I have been following this stock for a while, and really like it. I have done a small summary piece on it if anyone is interested. The key to this stock is achieveing distribution success, and I am confident it will. Food for thought on this stock below. Note these are only my opinions.
SEN
Background
• Leading global supplier of high speed hardware encryption technology.
• Products have the highest international levels of accreditation – US EAL and US FIPS standard.
• High speed military grade encryption provided over copper wire and fibre optic networks
• Clients include: US Govt, US Military, Australian Govt, Australian Military, Saudi Military, large financial institutions, commercial and govt clients in Middle East.
• Key products: 1Gbs Ethernet encryptors, Cypherblade, SONET encryptors
Competitive Advantages
• Key competitive advantage is accreditation at US EAL and US FIPS standards. As it takes approximately two years for competitors to achieve similar levels of accreditation, SEN has at least two years to maintain its dominant market position once a competitor announces its intention to obtain accreditation. To date, SEN are not aware of any competitors that have applied to begin the accreditation process.
• Established relationships with partners in key markets – Safenet in US and now Cybernet ($US 1bn revenue p.a.). Potential for distribution agreement with IBM still in negotiation stage.
• Established credibility in U.S and are leveraging that in negotiations throughout Australia, New Zealand, Middle East, Asia.
• Commitment to R&D has ensured regular release of new products or upgrades to existing products: ATM to SONET to ETHERNET within 18 months. Puts competition a long way behind given the two year proving period.
Strengths
• Strong cash flow
• Debt free
• Significant operating leverage – only 16 full-time programmers/engineers. Negligible capex required per additional client/contract.
• Customer stickiness – significant investment in deploying SEN “boxes” throughout client network. The technology is proven, and given mission critical nature of data protected makes it difficult and unlikely that client would put the contract out to tender unless there was a major failure by SEN.
• Daily share buy-back/capital management
• Payment of all profits as dividends.
Weaknesses
• Sales “lumpiness” – SEN to take more direct control of sales and marketing of product in Asia and Middle East.
• To get access to US markets and gain credibility during SEN’s early corporate life, particularly US military, SEN needed to form a strategic partnership with Safenet. Safenet was given exclusive distribution rights for SEN products in the US and Asia/Middle East. Safenet have not proved to be particularly effective in expanding the sales base beyond the US military. As having exclusivity over SEN products is clearly very valuable to Safenet, they are unlikely to be willing to renegotiate the deal (ie exclusivity) without something in return – most likely a lower royalty payment to SEN. However, sales made through other avenues generate almost double the revenue relative to sales through safenet.
Opportunities
• A recent discussion with the investor relations manager indicated an emerging opportunity exists in mobile phone encryption. No detail on potential market size etc, but given mobile phone penetration as well as rapidly progressing technology, the potential is obvious.
• Distribution – this is a key to the success of the company. New deals with Cybertrust, possibly IBM and reduced reliance on Safenet for sales in US a step in the right direction. In addition, recent agreement with Crescent Technologies that provides a $3 million upfront payment plus ongoing royalties of 15% of all sales that incorporate SEN technology. They have the product, they just have to get it out to the market. Revenue from non-Safenet sales is roughly double – obvious opportunities to expand revenue base if effective distribution network is built.
• Recent agreement with Crescent technologies not only provides additional royalty payments but has also opened up new high level security and defence contracts.
Risks
• After speaking with contacts at the company, it was indicated that while the company should achieve its stated earnings this year, the quality of the result may be a little weaker than usual. He explained that given the poor performance of Safenet, sales that were expected to materialise have been lost. The shortfall (approximately $2 million) is expected to be made up predominantly of asset sales rather than additional product sales. Hence, some weakness following the coming result could be possible.
• Key risk is that distribution network does not develop as hoped. Reliance on one partner has so far proved ineffective. Effective distribution network is critical. At the moment they are rapidly developing this. They have stated on numerous occasions that achieving “multiple routes to market” is now a priority.
• The revenue model currently does not have a significant annuity component, so steady revenue is reliant on continued and regular sales. Risk is very lumpy sales (currently being experienced).
• Technology obsolescence. Competitive advantages in relation to accreditation generally ensure that this is less of an issue than for other companies, but when a competitor does emerge, this should be monitored closely.
Selected Financials
• PE: 23 x ’06, 17 x 08 vs sector average of approximately 18-19 times ’06.
• ROE: 25% in FY06 growing to 50% in FY08 and 60% in FY11. Makes sense given high operating leverage, strong forecast profit growth and daily share buy-back program.
• ROA: approximately 30-40% for FY06 – FY11 (forecast horizon).
• NPAT margin: generally around 30%
• Dividend yield: approximately 5% on FY07 numbers.
• Valuation (DCF): $0.58
• Market Cap: $187m
Conclusion
• Very strong competitive position
• Very positive financial characteristics: no debt, strong cash flow, dividend paying, high operating leverage, daily capital management.
• Significant “flagship” clients – eg Pentagon
• Key risk is distribution failure. Significant inroads being made into achieving more diverse “routes to market” to mitigate this risk – new partnerships with Cybernet, Crescent Technologies, potentially IBM, Safenet.
• 2 year accreditation period provides protection against technical obsolescence
• Possibly some weakness going into full year ’06 result given potential earnings quality issues, but longer term (6-12 months) there is significant upside. Price target of $0.60 not unreasonable.