-over-year, for a total customer count of 20.7 million. ARPU increased 2.5% from the prior year to $9.10, and was up sequentially from $9.03 in 1Q21.
Non-GAAP operating income rose 72% from the prior year to $314 million. The non-GAAP operating margin expanded by 20 percentage points to 50%, management’s target margin. The sales of the Enterprise Security business in fiscal 3Q20 and the ID Analytics business in 4Q20 have had a remarkably positive impact on margin expansion, though this impact will begin to level off in 3Q and 4Q21 as the company laps those divestitures. GAAP operating income more than doubled to $230 million. Non-GAAP diluted EPS also doubled to $0.36 from $0.18 in 2Q20.
EARNINGS & GROWTH ANALYSIS
We are raising our FY21 non-GAAP EPS estimate to $1.42 from $1.33 and our FY22 forecast to $1.55 from $1.50. NLOK achieved its operating margin goal of 50% in fiscal 2Q21; now it must sustain that margin.
The November 2019 sale of the Enterprise Security segment to Broadcom was probably the most significant strategic turn in a series of asset sales and restructurings at this ‘perpetually in turnaround’ cybersecurity company. NLOK changed its name to reflect its new status as a pure-play consumer cybersecurity company. Management believes that it can move the residual Consumer Cyber Security business from flat/low single-digit growth to mid-single-digit growth over the long term on a base of about $2.5 billion per year, with above 50% operating margins and EPS growing faster than revenue. Apart from simply ramping up marketing efforts, annual marketing spending has increased by 50% to $300 million, management is looking to grow direct-to-consumer and indirect sales, and bolster customer retention in several ways. It is pushing to convert transactional customers into recurring fee-based members, and adding functionality to provide more value and thus increase average revenue per user. The company now has half of its customer base on its Norton 260 software-as-a-service platform. NortonLifeLock has also begun to release new add-on and stand-alone products, including Dark Web Monitoring, Privacy Monitor Assistant, and Norton 360 for Gamers, thus appealing to consumer niches. While just about 10% of the company’s customer base is through partners (indirect sales), NortonLifeLock sees the low penetration as an opportunity for growth. Management also sees an opportunity to expand its LifeLock personal identity theft protection service in international markets.
Fiscal 2Q21 was the last quarter in which NortonLifeLock had to work off the stranded costs from its recent divestitures, with a remaining $10 million in costs. Even including these costs, the company met its operating margin target. As part of its cost cutting, the company has laid off a significant portion of its workforce. Management has realized $875 million from asset monetization through sales of real estate and other assets, out of an expected $1.5 billion. However, COVID-19 effects have slowed these real estate sales. Management is looking to generate $1.50 in annualized EPS after the transition period. While NLOK appears to be finally getting on track after its many M&A deals and management changes over the last three years, CEO Vincent Pilette has warned that growth will be ‘non-linear,’ which we take to mean bumpy, with both up and down quarters.
Norton LifeLock declared a $12 per share special one-time cash dividend on January 9, 2020. The special dividend, $8 billion in the aggregate, partly fulfilled management’s commitment to return to shareholders 100% of the after-tax proceeds from the sale of the Enterprise Security assets. NLOK has also initiated a $1.6 billion share repurchase program. The special dividend went ex-dividend on February 3; this led to a 40% crash in NLOK shares – as is often the case with a large cash dividend payout.
NLOK management sees the sale as another step toward remaking the company into a pure-play consumer security business. The transaction was completed on January 31.
On November 7, 2019, NortonLifeLock announced that CFO Vincent Pilette would take over as CEO on November 8. Mr. Pilette joined NortonLifeLock in May 2019. Samir Kapuria, general manager of the Consumer Business Unit, was promoted to president.
With seven different CEOs over the last eight years, management change has plagued the company, and we think the market has punished NLOK shares for this uncertainty. However, the market appears to have approved of the sale to Broadcom and management’s pure-play consumer security transformation strategy.
FINANCIAL STRENGTH & DIVIDEND
At the end of 2Q21, the company had $1.05 billion in cash and $3.6 billion in total debt, though only $47 million in current debt. Fiscal 1H free cash flow was a paltry $54 million. NLOK expects to generate $900 million in annual free cash flow once it completes its transition to a consumer-focused company. The ratings agencies rate NLOK’s debt in the mid-B’s, two notches below investment grade. Outlooks are stable.
NLOK’s regular quarterly dividend is $0.125 per share or $0.50 on an annual basis. The current yield is about 2.5%. We are maintaining our dividend estimates of $0.50 per share. NLOK repurchased an insignificant amount of stock in 1H20; however, it did spend $1.9 billion to retire convertible notes, which had the effect of reducing the diluted share count by almost 40 million shares. Management is looking to buy back shares opportunistically. The company repurchased $1.58 billion of its stock in FY20. The share count fell 7% year-over-year in 2Q21.
MANAGEMENT & RISKS
Management turnover had become a primary risk for NortonLifeLock given the number of different CEOs the company has had over the last several years. At a minimum, rapid CEO turnover creates uncertainty both within and outside the company about its strategic direction, confusing both employees and investors. At worst, CEO turnover represents a vote of no-confidence in NortonLifeLock’s business by a succession of key leaders of that business. With Mr. Pilette, now in place for the last year, NortonLifeLock has begun to show some stability.
NortonLifeLock appointed Natalie Derse as its new CFO on July 8. Ms. Derse spent nine years as a finance executive at eBay and previously held financial positions at Black & Decker and GE. Investors could face significant losses if NortonLifeLock’s financial results come in below expectations. The company’s results could be hurt if technology spending does not grow as expected or experiences another downturn. With the Broadcom sale, NortonLifeLock has, at least, narrowed its competition down to just consumer enterprise security companies from a combination of both consumer and enterprise security rivals. The company continues to face competition from Intel’s McAfee, Check Point Software Technologies, Kaspersky Internet Security, Bitdefender, and a number of smaller competitors in what has become a largely commoditized market. Moreover, Microsoft has entered the IT security space and has invested heavily in efforts to reduce security vulnerabilities in both existing and future products. Nevertheless, Microsoft products continue to be prime targets for malicious viruses. Like its competitors, NortonLifeLock must keep pace with the rapid pace of developments in internet technology and the even swifter evolution of cyber threats.
NortonLifeLock is a pure-play provider of consumer internet security products. The company has made a series of transformational moves with the sale of its Veritas information backup and storage business to the Carlyle Group for $5.3 billion in January 2016. The company’s Norton brand is one of the most recognizable names in the software industry.
NortonLifeLock shares have been range-bound between $17 and $24 year-to-date and are currently below the midpoint of the range. NLOK topped out above $28 just before the $12 per share special dividend became payable on January 31, then took a 40% dive. However, since February 3, NLOK is up 10.4% on a capital-return basis, compared to a 12.5% gain for the S&P 500. NLOK’s forward enterprise value/EBITDA multiple of 10.1 is 37% below the peer average, compared to an average discount of 44% over the past two years. We are maintaining our BUY rating on NLOK to a target price of $27.
On November 16, BUY-rated NLOK closed at $19.14, down $0.66.