Technology

Secure Computing's Bid for Security


By Tuesday afternoon it had already been a rough week for John McNulty. The chief executive of Secure Computing (SCUR) was feeling anything but secure as he got on a conference call with investors to tell them he was buying Alpharetta (Ga.) CipherTrust for $273 million—largely using debt, since his company had only about $100 million in the bank and a market share not much bigger than the size of the deal. It had been less than a year since Secure Computing took a private equity investment from Warburg Pincus to help buy another security company, CyberGuard, for $295 million.

That alone might have been tough to swallow. But then McNulty followed it up with the unwelcome news that Secure would miss revenue expectations for second quarter. It had forecast revenues between $43 million and $45 million. Now, the company says the number will be closer to $39 million. That's the second quarter in a row the company, which sells network security hardware and software to companies, has missed its target. Ouch.

McNulty braced himself as he checked his company's stock price on the morning of July 12. he says. Sure enough, the company had lost some 35% of its market value overnight, a cool $150 million. It closed trading at $4.99—down more than two-thirds from its lofty 52-week high of $15.29.

BEEFING UP SECURITY. At least give McNulty credit for being gutsy. A lot of niche security vendors have been struggling with lower than expected revenues this year, and hundreds of smaller private companies are simply selling out to bigger vendors. But Secure Computing still believes it can build the next $1 billion security powerhouse, one that can compete with Cisco Systems (CSCO) and Symantec (SYMC) and growing companies like Barracuda Networks and IronPort, which are both considered near-term IPO candidates.

Being bigger should help. But because Security Computing is small, McNulty had to get outside help to purchase nearly $600 million worth of competitors in less a year—a whopping six times the company's revenues last year. CyberGuard was a combo of stock and a big private-equity investment from Warburg Pincus. But the acquisition of CipherTrust means that McNulty will have to use $70 million of the company's cash and borrow $115 million from Citibank (C). The deal is expected to close by Sept. 8. "It shows how big the stakes are in the security market," says Andrew Jaquith of market researcher Yankee Group. "If you're going to run with the big dogs you need to spend money."

Some analysts worry that McNulty may be getting in over his skis. The company is in a very competitive space that's not growing as fast as it once was. The overall computer security business is a $20 billion market that was expanding a healthy 20% annually. But it's expected to grow at only half that rate this year. That's why Friedman Billings Ramsey expects a few big deals slipped from the second quarter, leading to the lower-than-expected results for Secure. "We believe management simply took its eye off the ball in the quarter, as [Secure Computing] focused on closing the CipherTrust acquisition," according to a July 12 research report. "While things are not great at the company, we have certainly seen worse in the space." The firm lowered its price target from $15 to $9, although it still rates the stock a strong buy.

THUMBS-DOWN FROM THE STREET. McNulty understands the reaction on Wall Street. "Right now I'm the dumbest guy on the planet to a lot of Wall Street," he says, sounding exhausted. He hasn't slept much lately. Last week, he was in Atlanta feverishly trying to close the deal. He flew back to San Jose for the weekend, only to get the news that two big deals had slipped from the second quarter, one of which would have made up 7% of the quarter's sales. He worked all weekend combing through the numbers and talking to customers, making sure the deals had just been pushed back, not killed. He jumped back on a plane to Atlanta on Monday to sign paperwork. Then he braced himself for Wall Street's Bronx cheer.

But McNulty insists he's doing the right thing for his company and he'll prove it to Wall Street by the first half of next year, when all three companies will have gelled and the company is posting some $250 million in annual revenues—up from $109 million last year. "We've lost credibility," he says. "We understand that. I take that incredibly seriously. I have reported 28 quarters here and have met or exceeded expectations on 24 of them. You go from hero to goat in this work pretty fast, but if you believe in what you're doing and execute it'll work out."

If he can pull off the integration and tighten up the sales team's execution, McNulty could well win over investors. Security is a tough, competitive market dominated by big companies, and Secure Computing is one of the few small companies that's growing fast by stealing market share from declining players. Its core market is called Unified Threat Management. In layman's terms, that means they ship a piece of hardware and software to businesses that protects them from a myriad of threats coming at their networks. It's a no-fuss way of solving the computer security problem, compared to a firewall buttressed by other custom-built, add-on products. It's a segment of the security market that's growing 48% a year according to market researcher IDC.

With the CyberGuard deal, Secure Computing added protection from Web attacks, and the CipherTrust deal adds protection from all types of bad things sent over the Web through communication methods including e-mail, instant messaging, and VoIP. It'll all be bundled together in one piece of hardware and software.

TOO GOOD TO PASS UP.McNulty had been talking to CipherTrust's CEO Jay Chaudhry for years about a deal, but had hoped to put it off for six months or so while his company digested the CyberGuard transaction. No such luck. Bigger security companies were circling.

A few months back, Chaudhry called McNulty and warned him there wasn't a lot of time: "He said, 'I will put everything else on hold if you can move forward and try to put together a deal that makes sense.'" McNulty wasn't thrilled, but badly wanted CipherTrust's technology—which includes a network of offices that monitor Web activity and e-mail all over the world, identifying hackers by the way they launch attacks before they strike. It reads and analyzes some 120 billion messages a month and catches and blocks more than 250,000 infected "zombie" computers that are doing hackers' bidding every day. McNulty saw it as a valuable underpinning to bolster all three company's existing technology and couldn't let it slip through his fingers.

If melding together all the technology and management teams isn't enough of a challenge, there are the revenue hiccups to overcome. If Secure Computing can use the deals to add new customers, it can become more profitable fast. The company benefits from a low cost of sales, compared to some other software companies, because it sells more than 70% of its gear through resellers. But that's also proven to be an Achilles heel for the company. The first-quarter miss was due to Northrop Grumman (NOC), a reseller of Secure's products, exiting the market. The second-quarter miss was due to a potential customer switching to a new reseller midstream, McNulty says. "It was the morning of the last day of the quarter and it was sitting on the shipping dock," he says. "We talked to the customer and they are totally committed to the product, they just had a question over who the resellers should be."

If McNulty really wants to get the most out of a more complete product, he may have to invest in an expensive, more specialized sales force, Jaquith says. Whether McNulty agrees isn't clear. But one thing is certain: As McNulty wrestles with his recent acquisitions and a market that's growing at a slower rate, the rest of his year isn't going to get much easier.


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