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Morningstar | Symantec Remains Plagued by its Internal Audit Investigation; Reducing FVE to $19. See Updated Analyst Note from 03 Aug 2018

No-moat Symantec reported its first quarter of fiscal 2019, with subpar results prompting us to reduce our $21 per share fair value estimate to $19. We remain concerned that no further clarity was given in regards to the scope of the firm's internal audit investigation. For background, during Symantec's fourth-quarter 2018 results, after reducing guidance, it was concurrently revealed that Symantec would delay the filing of its 10-K for fiscal 2018, due to an unspecified internal audit committee investigation. The investigation began due to concerns raised by former employees, and this quarter, it was revealed that we have no further insights into when the 10-K will be released. Amid the uncertainty, in tandem with the reduced guidance, we would caution investors from opening a position in this name. We plan to reassess our stewardship rating for the firm.

Financially, Symantec reduced guidance for the year after already lowering guidance at the end of fiscal year 2018. GAAP revenue guidance was reduced from a range of $4.76-$4.9 billion to $4.64-$4.76 billion. We note that the muted profitability profile of the business is due to both slowing growth and Symantec's divesture of its web security and public key infrastructure, or PKI, business, which had a stronger profitability profile relative to some of the more nascent enterprise assets, to Digicert for $950 million.

In terms of our views on the audit, the audit may amount to nothing in the long-run, but this is a serious issue. While management further asserted in the press release that they do not expect a restatement prior to the third quarter of fiscal 2018 (meaning a restatement could potentially happen in fourth-quarter 2018), we believe Symantec operates in an industry where trust is paramount above everything else. In reporting an internal audit, a delay in the filing of the 10-K, and failing to quell concerns, Symantec has, in many ways, violated that trust. Investors should proceed with caution.

On the call, management was explicitly asked if the reduced guidance this quarter was actually due to deals falling through after the audit investigation was revealed. While management vehemently denied this, the question certainly brought to the forefront whether the audit would have future implications.

After the fiscal year-end, when the audit was revealed, we scoured Symantec’s financial results for irregularities. We think investors should be aware of the two speculative theories that could have triggered the audit. First, we’ve noticed an expansion in the spread between both GAAP and non-GAAP results. It seems the restructuring line item of its income statement has increased, and it could be in the realm of possibility that management may have inflated restructuring expenses, by placing expenses that would have typically been regular operating expenses into this line item. Whether an expense falls in the restructuring line item versus regular operating expense (S&M, R&D, or G&A) has no bearing on GAAP profitability, but when calculating non-GAAP Net Income, restructuring expenses are added back into the results. Thus, it is within the realm of possibility that management inflated the restructuring line item to produce a better-looking non-GAAP EPS metric, allowing the firm to hit stock-based compensation targets. Second, we note that articles over the past few months have drawn attention to “ghost revenue,” where deferred revenue written off after an acquisition (known as deferred revenue purchase accounting adjustments in GAAP accounting) is added back to GAAP revenue numbers at a later date to create adjusted revenue metrics that are reported to investors. We note that this is a financial grey area of accounting, and Symantec has added back some of the written-off revenue each period following the acquisitions of Blue Coat and LifeLock. We think investors should be cognizant of potential issues with Symantec’s financial results.

Overall, Symantec has some high-growth assets, specifically secure web gateway (SWG) offerings acquired from Blue Coat, which are weighed down by slowing growth in the consumer business and the Norton franchise. We think bundling LifeLock and Norton creates a more enticing value proposition, but with Windows Defender, the lack of a market for endpoint products for mobile devices, and the rise in freeware (such as Malwarebytes), which provide offerings on par with Symantec’s consumer business that are free of charge, we think it will be a tougher road ahead. Even with Symantec’s higher growth enterprise business, consolidated Symantec is akin to an oil tanker, too big for these growing offerings to materially move the needle.