2. June 19, 2009 Scott Zeller • szeller@needhamco.com • 617-457-0903
Infrastructure Software / Software
ArcSight, Inc. (ARST) – Buy
ARST: Reiterate BUY, raise target from $19 to $21 after positive investor meetings
We hosted ArcSight management on Thursday for investor meetings;
investor interest was quite strong. We found discussions to be positive,
Price Target Change
with the questions noticeably shifting away from a focus on earnings and
margins, and focusing more often on drivers for revenue growth. Our view Market D ata
is investors are weighing the fundamentals of demand for ARST products Price (06/18/09) $17.48
vs. ability to scale the company, and also the timing of such revenue
12-Month Price Target $21.00
growth (near-term vs. long-term). Our impression is investors view last
week’s quarterly guidance as conservative, yet appropriate – as evidence, 52-Week range $18.72-4.74
we point to the flattish recent performance of shares, despite conservative Shares Out. (MM) 34.4
guidance below consensus for F1Q. We believe near-term (FY10) revenue Market cap (MM) $601.6
growth is likely to be driven by continued growth in the public sector and Avg. daily volume (000) 562.7
enterprise appliances; longer-term growth (FY11, beyond) is likely to be
driven by utilities/power grid/infrastructure, as well as certain just-initiated Financial Data
government agency projects, called out by management as important Total Debt/Cap. 0.0%
contributors, yet still too early for FY10 contribution. On the earnings Price/LTM Rev. 4.4x
picture, we believe the company has moderated expectations for margins Tangible BVPS $2.02
with last week’s comments about FY10 being an investment year for the
Net Cash Per Share $2.63
company; investors may find this passable, so long as the revenue growth
remains robust. Reiterate BUY, upping target from $19 to $21, no change
to our above-consensus estimates, which are likely conservative.
• Focus on revenue growth – near-term vs. long term. A nuance we had ArcSight, Inc. participates in the security
not previously understood is that although government is the biggest revenue
software market, where it is a leader in the
vertical at ARST, several government projects were started in the most
recent two quarters, and have “seeded” large projects for the future; we were event management market. ArcSight products
encouraged by this because it suggests FY11 revenue strength, and at the help customers manage IT performance alerts
same time explains why currently 70% of revs come from existing customers. by collecting, correlating and prioritizing risk
• Customer “lifecycle” revenue growth grabs attention. We believe items.
management’s emphasis on how an initial $300k deal grows over a few
years to be 3x original investment (or greater) caught investor attention and
is a positive of the ARST long term growth story.
• Reiterate BUY, raise target from $19 to $21, no change to our above-
consensus estimates, which are likely conservative. Our $21 target is
3.0x EV/FY11 revenue, and 30x our FY11 $0.70 EPS estimate. We chose to
up our target from 2.7x up to 3.0x EV/FY11 revenue, based on similar
valuations for revenue growth comps, including RVBD (now 3.1x EV/revs)
and VMW (now 5.2x EV/revs).
ArcSight, Inc. Price 06/18/09
FY FY FY 20
04/30/09 A 04/30/10 E 04/30/11 E 18
Old New Old New 16
14
Rev. (MM) $136.2 $159.2 $159.2 $189.0 $189.0 12
Growth 34.1% 16.9% 16.9% 18.7% 18.7% 10
8
Op. Mar. 13.8% 18.2% 20.8% 6
EPS: 1Q 0.01 0.08 0.08 0.15 0.15 Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun
4
EPS: 2Q 0.11 0.13 0.13 0.17 0.17 Volume (000)
EPS: 3Q 0.21 0.16 0.16 0.19 0.19 3,500
3,000
2,500
EPS: 4Q 0.18 0.17 0.17 0.20 0.20 2,000
1,500
EPS: Year 0.51 0.54 0.54 0.70 0.70 1,000
500
0
Growth nm 7.1% 7.1% 29.9% 29.9% Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun
P/E Ratio 18.0x 32.3x 32.3x 24.9x 24.9x
Note: Pro forma earnings estimates displayed above do not include one-time items or any
stock compensation expenses.
Disclosures applicable to this security: B, G.
Disclosure explanation on the inside back cover of this report.
3. Summary
We hosted ArcSight management on Thursday for investor meetings; investor
interest was quite strong. We found discussions to be positive, with the questions
noticeably shifting away from a focus on earnings and margins, and focusing more
often on drivers for revenue growth. Our view is investors are weighing the
fundamentals of demand for ARST products vs. ability to scale the company, and
also the timing of such revenue growth (near-term vs. long-term). Our impression
is investors view last week’s quarterly guidance as conservative, yet appropriate –
as evidence, we point to the flattish recent performance of shares, despite
conservative guidance below consensus for F1Q. We believe near-term (FY10)
revenue growth is likely to be driven by continued growth in the public sector and
enterprise appliances; longer-term growth (FY11, beyond) is likely to be driven by
utilities/power grid/infrastructure, as well as certain just-initiated government
agency projects, called out by management as important contributors, yet still too
early for FY10 contribution. On the earnings picture, we believe the company has
moderated expectations for margins with last week’s comments about FY10 being
an investment year for the company; investors may find this passable, so long as
the revenue growth remains robust. Reiterate BUY, upping target from $19 to
$21, no change to our above-consensus estimates, which are likely conservative
Focus on revenue growth – near-term vs. long term. A nuance we had not
previously understood is that although government is the biggest revenue vertical
at ARST, several government projects were started in the most recent two
quarters, and have “seeded” large projects for the future; we were encouraged by
this point because it points to FY11 revenue strength, and also answers how
revenue from existing customers has climbed to 70% range in recent two quarters
(customer wins healthy, yet some newer gov’t wins generating moderate/early
revenue).
Margin story consistent with recent call – this year is an investment year. As
described on last week’s earnings call, FY10 is an infrastructure growth year for
ARST as it focuses on international revenue growth and domestic channel partner
programs; this is baked in shares, as FY10 EPS growth now sub 5%. Focus is on
revenue growth.
Customer “lifecycle” revenue growth caught attention. We believe
management’s emphasis on how an initial $300k deal grows over a few years to
be 3x original investment (or greater) caught investor attention and is a positive of
the ARST long term growth story. Follow on purchases include: additional
endpoint tracking, new geographies, and additional appliances.
Field info encouraging. Our view is fundamental demand for ARST’s
compliance security software remains solid; we base this view on field discussions
with several private company competitors to ARST. As CEO Tom Reilly has said,
(paraphrase) “audit occurs during a down economy as well as a good economy”,
and ARST software supports compliance and audit, making it less discretionary in
IT budgets.
Reiterate BUY, raise target from $19 to $21, no change to our above-
consensus estimates, which are likely conservative. Our $21 target is 3.0x
EV/FY11 revenue, and 30x our FY11 $0.70 EPS estimate. We chose to up our
target from 2.7x up to 3.0x EV/FY11 revenue, based on similar valuations for
revenue growth comps, including RVBD (now 3.1x EV/revs) and VMW (now 5.2x
EV/revs)
Risk statement: Buyers of ARST shares face risks including but not limited to: a
continued challenging IT spending environment, competition from larger better
2 An Investment Analysis by Needham & Company, LLC
4. capitalized participants in the network equipment and enterprise software markets;
the challenge of growing international revenues.
An Investment Analysis by Needham & Company, LLC 3
7. ArcSight, Inc.
($ in MM, except per share data) Annual Quarterly
Fiscal Year Ending April 30 FY FY Ending Ending Ending Ending
4/30/2008 4/30/2009 7/31/2008 10/31/2008 1/31/2009 4/30/2009
BALANCE SHEET
ASSETS
Cash & Short-term Investments 71.9 90.5 74.2 75.7 82.9 90.5
Receivables 26.7 34.2 17.3 23.2 22.2 34.2
Inventory 0.0 0.0 0.0 0.0 0.0 0.0
Other Current Assets 5.6 3.9 5.9 4.2 3.2 3.9
Current Assets 104.2 128.5 97.4 103.0 108.3 128.5
Property and Equipment 4.8 4.4 5.5 5.2 4.7 4.4
Goodwill and Intangibles 7.9 7.1 7.7 7.5 7.3 7.1
Long-term Marketable Securities 0.8 0.0 0.0 0.0 0.0 0.0
Other Assets 0.8 1.2 1.4 1.4 1.4 1.2
Total Assets 118.6 141.2 112.0 117.1 121.7 141.2
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities 57.5 54.0 50.2 50.8 49.0 54.0
Short-term Debt 0.0 0.0 0.0 0.0 0.0 0.0
Long-term Debt 0.0 0.0 0.0 0.0 0.0 0.0
Shareholders' Equity 54.8 76.7 55.0 60.1 67.1 76.7
Total Liabilities + Shareholders' Equity 118.6 141.2 112.0 117.1 121.7 141.2
INCOME STATEMENT
Revenue 101.5 136.2 27.7 32.8 36.4 39.3
Gross Profit 85.5 111.2 22.4 27.0 29.6 32.1
Operating Income 4.1 18.8 (0.6) 4.1 9.0 6.3
Pretax Income 4.6 19.5 (0.3) 4.4 9.1 6.2
Net Income 3.5 16.9 0.3 3.6 6.9 6.1
Shares Outstanding 25.9 33.5 33.1 32.8 33.5 34.4
CASH FLOW STATEMENT
Depreciation and Amortization 2.5 0.0 0.8 1.6 2.5 0.0
Cash Flow from Operations 13.5 0.0 3.8 4.5 12.3 0.0
Capital Expenditures (4.0) 0.0 (1.2) (1.6) (1.8) 0.0
CASH MANAGEMENT*
DSOs 75.9 81.5 71.5 55.5 56.2 64.6
Inventory Days 0.0 0.0 0.0 0.0 0.0 0.0
Days Payable 67.8 33.2 48.5 45.7 30.4 16.8
Cash Conversion Cycle 8.0 48.3 23.0 9.8 25.7 47.9
PROFITABILITY
Gross Margin 84.2% 81.7% 81.0% 82.3% 81.4% 81.8%
Operating Margin 4.1% 13.8% (2.1%) 12.4% 24.6% 16.1%
Net Margin 3.4% 12.4% 1.0% 10.9% 19.1% 15.5%
Return on Assets* 4.2% 13.0% 1.0% 12.5% 23.2% 18.6%
Return on Equity* 11.7% 25.7% 2.1% 24.9% 43.7% 33.9%
Total D ebt/Capital 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
PER SHARE DATA
Tangible Book Value 1.81 2.08 1.43 1.60 1.78 2.02
Cash 2.81 2.70 2.24 2.31 2.47 2.63
Net Cash 2.81 2.70 2.24 2.31 2.47 2.63
EPS (Pro Forma) 0.12 0.51 0.01 0.11 0.21 0.18
EPS (Pro Forma Including Option Expenses)
EPS (GAAP)
6 An Investment Analysis by Needham & Company, LLC
8. ANALYST CERTIFICATION
I, Scott Zeller, hereby certify that the views expressed in this research report accurately reflect my personal views about
the subject company (ies) and its (their) securities. I also certify that I have not been, am not, and will not be receiving
direct or indirect compensation in exchange for expressing the specific recommendation(s) in this report.
Price, Rating, and Price Target History: ArcSight, Inc. (ARST/NASDAQ) as of 6-18-09
9/29/08 12/10/08 1/13/09 3/6/09 3/26/09 6/12/09 6/18/09
B : $11.0 B : $8.0 B : $11.0 B : $13.0 B : $14.0 B : $19.0 B : $21.0
22
20
18
16
14
12
10
8
6
4
Dec 07 Mar 08 Jun 08 Sep 08 Dec 08 Mar 09 Jun 09
Source: Factset (Prices) / Needham (ratings and target price)
Disclosures applicable to this security: B, G.
An Investment Analysis by Needham & Company, LLC 7