When disaster strikes
ISA’S loss of favourable terms with a key vendor partner has hit it hard, writes
HE JSE is a scary place these days, and likely to get scarier if even the most trusted companies are rendered vulnerable by events they cannot influence.
Corporate scandals and strategic stuff-ups involving
“big bourse names” has meant investors have increasingly started to back companies with business models that are not only finely focused and robust but, probably more importantly, also easy to understand.
One such counter is ISA Holdings, which has had a longstanding singular focus on the critical niche of information and IT security. IM recommended the counter as buy in our August edition last year, based on a long history (dating back to its listing in 1998) of reliable cash flows, a strong balance sheet and a cost-conscious corporate culture.
What’s more, there was much reassurance to be taken from ISA’S well-established position as a meaningful player in the local cyber security landscape, which is constantly evolving as new threats emerge. It was difficult to imagine ISA short of work — especially considering its wideranging client base.
ISA’S financial year to end February 2019 had the confident declaration of a special dividend of 20c a share on top of a final dividend of 19.2c a share, equal to its EPS of 19.2c.
TWith cash flows strong and development expenditure not terribly demanding, it made sense for ISA to distribute excess capital back to shareholders.
But earlier this year came a bolt from the blue. ISA’S key strategic vendor partner, Check Point Software Technologies, decided to demote ISA, changing its partner status to that of an entry-level reseller.
This meant effectively downgrading ISA’S position of more than 20 years in Check
Point’s reseller programme from the highest tier available (that being a “4-star elite partner”) to the lowest tier available (“not-in-program reseller”).
Obviously this development will have a substantial effect on ISA’S business due to the summary reduction in Check Point reseller benefits — such as unfavourable reseller discounts, the removal of all cooperative marketing support and the limited access to
Check Point’s advanced technical escalation structures.
This is nothing short of a disaster for ISA.
The company admits that for as long as it remains at this entry-level reseller tier, it is unlikely to be able to win major new Check Point-based projects or even retain its existing customers (who have a committed investment in Check Point technologies).
And here is the really scary part … business from customers who have an investment in Check Point technologies accounted for as much as 90% of ISA’S turnover in the financial year.
IM understands there have been a number of desperate discussions with Check Point since the demotion late last year. But the official word is that no progress was made in mending the relationship.
The thread of hope that had dangled on recent communications to shareholders is that while “ISA continues to search for ways of working with Check Point in a mutually beneficial manner into the future, the company will be increasing its focus on its stated plans of “onboarding” other emerging next-generation technologies and brands that are required by their customers to effectively address the rapidly evolving information security threat landscape”.
The market, in the meantime, has voted with its feet. ISA’S shares, which reached a record high of 209c in July last year, reached a multiyear low
Katz stresses ISA has strong client loyalty, and says clients’ support through this difficult period has been encouraging
of 35c in mid-january this year.
With ISA still holding around 20c a share in cash (or around R31m), the market has lately taken a more pragmatic view of proceedings.
The share, at the time of writing, in mid February, had clawed its way back to 65c.
In a worst-case scenario — and that would presume ISA simply threw in the operational towel and realised value for investors — there is what seems to be a very conservative tangible NAV of about 30c a share.
ISA, however, is clearly not capitulating. While it’s great to see it fight back, can the company really restore its fortunes?
Perhaps the key consideration, at this delicate juncture, is why the longstanding, and mutually beneficial, relationship with Check Point went sour.
With ISA preferring to tread diplomatically around the issue (which is probably prudent), IM might enjoy some poetic licence to speculate about developments.
Stepping away from ISA and looking at the bigger cyber security picture it could easily be argued that the operating environment has changed with the emergence of new (er) product providers like Palo Alto and Fortinet.
In fact, IM notes that Palo Alto and Fortinet now both have larger market capitalisations than Check Point — which might point to intensified competition in the market and shifts in technological applications.
With this in mind, the commentary about “onboarding other next-generation technologies” in ISA’S August 2019 interim results becomes all the more profound.
IM well imagines ISA executives sensing a straining relationship with Check Point became even more determined to mitigate the risk to margins by finding new security products to take to market while, at the same time, Check Point would probably have been aghast that ISA was looking to start marketing technologies of its fiercest rivals.
IM hears that ISA was officially notified by Check Point that its demotion related to the company not complying with certain partner programme requirements as well as a lack of co-operation on certain of its market development initiatives.
ISA CEO Clifford Katz declined to elaborate about details of the dispute with Check Point — but he did point out that the company had addressed the validity of these claims.
“We challenged them on every issue … these issues are nonsensical.” IM reckons the bigger issue could be that Check Point might be fretting about ISA marketing other security products.
Katz confirmed that Check Point was keen to stop ISA offering other vendor brands to its customers and adopt a “Check Point first” type of strategy. “Then they would be prepared to reinstate us into their partner programme.
“I said we could comply with any reasonable partnership requirement they asked of us, but would never agree to any form of anticompetitive demand that does not serve the best interests of our customers.”
What transpires in the next few months will be an intense game of corporate poker.
If ISA’S clients are supportive of its service and maintenance regime, it can be reasonably expected that some of the revenue line can be rebuilt — albeit slowly.
One might well imagine
Fortinet and Palo Alto itching to obtain access to ISA’S client base — hopefully on terms that allow the company to build a fortified margin.
But if ISA’S clients prefer to stay with the Check Point products rather than switch to other cyber security brands, the bottom line could flounder dangerously.
Katz stresses that ISA has strong client loyalty, and says clients’ support through this difficult period has been encouraging.
“Our customer relations have been going on for almost 30 years — and seem to be paying off.
“There are not too many dedicated and enterprise-grade managed security services providers out there with a long history as strong as ISA’S.”
If ISA is successful in taking its clients onto new software platforms, there will be a cost. Additional competitive pressure from Check Point might mean new business is not built on the traditional gross margin of 40% to 45%, but will probably bring about some sacrifice to a gross margin of between 35% to 40%. That might mean the profitafter-tax margin is shaved from about 20% to possibly 15% — though the high cash-generative and the low capital expenditure characteristics will probably remain.
For the unrepentant smallcap punters, ISA offers an interesting option on a new business model in a viable (and sustainable) niche. ISA has an experienced (and, IM assumes, a highly motivated) management team, a sturdy balance sheet and a longstanding business model.
Of course, the next nine months probably won’t be pretty at all as the Check Point arrangements unwind. With cynical sentiment prevalent in the small-cap sector, there may be opportunities to strike ISA at a very attractive option price.