CAPScall of the Week: Qualys

For years, satirical late-night TV host Stephen Colbert has been running a series on his show called "Better Know a District," which highlights one of the 435 U.S. congressional districts and its representative. While I am no Stephen Colbert, I am brutally inquisitive when it comes to the 5,000-plus listed companies on the U.S. stock exchanges.

That's why I've made it a weekly tradition to examine one seldom-followed company within the Motley Fool CAPS database and make a CAPScall of outperform or underperform on that company.

For this week's round of "Better Know a Stock," I'm going to take a closer look at Qualys (NASDAQ: QLYS  ) .

What Qualys does
Qualys is a global cloud security and compliance solutions software provider. The company's QualysGuard Cloud Platform is instrumental in protecting enterprise IT networks from intrusions while cost-effectively managing its solutions by automating many of its protective and compliance procedures.

In Qualys' most recent quarter, the company reported a 17% increase in revenue to $24.9 million, which was driven by the addition of new subscriptions as well as add-on sales for its existing customers. Fourth-quarter bookings also rose 16% to $105.1 million. The bottom line wasn't nearly as impressive, though, as gross margin dipped four percentage points to 77% because of higher capital expenditures from increased staff and R&D spending. The result was net income for the quarter of just $0.02 per share.

The competition
There are two sides to the cloud-computing security story. On one hand, the need for next-generation IT security that's scalable and easily adaptable is no longer an option for most businesses. This means that the business is out there in nearly every economic environment and that the size of the pie is only likely to grow.

On the other hand, there's no lack of competition among cloud-computing security companies for those dollars. Cisco Systems (NASDAQ: CSCO  ) and Juniper Networks (NYSE: JNPR  ) still make a lot of sense for many enterprises. Both Cisco and Juniper are valued brand-names in the networking and security industry and build their firewalls directly into their servers. However, Cisco and Juniper's drawback is that their servers aren't scalable. If you want to update, you need to buy a new server, plain and simple! Their products also aren't geared specifically for social-media intrusions, which are what cloud-specialists like Qualys are focused on.

Qualys faces considerably tougher competition from the likes of Palo Alto Networks (NYSE: PANW  ) , which is a cloud-based security company that's built its business on many of the same ideals that Qualys echoes. Palo Alto has taken away much of the burden of upgrades from the business itself and allowed its cloud-based system the ability to generate security updates internally throughout its network of customers. This is extremely convenient and efficient, and it keeps customers loyal. Unfortunately, even Palo Alto is struggling because of its reliance on government funding to drive some of its business. With the U.S. government scaling back its spending and Europe doing so to an even greater extreme, it commented to shareholders that its growth rate would be slowing in the interim. 

The call
After carefully reviewing the prospects of Qualys I've decided to make a CAPScall of outperform on the company.

The first aspect that attracts me to a company like Qualys isn't its double-digit growth rate, but the simple fact is that protecting your IT network and systems is no longer optional. We saw multiple attacks on the U.S. Department of Defense earlier this year that demonstrate the will and know-how of hackers, making security an utmost priority for today's business -- especially those engaging customers on social media.

Qualys' platform is also set up very similar to the razor-and-blades model employed by Check Point Software (NASDAQ: CHKP  ) . Check Point hooks the customers on its security hardware and initial software and then uses its "blades" (additional software upgrades) to keep them loyal. This model results in high levels of recurring revenue and often minimal customer attrition, since it's often expensive and/or time-consuming to switch security vendors. Qualys' model is set up the same way -- hook the customer with the initial security and procedure software, and then make additional sales, which results in a recurring and loyal revenue stream.

Qualys certainly isn't going to win any awards for being cheap. The company, after its disappointing first-quarter profit, is valued at a whopping 50 times next year's earnings. Even taking into account its higher growth rate, we're talking about a PEG ratio in excess of three! Despite this valuation, though, I think the necessity of cloud security is only going to grow over the next decade, more than making up for what shortcomings the company is exhibiting now.

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