Company Uncovered: Commtouch (Nasdaq: CTCH)

An interview with Commtouch (CTCH) was featured as part of our new subscription newsletter, Israel Opportunity Investor. You can find out more about the company and the opportunities we cover at www.israelnewsletter.com

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Can you tell us a bit about Commtouch (CTCH)?

Gideon Mantel, CEO: Your timing is fantastic, by the way. Small-cap Israeli stocks have been hammered over the past 9 months. With the shekel appreciation, funds in the states lost money just on the currency divergence. Commtouch (CTCH) has a unique piece of technology. We have the ability to look at a huge stream of data and monitor and recognize patterns. Essentially, we function in the cloud [Ed.: the cloud refers to computing resources being accessed which are typically owned and operated by a third-party provider on a consolidated basis]. Scalability, performance, cost and results can be very attractive in the cloud. Over the past 4 years, we’ve used our technology to address secure messaging problems: that is, we aim to stop spam and viruses propagated over email.

How do you distribute your anti-spam solution?

GM: We have traditionally worked solely via OEM agreements. Because we focus on the enterprise, it’s our opinion that it’s more important to sell software bundled together as all-in-one solutions, not best of breed.

Can you give us an idea about Commtouch’s financial performance?

GM: We have almost 100 OEM partners which have helped us to achieve between $15 and $16 million of top line sales which given our scale translates into $0.16-$0.19 per diluted share. We have $16 million in cash, $2 million of which is in AAA-rated ARS. We’ve been cash flow positive for 2 years

Commtouch processes 2 billion emails/day. We are, in a way, content aggregators. We see everything that goes over Internet. We see broadly as opposed to Google, which sees traffic only over one domain. The business is growing 35%-40% year over year. We’ve announced an end-of-year launch of a web security product which would combine URL filtering and a malicious site database. We believe that this market is at least the size of email security market We know because many of our existing customers have needs in the space. In effect, by the end of 2008, we’ll be doubling our addressable market. We’ve also announced that we are investing $1.5 million in R&D to get us there.

How do you expect customer spending to change in a bad macroeconomic environment?

GM: Overall, the IRR for antispam solutions is like 2-3 months. No one we know of is thinking of cutting this. Additionally, the OEM model is very leveragable. It’s almost a money machine. 100% of revenues is service with almost all of it recurring, with very few customers going away. Our P&L is pretty predictable. That said, the OEM model in a service environment has a lot of challenges. It takes a long time to sign and recognize revenues. It generally takes 1.5 years before you start recognizing revenues in this model. We’re already there and that positions us well to sell new solutions through our model.

Tell us about the web security market.

GM: Websense (WBSN) bought Surf Control. Listen to the recent conference call where the CEO says that they’re getting out of the OEM business. IBM (IBM) bought ISS which had bought Cobian. That leaves the big players out of the game. Most solutions are static solutions, meaning they are database driven. Commtouch will provide a real-time web filtering system in the cloud. We have a huge advantage because we already see 2 billion emails per day and have the vision to see where problems stem from. Eventually, all smart phones will have web filtering/URL systems in the years to come. Smart phones will have to tap the cloud when they surf on the Web. We’re basically a cloud vendor. All the pieces and stars are aligned very nicely. The end result, from my perspective, is a big dream with a great reality.

And the anti-spam market?

GM: In anti-spam, we are definitely the OEM leader. We continue to sign 5-7 new deals on a quarterly basis. The quality is improving in our customer base. We announced Aladdin (ALDN) and CheckPoint (CHKP). For us, the Far East is an important growth market. We already have 22 OEM customers in Far East. It’s always a constant war to maintain great detection.

Commtouch is investing in its future via the web security launch. Are you willing to jeopardize profitability to achieve future growth?

GM: The Commtouch story is about profitability, growth, and cash. We made the decision to not make our $6 million but instead make $4.5 million and invest $1.5 million in future growth. We are looking to be an acquirer of technology that will complement what we have today and enhance our existing products. We won’t compete with our customers; we’re not going directly to the enterprise. I don’t think that we’re looking to be acquired.

What could go wrong in the thesis?

GM: The economy impacts everyone. However, we are in a defensive sector. We don’t envision anyone cutting their spam service to save a few thousand dollars. The fact that we are looking at service revenues lessens the impact. We need to stay on top of the bad guys. We’ve done a great job but we need to continue to do so in the future.

What about the strength of the Israeli shekel?

GM: It has impacted us. We’ve communicated all the details to the market. We are very open and the damages weren’t that big. When we budgeted for 2008, when the shekel was at 4.10 per U.S. dollar, we used 3.80. We cut some expenses when we saw the move in the shekel. The impact in Q1 was $80k or so and probably will be a little higher in Q2. Our forecasts are intact.

What are you doing to get the story out about CTCH?

GM: Our CFO does roadshows. We are constantly talking to investors both in Israel and in US. Personally, my time spent is elephant hunting to attract those few investors who are committed to building and staying with a position in Commtouch. Our trading volume is increasing after a couple of months. So, in that sense, a mutual fund investor is more of a target than a hedge fund. We did a reverse split at the end of 2007. The main reason was to get on institutional investors’ radar screens. The stock was significantly higher than it is today with the intention to move from the NASDAQ Small Cap exchange to the NASDAQ Global Markets. Unfortunately, the market fell apart right after the reverse split, which didn’t help.

Thanks.

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