Description

We are long Citrix and believe it to be an intriguing and exciting opportunity to invest in a high-quality business at a significantly discounted valuation as the business is about to inflect positively. The opportunity exists also because the company is currently overlooked by investors. The fact that a software company with effectively 100% free float, publicly listed for almost a quarter of a century and with a market cap in excess of $10bn has never been written before on VIC is already telling. Buy side attitude towards Citrix is one of apathy, with similar attitude from the sell side with only 5 out of 20 Buy ratings. The company is going through a transition from on-prem license and maintenance model to a cloud based subscription model and such transition is negatively affecting near term results, causing investors to mistakenly believe the business is decelerating due to structural challenges. This narrative gives credence to the bearish view that virtualisation, Citrix core business, is in structural decline as obsolete in a world dominated by web-based applications. Such views create the opportunity to invest in a high-quality software business on low teens FCF multiple. We believe there is a clear opportunity to generate 20+% IRR in Citrix over the next 3 years.

Business Description

Citrix operates 2 segments that offer vastly different sets of products: Workspace and Networking

Workspace

The name Citrix in the software industry is directly associated with the concept of “virtualisation”. Virtualising an application or an operating system means detaching it from the physical machine and allowing different applications, operating systems or functions to be run on a single computer or server. Virtualisation can simplify the overall software and server architecture, thereby improving the overall performance thanks to a technology that can balance and maximise the resources available. Due to its first mover advantage, a superior product offering and a high reputation in the marketplace, Citrix became a synonym for virtualization. The company historically dominated the market and still holds as much as 50% market share, well ahead of peers Microsoft, VMware and smaller ones. Over ¾ of large enterprises worldwide use Citrix in some shape or form. Its installed base is vast and incredibly valuable. Citrix customers are remarkably loyal and sticky.

Historically, the virtualisation software represented the vast majority of Citrix business, especially after the sale of the GoTo SaaS business to LogMeIn in 2016. The virtualisation business is now included in its core Digital Workspace segment which includes core desktop and apps virtualisation businesses. Workspace now represents c. ¾ of Citrix sales.

Virtualisation takes different shapes:

• Virtual Desktop Infrastructure, where each user has their own personal desktop images on shared machines
• Application virtualisation, where only the application is stored in a data centre and then streamed to the user’s physical device
• Terminal Services

Workspace covers the whole gamut of services, including:

a)   Desktop and Application Virtualisation - the whole Windows desktop or an application is delivered remotely from an organization's datacentre. This allows businesses to reduce IT costs, improve redundancy and recovery time from hardware failures, and increase flexibility in scaling resources used with the changing needs of the business. Offering flexibility to employees to work remotely is also an important use case driving adoption

b)  Mobile app delivery - mobile device management solutions (XenMobile) that allow administrators to provide users with secure access to applications (mobile apps or even Windows apps) and data (e.g., email) on mobile devices (e.g., smartphones, tablets)

c)   Workspace Aggregator (Workspace Suite) is the third product category in this segment. The Citrix Workspace Suite is an integrated solution allowing enterprises to deliver secure access to apps, desktops, data and services from any device over any network. This product bundles the capabilities of XenApp, XenDesktop, XenMobile and other capabilities into a single platform

In very simple words, Citrix allows enterprises to maintain a hybrid model where people still work at their workstation or on their own devices but access to share data and shared applications. Citrix comes in handy when large enterprises want to manage the data flow of employees when they can access it from everywhere. Apps like Box and DropBox can’t do that effectively. The CIO of a large legal office can decide what kind of information associates have access to, what kind of data a partner can download on his device, how much data download becomes suspicious etc. Citrix also ensures that apps and data are secure. It also offers analytics solutions. Workspace has clearly changed and it’s no longer a simple VDI solution, it’s a “platform for work” that goes beyond virtualisation.

Citrix offers a unified consumer experience with continuity across web, mobile and desktop. In a secure and controlled environment, employees have access to all different sort of apps via 1 gateway / centralised app. It makes life easier for IT guys as well as for employees. As in our own office, we only need to sign-on to the system once, we don’t need a password for each app. It provides universal access across all apps and content.

Citrix commands a leading market share in the space. My understanding is that VMware has been aggressive as of late winning market share but Citrix close collaboration with Microsoft is providing them with a strong moat.

While this business hasn’t grown much in recent years (some of it was due to model transition headwinds, some of it due to bad commercial policy now rectified), the structural tailwinds are strong and recent quarterly performance suggest an acceleration in growth.

We believe there are numerous tailwinds to growth:

• White collar employment – the larger the white-collar workforce, the more seats under Citrix products are required
• Penetration of remote access / remote workforce. Hot desks are increasingly more common, people want to work from home, WeWork phenomenon – these are positive drivers for Citrix
• BYOD (Bring Your Own Device) – in the past, Citrix offered only “workstation virtualisation”. It now offers the same capabilities for both mobile and desktop. The more complicated an ecosystem of devices, the better it is for Citrix
• Shift to the cloud – virtualisation will only increase going forward amongst global enterprises. This is something currently not well understood by the Street

Networking

Citrix networking division is primarily constituted by 2 businesses: Citrix ADC (Application Delivery Controller), formerly known as NetScaler, and Citrix SD-WAN.

The ADC business consists of a combination of hardware and software designed to accelerate web services and removes workloads from web servers. They help large e-businesses deal with vast volumes of traffic. Revenues are under pressure as the model is shifting towards software only and the hardware business is consequently suffering. Furthermore, the business is very lumpy as a Cloud provider will purchase a large quantity of Citrix ADS as they expand their datacentres in one year with little revenue in the subsequent years.

Web-scale buyers now represent a very small (13% in Q1) proportion of Networking sales but its revenues were down 65% YoY in Q1, causing the whole segment to be down 18% YoY. Citrix reported growth rate would be much higher if not for the SSP part of the Networking business which has now become a tiny part of the mix.

Citrix SD-WAN, or software-defined wide-area network (SD-WAN) is a service that grants the enterprise with the ability to dynamically connect branch offices and data centres on a global scale. It’s effectively a traffic optimization product that bundled with Workspace deals has become again a growth driver for the company. As traffic grows because of growth in cloud-based applications, traditional WAN networks are unable to maintain adequate speed and therefore SD-WAN emerged as a cost-effective solution to optimize connectivity.

Investment thesis leg 1: Workspace strength

Our investment thesis rests on the conviction that the core workspace business is actually doing very well. The bearish narrative of Citrix exposed to a structurally declining virtualisation on-prem market is unfounded. Furthermore, the transition to a subscription model is impacting near term results which would be otherwise even stronger.

While on the surface Citrix is not growing much (reported Q1-19 top line growth was 3% and 5% in FY 2018), we can observe under the radar very strong growth  from its Workspace segment, which is the core of the business. As per chart below, workspace sales growth accelerated to 6% in FY2018 and to as much as 13% in Q1-19.

These reported results are actually understated due to the mix shift from license + maintenance model to subscription. Consider that in Q1-18, 47% of all Workspace deals were rateable. This number moved to 62% in Q1-19. While management doesn’t quantify the implied headwind from the model transition in the way other software companies do (like PTC for example), it is estimated to be c. 200-300bps. This means that on an organic basis, Workspace grew as much as 15% in Q1-19 with its backlog growing more than 20% YoY. Such growth doesn’t seem compatible with the commonly accepted view that Citrix is an old established software company offering a legacy product in terminal decline.

Contrary to popular belief, we believe that the migration to the cloud model in fact increases the demand for desktop / app virtualisation. Cloud hosting has become an enabler for Citrix, not a threat. A common misconception is that there is no room for Citrix in a web-based powered application architecture. The actual reality is that the vast majority of enterprises are moving towards a hybrid model where cloud will co-exist with on-premises applications. Security and latency concerns are pushing CIOs to look at hybrid solutions. As long as there will be even a single app run on-prem, there will be need for VDI solutions. The outlook for Citrix is therefore bright. The feedback received from our conversations with clients and resellers is that Citrix product is a good fit for public cloud. Citrix is acting as an aggregator for all web-based apps, whether Microsoft, SAP, CRM, WDAY etc., significantly simplifying life for both users and system integrators.

As described above, Workspace allows customers to have a unified customer experience in 1 app. Whether the application is virtualised (e.g. Eze or Bloomberg), whether it’s on the company’s server (e.g. Outlook) or whether the application is web-based and SaaS-based (e.g. Workforce, Workday, Concur), Workspace allows the user to access them all from one secure application, without having to sign in and out every time and giving the IT department the flexibility and control to decide what data each employee has access to across all applications. It makes the job of the IT much easier and the consumers experience much better as the front-end looks the same:

The potential for growth is huge here because it’s platform agnostic. It’s obviously much easier to sell Workspace to Xen customers that want to integrate all applications in one. However, Workspace can also be used as a net new product to attract new customers that use the likes of Workday, Salesforce, Concur, Microsoft etc. and want to have a unified, simple, secure consumer experience that can be easily implemented and controlled by the IT department. Speaking to numerous industry contacts, it appears the product is doing well but it’s very new. There are 3 versions of Workspace:

·         Workspace Standard

·         Workspace Premium

·         Workspace Premium plus

Not all versions are fully released, it’s really new. The potential impact on Citrix though is huge. The following chart produced at Q4-18 results illustrates the opportunity and shows how Virtualization, which represents today the vast majority of Citrix business, is actually a smaller percentage of the total revenue opportunity:

The key Citrix products, XenApp and XenDesk, which are the historical success stories in virtualization, represent a small percentage of the potential customer adoption. It’s very interesting to note that Citrix is very well penetrated amongst larger customers, especially in the enterprise:

Large customers know Citrix very well and ¾ of global enterprises use Citrix in one way or another. However, only 39% of Enterprise users are Citrix customers:

This means there is a huge opportunity for Citrix to grow adoption within the organisation. This is a lot easier than spending money trying to acquire new customers. Conversations with experts suggest that Workspace could be the tool to accelerate this process for Citrix.

Furthermore, having realised that the immediate growth opportunity for Citrix is to grow within the existing customer base, the whole salesforce has been restructured and refocused on this opportunity. Winning new customers is probably the least important of the 4 commercial strategies below:

We believe this strategy is fundamentally lower risk and less costly than a traditional commercial strategy focused on customer acquisition. Citrix always had a strong reputation and a huge installed base. Now it has the right product (Workspace) and the right commercial strategy to capitalize on the opportunity.

Investment thesis leg 2: transition to subscription upside

We believe Citrix is poised to re-rate in the next couple of years due to a business transformation that will take the business from a primarily perpetual license model to a subscription model. Over the next 3 years, we expect the business to change positively in the following way:

• Subscription revenue to move from c. 15% of the total today to over 40%
• Recurring revenue to increase from c. 75% of the total today to over 90%
• Revenue growth to accelerate from c. 4% to c. 7%+
• Operating margin to expand significantly from c. 31% to c. 35%+

We believe these changes are not fully reflected in today’s share price and will lead to a significant re-rating of the stock. First and foremost, software businesses that move to a SaaS based subscription model naturally attract higher valuation multiples. The LTV of a customer increases in moving from perpetual to license as the implied price of the license paid increases and more products are being packaged together representing upselling opportunities. Citrix argues that the revenue uplift from a full transition, before factoring any potential incremental up-selling, could be as high as 30-35%. The revenue streams become then increasingly more predictable and not prone to large quarterly / annual swings. The business therefore becomes inherently more stable and less volatile. These positive attributes naturally garner higher valuations:

Secondly, while the transition to a subscription model leads to short term reduction in top line growths and margins, it leads to a reacceleration thereafter. This is a well know dynamic we have witnessed with the likes of Adobe, Autodesk and PTC. As a result, SaaS based subscription businesses exit their transition phase with an acceleration in revenues and an expansion in margins:

Such an acceleration in margins, but especially in revenue growth, leads to a re-rating of the company. This is very intuitive for any company in the world but especially for software stocks, where P/E valuations are very much tied to their expected top line growth. Sales growth is a much more important valuation driver than EPS growth. Citrix’s history demonstrated this. As per 2 charts below, Citrix’s P/E was much more closely correlated to its top line growth (left hand chart) than its EPS growth (right hand chart):

In 2015 and 2016, Citrix margins inflected positively, primarily following an activist campaign led by Elliott. While the large EPS acceleration boosted the stock price, it didn’t help the rating of the stock – in 2015 and 2016 Citrix P/E multiples fell from 20x+ to as low as 13-14x. It’s our belief that as the shift to subscription model normalises in 2020-21, top line will re-accelerate and the stock will significantly re-rate. There is a very close correlation in the software space between top line growth and P/E valuations as per chart below. Citrix will move upwards in the valuation matrix as illustrated below:

There is a reason the valuation discount exists today. Management has not been at all transparent as to how the transition to subscription sales will affect the company and as to what is the true underlying growth of the business. To date, management released very little information to help analysts properly model the transition. Some of the basic KPIs that companies such as Adobe, PTC, Tableau etc. provide to the market to help them model a business transition include ARR (Annualised Recurring Revenue), New Bookings, rateable license bookings as % of total bookings and churn. Without these KPIs it’s virtually impossible to accurately predict the transition of the business and Citrix doesn’t disclose these, yet. We believe this to be the single biggest factor depressing the stock valuation – Citrix currently trades on this year (2019) estimated free cash flow yield of nearly 8%. The stock is unduly cheap. A couple of brokers’ commentary / comments made support this view:

Morgan Stanley (SELL rated) – “In short, management is asking investors to focus more directly on the shift in business towards subscription sources versus the revenues and earnings showing up on the income statement, in the near-term. While this leap of faith is common in most Cloud transition stories, we think Citrix currently lacks two of the key elements needed to give investors’ confidence in the transaction: 1) a clear leading indicator of success… 2) a clear Cloud value proposition… we'd need to garner more conviction in the momentum and uplift available from the Citrix Cloud transition before shifting our focus away from the income statement and getting more constructive on the shares” 

ML (NEUTRAL rated) – “There is still uncertainty as to the pace of the cloud transition...The cloud transition creates some uncertainty on the EPS/FCF profile, which has been a tenet of valuation support”

Jefferies (SELL rated) – “My question has to do with this transition to subscription. And I guess I'm just a little confused… depending upon the duration of the contracts and if that were to change, things like that, it's – and without a lot of historical information, it's really hard to just place our faith in that number right now”

We believe many of the above points will be addressed at the next Investor Day in scheduled for September 9th.

Microsoft – friend or foe?

We believe another important overhang for Citrix is the competitive threat from Microsoft. Microsoft is expanding its desktop virtualization offering and the move is perceived to be antagonistic to Citrix. This would be a big risk as Microsoft is an important strategic partner, as per 10K disclosure: “In partnership with Microsoft, Citrix Virtual Apps is designed to embrace and extend Microsoft Remote Desktop technology by providing advanced provisioning, performance, monitoring and management functionality. Our joint solution with Microsoft lowers the cost of delivering and maintaining Windows applications for all users in the enterprise”.

Microsoft and Citrix maintained a strategic relationship for nearly 30 years and together offer solutions to facilitate the move to hybrid-cloud or multi-cloud delivery models. In 2018, Citrix announced a new collaboration agreement to provide customers a simplified experience by enabling them to purchase and deploy Citrix-powered digital workspaces and networking solutions directly within Microsoft Azure. Microsoft is clearly Citrix’s most important partner.

Following conversations with industry participants, our understanding is that Citrix is becoming increasingly important to Microsoft from a strategic perspective as virtualisation apps run in the cloud on Azure create highly profitable revenue streams for Microsoft. The move to the cloud seems to bring MSFT and Citrix closer than ever before and the Windows 10 upgrade cycle represents a strong tailwind for Citrix and Workspace. The launch in 2018 of Windows Virtual Desktop was initially seen as a dangerous, potentially competing alternative to Citrix. In reality, it appears the two solutions are perfectly complementary to each other, not competing. Citrix is in fact going to give Microsoft sales reps the possibility to sell Workspace along with Azure, demonstrating the strong partnership between the two.

Assumed returns

Citrix seems comfortable with long term growth targets of 5-9% for Workspace due to the numerous tailwinds described above. This is in line with our 2021-22 growth rate of c. 7%. However, these growth targets are still somewhat affected by c. 200bps of annual headwind from model transition to subscription. From 2023, the headwinds will dissipate and we believe Citrix could accelerate top line growth to as much as 9%. As the short-term headwinds from the model transition abate, margins will also expand. We therefore estimate non-GAAP operating margins to expand from 31% in 2019 to 34% in 2022 and to continue expanding thereafter into the high 30s in the long term. Our returns assumptions are based on 2022 earning power in excess of $9 per share and FCF per share in excess of $10 per share. We believe that an acceleration of the top line growth and a shift to subscription will lift the valuation multiple from low-to-mid-teens P/E to high-teens, for nearly a doubling of the shares over the next 3 years.

We also believe the prospective returns are highly asymmetric as we see very little downside in a bear case scenario where growth continues to stagnate and margins don’t expand, as this is the scenario the market is currently implicitly assuming in valuing the shares today.

Catalyst

• Continuous strength in Workspace business
• Investor Day on September 9th
• Tough networking comps lapped in Q4-19