Acquired Growth Keeps LogMeIn Inflated

LogMeIn Inc. (LOGM, Financial), a cloud-based connectivity provider, recently reported its second-quarter results, beating earnings consensus and missing on revenue. The company posted revenue of $257 million, up 208.6% on a year-over-year basis. Analysts were projecting revenue of $265.08 million. EPS came ahead of consensus as earnings grew 106.1% to reach $1.01 per share on a year-over-year basis.

LogMeIn expects revenue to range between $271 million to $273 million for the third quarter of 2017, which is in line with the consensus of $272 million. EPS is expected to be in the range of $1.10 to $1.12. Estimates for the third quarter stand at $1.11. For the full fiscal year, the company is guiding for mid-point revenue of $1.014 billion, leading to mid-point non-GAAP EPS of $4.05. As the company is performing better than expected, the market reacted favorably to the news as the stock is up 5% since the earnings release.

Revenue insights

LogMeIn generates revenue from three business areas, including communication and collaboration, identity and access management and customer engagement and support. All services are provided through the cloud.

During the first half of 2017, revenue growth was primarily supported by communication and collaboration, which grew more than 11 times to reach $230.9 million. Other areas of business also supported revenue growth; identity and access management grew 40% while customer engagement and support revenue grew 64% on a year-over-year basis.

‘Communication and Collaboration’ dominates the revenue base now

Note the company generated more than 50% of its revenue from communication and collaboration during the first half of 2017. This is a material transition as LogMeIn only generated 11.8% of its revenue from this segment during the first half of 2016. See the chart below:

Source: LogMeIn Q2 2017, 10-Q

Things are different from 2016; the company now relies primarily on communication and collaboration for its revenue followed by identity management. The acquisition of Citrix’s (CTXS, Financial) GoTo business changed the makeup of LogMeIn’s revenue classification as it mostly relates to communication and collaboration business.

Organic growth is not rosy

It is vital to note the first-half revenue consolidates $267 million from the GoTo acquisition. This indicates organic growth for LogMeIn was around 8.5% during the first half of 2017.

Since growth was acquired, the company will not be able to replicate this kind of growth in 2018. As a result, analysts are projecting only 13% top-line growth for fiscal 2018.

Why organic growth matters

LogMeIn is trading based on its top-line growth; it is considered a growth stock. The forward price-earnings (P/E) ratio stands around 24, which puts the company slightly ahead of the S&P 500's current P/E ratio. The point is investors should analyze LogMeIn’s growth cautiously. Acquired growth should be distinguished from actual growth as it is a one-time occurrence.

Other factors to consider include financing of the GoTo merger, costs of the merger and the dilution effect of the merger. Buying LogMeIn merely on acquired revenue growth might not be a good idea as the stock is already priced for perfection.

Earnings insights

During the first half of 2017, the company posted a net loss on a GAAP basis. Operating expenses were the primary reason for this loss. Sales and marketing expenses increased 101% and general and administrative expenses increased 281% on a year-over-year basis.

The increase in expenses primarily relates to the acquisition of GoTo. LogMeIn consolidated GoTo’s first-half expenses on its income statement. All in all, the rate of expense growth was higher than revenue growth, leading to a net loss compared to a net profit on a year-over-year basis.

Non-GAAP earnings growth was backed by acquisition costs and amortization

Nevertheless, non-GAAP earnings grew to reach $92.5 million in the first half of the year. Non-GAAP earnings were backed by exclusion of high stock-based compensation along with acquisition-related costs and amortization.

Source: LogMeIn Q2 2017, 10-Q

High amortization indicates the company acquired considerable intangible assets. Although intangibles entail non-cash expenses, they are among the critical expenses in technology businesses. Therefore, excluding amortization from non-GAAP earnings can distort the company's reported performance.

Investor considerations

There are several factors investors should consider before making a decision on LogMeIn

First, current growth is acquired growth. The company will not be able to sustain this kind of growth going forward. Single-digit growth is expected over the next several years. Analyst estimates conform to this statement. As growth will be low, paying 24 times forward earnings is not exactly cheap for LogMeIn.

Second, the company relies heavily on amortization and stock-based compensation for its non-GAAP earnings. This can render analyst estimates useless as estimates, including forward P/E, are based on non-GAAP earnings. Investors should always consider the disconnect between GAAP and non-GAAP earnings while weighing the risks of the investment.

Finally, the stock is already priced for perfection. See the valuation below:

Focus Equity Estimates

The valuation translates into a downside of 25% based on today’s market price.

Bottom line

If it was not for the acquisition of GoTo, LogMeIn would have witnessed single-digit growth, which does not warrant a high forward P/E. Aggressive non-GAAP accounting also makes the company a risky prospect. Regardless, the current stock price cannot be justified based on the EVA valuation model. Overall, LogMeIn is set to underperform the market going forward.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours