Analysis: NLOK AVASF

Tuesday after the closing bell, NortonLifeLock (NLOK) and Avast (AVASF) announced that they reached an agreement to merge and create the global leader in consumer cyber safety. You can find the slide deck to the merger announcement at the link here.

The deal does not come as a surprise as we wrote late yesterday in our alert here that the deadline to make an announcement was nearing. You may recall that talks of a deal first began in mid-July and caused NLOK to trade sharply lower, as we discussed in our alert here. We urged patience that afternoon and our willingness to own NLOK through this period is being slightly rewarded today with the stock now trading back above its July 15th levels thanks to today's ~8% rally.

Let's talk about the transaction itself and start off with the terms. The transaction details are a bit complicated, but Avast shareholders can elect to choose a majority stock option or a majority cash option that values Avast at an enterprise value somewhere between $8.6 billion to $9.2 billion. This is a large transaction for NortonLifeLock, which currently has a market cap of about $14 billion, and rightfully so, one concern the market initially had when this merger was first rumored centered on the amount of stock the company would have to put up to acquire a company this large. Dilution can be a problem. In a surprise to many, NortonLifeLock announced that they plan to increase its share buyback program by about $3 billion if the majority stock option plays out to offset dilution. Investors most certainly like this, plus the fact that management expects the deal to be double-digit accretive to earnings per share within the first full year following completion.

As for the strategic and financial rationale, management outlined five reasons why the two companies will be better together in the slide below. When we first talked about the possibility of this deal happening, what we liked most was how it consolidates a highly fragmented consumer endpoint market. The combined company will become the global leader in this category with a market share of about 35% to 40%, with over 500 million total users and roughly 40 million direct customers. Based on the latest reported full-year results, the combined company does about $3.5 billion in revenue at a blended operating margin of 52%, before synergies of course. As for those synergies, the companies expected to achieve $280 million in annual gross synergies. That's more than double Morgan Stanley's $125 million estimate. NortonLifeLock expects to deliver about $75 million of cost savings in year one post-deal, $245 million in year two, and the full $280 million in year three.

From a growth perspective, the combined company is expected to grow in the high single digits on the top line, with double-digit revenue growth over the long term. Additionally, the annual free cash flow profile is compelling here at roughly $1.5 billion pre-synergies. Given this strength of cash flow generation, we think the company will have little problem rapidly delivering back towards a net leverage ratio of approximately 2x to 3x from about 3.5x post-close. No changes were made to management's long-term capital allocation policy of returning 100% of free cash flow back to shareholders over the long term.

Now, the one big question we do have about the transaction relates to regulation. From a competitive standpoint, the combination of two of the largest companies by market share in the consumer endpoint market probably won't go over well with regulators. However, cybersecurity threats have been a growing theme over the past few years and won't be going away any time soon. Consumers need a trusted and innovative solution to combat these threats. If NortonLifeLock and Avast can prove to regulators that this deal will create more value to customers and protect their security, then we could see this deal get approved with few issues. Due to regulator timing, the deal is not expected to close until the middle of 2022.

Overall, we are pleased to see this deal get announced because the strategic rationale is clear. It consolidates a highly fragmented market and creates the global leader by market share. We already liked how NortonLifeLock operated at ~50% margins and generated a solid amount of cash flow, but this further improves the company's profile. It unlocks cost synergies and opens the door for additional revenue synergies like cross/up selling opportunities that we didn't even get into today. Finally, the combination accelerates NortonLifeLock's ability to deliver $3 in earnings per share, which the market today may not be giving the company enough credit for based on the current multiple.