Carbon Black S-1 Analysis — Not the Endpoint, Just the Beginning

Carbon Black, the endpoint security and predictive analytics company, filed to go public this week and is seeking to raise $100M. Founded in 2002, Carbon Black’s IPO has been long awaited and follows Zscaler’s IPO earlier this year. It is encouraging to see security companies go public as we actively invest in next-generation solutions in the space.

Carbon Black has done a great job expanding revenue, which grew from $71M in FY15 to $162M in FY17, a compound annual growth rate of 51%. Additionally, subscription revenue growth outpaced services revenue.

Product revenue stems from five software offerings:

  1. Cb Defense, an antivirus and endpoint detection and response solution;
  2. Cb Response for threat hunting and incident response;
  3. Cb Protection, which provides application control;
  4. Cb Defense for VMware to protect applications running inside virtualized data centers; and
  5. Cb ThreatSight, a managed service.

Like Zscaler, Carbon Black’s S-1 emphasized the large recurring revenue component of the business. ARR grew over the period from $77M in FY15 to $174M in FY17, a compound annual growth rate of 51%. Recurring revenue as a portion of total revenue expanded from 77% in FY15 to 88% in FY17, generating more predictability in the business. Customers have the choice to purchase Cb Defense and Cb Response as cloud-based products. The percentage of total recurring revenue generated by sales of these cloud-based products is growing, but remains less than 20%.

Customer count grew from 1,774 in FY15 to 3,739 in FY17, with YoY growth accelerating from FY16 to FY17. Carbon Black heavily leverages channel partners to grow its customer base. According to the filing, in FQ4'17 Carbon Black closed 94% of new and add-on business in collaboration with channel partners. The company’s annual revenue retention rate averaged 93% over the period, which is in-line with well-functioning SaaS businesses.

COGS as a percentage of revenue increased over the past three years. Digging deeper, Carbon Black’s COGS for services improved five points but its COGS for subscription revenue worsened nine points due to more customers purchasing cloud-based products. The business expects more customers to buy cloud-based solutions, increasing hosting costs and decreasing subscription margins.

Despite customers shifting to cloud-based solutions Carbon Black’s gross margins of 78% remained significantly above the public SaaS gross margin median of ~71%. Additionally, Carbon Black’s gross margins in FY15 and FY16 were above Zscalers’ and equivalent in FY17.

Since Carbon Black is a recurring revenue business, we thought it was best to look at sales and marketing in terms of sales efficiency ratios. Carbon Black achieved a sales efficiency ratio above 1.0 over the period, in line with other best of breed SaaS companies like Dropbox.

Sales and marketing margin decreased from 79% in FY15 to 66% in FY17 but is still high compared to public SaaS medians, now around ~47%.

Carbon Black’s P&L includes a “accretion of preferred stock to redemption value” line below net loss from operations. As this line item severely impacts the total net loss calculations, we decided to back it out for our business operations analysis. Carbon Black’s net income margin of -34% is below the public SaaS median of -13% and is mostly driven by the its higher S&M expenditure as a percentage of revenue.

Below is a table comparing Carbon Black’s financial metrics to 52 publicly traded SaaS companies. The exhibit highlights that S&M and R&D spend as a percentage of revenue is above the public SaaS median.

We expect Wall Street to compare Carbon Black to Zscaler, which recently IPO-ed and is also a subscription-oriented security business. The table summarizes some key metrics.

Since 2003 the company has raised $190M in venture funding from Atlas Ventures, Highland Capital Partners, KPCB, Sequoia Capital, among others. Carbon Black’s last round was a $68.5M Series F with a $609M post-money valuation.

Assuming the market values Carbon Black similarly to Zscaler, the implied market cap for Carbon Black is roughly $3.5B. Given Carbon Black’s YoY revenue growth rate is significantly below Zscaler, we believe Carbon Black will receive a lower MC/Rev multiple so $3.5B market cap is likely an upper bound.

After a sixteen-year journey, Carbon Black has built a relatively healthy recurring revenue security business. Revenue growth remains strong while subscription COGS and S&M spend could be improved. Overall, we are excited to see if the second security IPO of 2018 performs as well as the first.