Dow Jones 14066.01 +91.70 7:45 am PDT, October 6, 2007 NASDAQ 2780.32 +0.00 For info, visit access.smallcapnetwork.com S & P 500 1557.59 +14.75 Change your subscription status here Russell 2000 844.88 +0.00 VOLUME 07 : ISSUE 94 Enigma Software: No Mystery About Growth and Margins  Company Name: Enigma Software Group Inc. Stock Symbol : ENGM Coverage Initiated: October 6, 2007 Current Price: $0.18 Average Volume: 11,063 52 Week Range: $0.12 - $0.65 Suggested Target: $0.65 Suggested Stop: $0.11 It's no accident VMWare (VMW) is up 75% over the last seven weeks after its August IPO, nor is it a coincidence how Vasco Data Security (VDSI) has gained more than 540% in less than a decade. Blue Coat Systems (BCSI)? Try 334% over the last twelve months. Yes, somebody out there reaped huge rewards because they had the guts and the foresight to take action with these Internet security stocks before the rest of the crowd did. The good news for you? Our perpetual hunt for the next great small cap stock has revealed a similar early-stage-growth software company. We think this stock has major potential for investor gains over the next several months...you just have to be willing to do something about it now. The company's name is Enigma Software Group (OTCBB: ENGM). Their business plan is brilliantly simple, and proven - skip the middle man and sell their Internet privacy/spyware protection software straight to the consumer over the web (read 'better margins'). What makes ENGM special as an investment opportunity - aside from being the only pure Internet security play out there - is the same thing that makes the company a great competitor in the spyware arena. They've made it easy to effectively protect your computer, and they've made it easy to do business with them.  I could literally give you a dozen specific reasons why I think a savvy trader would want to own Enigma Software right now, but I think my top three are more than enough:  1) Business Model: Why bother with wholesalers and retailers, each of which takes a cut of the sales total? Enigma has a fiscal edge on all the Microsoft's and Oracle's out there.  2) Demand: Most computers have some sort of spyware on them, yet most computers still don't have some sort of spyware protection...yet  3) Timing: The stock price is well under recent averages, yet the company's attracting more subscribers than ever.  No hoopla needed - let's just cut to the chase.    Business Model I've never seen anything quite like this. There's no packaging, middle-men, or distribution ...Enigma sells by direct download only. Do you know the kind of cost savings that generates? The boxed software you purchase for $50 at your electronics outlet has a markup of about 50% and half the wholesale price is likely to pay for packaging and delivery. So, despite software being an incredibly profitable business to be in, the major security software companies are actually leaving money on the table.  The key to the success of Enigma's revenue model is essentially the approach of being a service provider, via the Internet, rather than a one-shot software seller. Every six months, subscribers are automatically billed $29.99 for their constantly-updated spyware software and accompanying service.  How much of that $29.99 does Enigma get to keep? That's the point...all of it. Yes, there's fixed overhead (which we'll discuss below), but virtually no cost of goods sold now that the software has been developed. Ergo, the swing to profitability is purely a function - and not a scaled one - of sales. And folks, that swing to profitably doesn't look too far off to me. If and when the right subscriber critical mass is created, the net profit margin percentage will see explosive growth.  Of course, high margins with no sales volume doesn't do anybody much good, right? That's not a worry with Enigma though ...attraction and retention are part of the formula.  Kudos to Enigma's management team for figuring out that service is the secret to recurring revenue. Any malicious software unable to be removed by the software automatically can be submitted via a ticket to the company. >From there, a customized solution/fix is delivered via a direct connection with a user's PC, often just within hours. When needed, a personal phone call is also placed to the user. In comparison, we've heard some of the major names can take weeks to respond to individual problems. When's the last time a major software company called to help you with their software? The price for all the little extra effort? Nada.    Growing Demand = Growing Revenue If you think wide margins are exciting, then I think you're also going to like the kind of sales volume Enigma could cultivate over the next few years. The choice to enter the spyware/malware market (as opposed to any other web venture) was no accident. The costs and frequency of issues associated with spyware and identity theft are staggering. Think about these industry estimates...  * 8 out of 10 PCs are infected with spyware * In the first part of 2007, more than 800,000 computers in the United States were outright replaced due to spyware problems  * Identity theft is the hands-down leader of reasons for consumer fraud complaints  * In 2006, identity theft cost consumers a little over $49 billion And the complete list of problems is actually longer. Scary? Yeah, a little. More importantly though, it's fuel for security software demand.  Now ask yourself through an investor's eyes, do you think that's the kind of thing people would gladly pay money for? That's the point were making - more and more people are paying for it. However, don't take our word for it - let the numbers speak for themselves. Last week, renewals and subscription rates were up by 185% from a year ago (3199 versus 1120). Check out the full-sized growth chart in processed subscriptions by clicking here.  You don't need me to tell you the chart's rising quite nicely, and that's just the tip of the iceberg. I have to think the stock's chart isn't far behind. At the same time, Enigma's top line progress largely reflects the growing demand. Last year they did $1.3 million in sales. This year they appear to be on track to do about $3.5 million. In 2008 I seriously think they could do $6.0 million now that the number of new users is starting to grow exponentially ...a sales figure the company also believes could mean operating profitability.  How are they going to get to the $6.0 million mark? Besides the organic growth in demand discussed above, a big chunk of it is going to come from the relatively under-served overseas market. As of right now about 1/3 of the company's sales are made to subscriber's outside of North America. Enigma thinks there's a lot more opportunity than that out there and they're gunning for a bigger piece of that pie. Spyware protection is not their only product either. They also offer a system optimizer, registry repair software, and can add similar titles to the menu fairly easily.    The Numbers Say The Time Is Now OK, so what are investors really looking at here? If there was ever a capitalization deserving of a detailed explanation, Enigma has it.  Presently a few thousand of Enigma's 4.6 million I&O shares trade hands every day though we think that number is about to get much bigger. With shares priced at 18 cents the current market cap is about $830,000.  Now before you get too giddy, bear in mind the current float is probably only temporarily at one end of the spectrum (and includes a healthy dose of preferred stock - 7.4 million shares - owned by the two founders). The other end of the spectrum is a fully-diluted scenario. Dutchess Capital Management is holding 40 million warrants, and there's a lot of convertible preferred and convertible debt out there, much of which is also held by Dutchess. What makes it tricky is the number of common shares that could be issued varies with the stock price. At the other end of the spectrum the company thinks more than 200 million shares could be injected if everything is converted.  All of this may seem daunting at first but there's a tidbit about all those conversions that might make it all moot - the maximum number of warrants you can exercise or debentures you can convert is about 1% of the total float every 90 days. In other words, the immediate dilution risk is negated. It could take years for Dutchess to burn through those warrants which means we can indeed focus our attention on the present.  I previously mentioned $6.0 million in sales in 2008 is possible which could get them within striking distance of an operating profit. Here's the math behind my thinking...  The hefty items on the income statement are the booked expenses associated with, you guessed it, all the warrants and convertibles (including a loan from Dutchess). Those will progressively shrink as time goes on. My primary concern right now is on the operating numbers.  Overhead expenses are stabilizing at a little under $1 million per quarter, or $4 million per year. I'll even throw in extra $1 million a year to add to the operating expense lines, meaning the company has to cover $5 million or so. At the same time, Enigma has been processing an average of about 3000 customers over the last few weeks - a number that's been basically growing since day one. At $30 a pop ($29.99, technically) this translates into about $90,000 in sales per week or about $4.7 million per year. Of course, I have no reason to think subscriber growth is going to slow down now if it hasn't yet. So for 2008 I'll conservatively estimate abut a 30% growth rate. This brings the number right up to $6.0 million. It's only a ballpark but a plausible $6.0 million minus a plausible $5.0 million? You do the math.   Bottom Line It doesn't seem to me the current bottom line truly reflects just how big the opportunity is here. The top line is increasing and the warrant/convertible liability should shrink (relatively) as time passes on. You already know the deal on sales - they're growing, and it's almost all margin due to its web-based nature. I'm not sure exactly when Enigma will turn an operating profit, and then a net profit. However, I do feel it could happen well before most people realize.  Based on the sales growth and current path to profitability, and even factoring in the near-term potential dilution, I think ENGM has a great shot at moving up to 65 cents within the next few months. As for downside protection I'd personally use 11 cents as my line in the sand.  One final thought...ENGM seems to have perked up the last few days as it did earlier in the year. We've also seen some patches of quite heavy accumulation since late 2006. What's it all mean? I think the word is getting out on Enigma - people are voicing their opinion with dollars. With that idea swimming around in the back of my head, I see the June/July pullback as an outright gift from the market. Enigma was trading at 65 cents just a few months ago, and it seems to me that it may be more than able to revisit that upper resistance line (see the chart) with little problem whatsoever.  Between the chart, the margins, the demand, and the business model all the planets seem to be lining up for Enigma. What's not to like? I really believe the time to accumulate is now.     We Value Your Feedback   Got comments, questions or suggestions? Send 'em on over: Email the Editor If you wish to send a written request or inquiry, please send it to our physical address: TGR Group, LLC 4653 Carmel Mtn Rd Suite 308 #402 San Diego, CA 92130 Subscribe Information is power and timely information is profitable. Become informed and profit from Small Cap Network Profiles and Trading Alerts by becoming a Preferred Member today. 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