(MENAFN- ValueWalk)
Failing to adapt in a timely fashion can send a business into a downward spiral. This firm's late transition to the cloud based software market has left it with falling profits, lagging margins, and a significantly overvalued stock. CommVault Systems, Inc. (CVLT: $61/share) is this week's pick.
Revenue Growth with No Profits to Show For
Per Figure 1, CVLT's revenue has grown 4% compounded annually since 2014 while its after-tax profit () has fallen from $65 million in 2014 to -$1 million over the last twelve months (TTM). The disconnect between revenue and profits comes from rapidly declining margins. The company's NOPAT margin fell from 11% in 2014 to 0% TTM.
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Figure 1: CVLT's NOPAT & Revenue Since 2014
Sources: New Constructs, LLC and company filings
Declining margins have sent CommVault's return on invested capital () into negative territory (-1% TTM). Further, the company has burned through a $25 million (1% of market cap) in cumulative since 2014. The firm's -$39 million in FCF over the last twelve months equates to a -2% FCF yield, which is well below the 2% average of the stocks in the S & P 500.
Compensation Plan Misaligns Executive Interests
CommVault's executive compensation plan fails to with shareholders' interests. The misalignment drives the profit losses shown in Figure 1. Worse, the current compensation plan allows executives to earn large bonuses while shareholder value is destroyed.
Executives' cash bonuses are tied to the achievement of goals. Non-GAAP operating income conveniently removes real operating costs such as stock-based compensation and tax expenses on stock options and restricted stock awards.
The performance measures used for equity awards include total shareholder return, revenue and non-GAAP operating income.
We've demonstrated through that ROIC, not revenue or non-GAAP metrics, is the . A recent white paper published by Ernst & Young also validates the importance of ROIC (see here: ) and the superiority of our data analytics. Without major changes to this compensation plan (e.g. emphasizing ROIC), investors should expect further value destruction. In addition, we suggest the board of directors, especially the compensation committee, consider their culpability and responsibility for the misalignment of interests.
Non-GAAP Metrics Hide the Firm's Profitability Issues
CommVault uses such as non-GAAP operating income and non-GAAP net income to overstate its true profitability. Our research digs deeper so our clients see through the illusory numbers. Below are some of the items CommVault removes to calculate its non-GAAP net income:
Stock-based compensation Payroll tax expense on stock options and restricted stock awards These adjustments have a large impact on the disparity between GAAP net income, non-GAAP net income, and . In 2017 and 2016, CommVault removed over $74 million (11% of revenue) and $64 million (11% of revenue) respectively in expenses related to stock-based compensation to calculate non-GAAP net income. When added with the other adjustments, CommVault reported 2017 non-GAAP net income of $48 million. Per Figure 2, GAAP net income was $1 million and economic earnings were -$5 million in 2017.
Figure 2: CVLT's Misleading Non-GAAP Metrics
Sources: New Constructs, LLC and company filings
Formidable Competition Limits Profitability Expectations
CommVault's business covers a wide-range of products and services, largely grouped into the data and information software application market. More specifically, CVLT provides software solutions that provide data protection, backup, and recovery, cloud infrastructure management, and data indexing/archiving. The data management market is highly competitive, with firms ranging from small one-off solutions to industry leaders with a suite of products able to meet the many needs of customers. The proliferation of cloud computing in recent years has also increased the competition in the market. Competitors include firms such as Oracle (ORCL), VMware (VMW), SAP, Dell EMC, International Business Machines (IBM), and Veritas (recently spun out of Symantec (SYMC) among others.
Per Figure 3, CVLT's ROIC and NOPAT margin fall well below nearly all competitors/peers. In fact, the only firm with a lower margin is prior . Success in the information software market is largely dependent on product functionality, scalability, and price. The firms with the highest profitability have greater flexibility to invest in product enhancement, new offerings, increased integration across data management, and ultimately undercut competitors pricing if necessary. Firm's with lower profitability, such as CommVault face consistent margin pressure and limited resources to build industry leading technologies.
Figure 3: CommVault Systems' Lagging Profitability
Sources: New Constructs, LLC and company filings
Bull Case Ignores CommVault's Struggles Post 'Transformation'
Prior to 2014, CommVault was consistently growing revenue and profits while selling its Simpana branded software platform. However, the shift to cloud based solutions, one-off software offerings (one piece of the data management 'puzzle), and even a shift from license to subscription based arrangements left CVLT behind in a rapidly changing industry. Since then, the firm has been unable to stop the downward trend in profitability. To buy into the bull case now requires belief that years of struggles are suddenly coming to an end, despite a more competitive market.
Beginning in 2014, CommVault began transitioning its business to address the changing landscape. The firm looked to build on its existing platform, move solutions to cloud-based services, and target standalone software solutions. Management was upfront about the struggles the company would face, but the results have not been as positive as expected. As early as fiscal 3Q15, management noted that the transformation of CVLT was designed to 'bring the firm back to historical financial performance in the second half of fiscal 2016.' However, profitability continued its decline, as NOPAT margin fell from 4% in 2015, to 0.3% in 2016, and then 0% in 2017.
The side effects of this business transformation have been rising costs that are eating away at profitability. Per Figure 4, research & development, sales & marketing, and general & administrative costs have risen 15%, 11%, and 8% compounded annually respectively since 2014. Meanwhile, revenues have grown only 4% compounded annually over the same time.
Figure 4: CommVault's Expenses Outpacing Revenue Growth
Sources: New Constructs, LLC and company filings
The growth in expenses presents a troubling situation for CommVault. The company must spend heavily in development and advertising to introduce new products and/or move into different pricing strategies. However, continued expense growth limits the firm's ability to achieve profitability. Further compounding the issue, creating new products always brings uncertainty and the firm must execute to perfection to ensure the market uptake.
Despite the execution risk, the expectations baked into CommVault's stock price imply that the firm will reverse years of issues, immediately achieve profitability, and significantly grow profits, as we'll show below.
CommVault's Valuation Implies Unrealistic Profit Growth
CVLT has risen 76% over the past two years and 24% year-to-date while the S & P 500 has risen 29% and 12% over the same time frames. This performance has occurred despite NOPAT and ROIC declining. This move
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