Don't Be Deceived by These Numbers

If ever a rule of thumb were made to be broken, it's this: Never invest in an unprofitable company.

Balderdash. I'm an investor in network security specialist Secure Computing (Nasdaq: SCUR  ) , which last week reported a $0.18 per-share Q2 net loss. Yeah, that sounds bad. But is it really? I don't think so. Here's why.

The gap in GAAP
First, GAAP accounting rules are preventing Secure from recognizing more than $6 million in real cash revenue. When Secure acquired CipherTrust last year, it also inherited significant deferred revenue. The result? Secure would recognize just a fraction of the actual cash acquired as operating income.

Second, acquisitions of CyberGuard and CipherTrust have created $4.8 million in charges for intangible assets that also have zero impact on cash earnings.

Third, each of Secure's last three acquisitions brought with them net operating losses that could be used for reducing its tax liability. In Q2, these credits equaled $1.7 million.

Fourth, Secure Computing booked a $4.3 million noncash charge for stock-based compensation.

Management adjusts for these items when reporting non-GAAP results. The adjusted total shows $5.0 million in non-GAAP net income, or $0.07 per share.

It usually is worth your time to be suspicious of companies that aren't reporting GAAP profitability. But after looking at the operating cash flow numbers, I'm more convinced than ever that Secure isn't getting enough credit for its cash production. Cash flow from operating activities is, after all, strong and growing.

A better bottom line
Were you never to look beyond the income statement, you'd likely never invest in Secure Computing. But the income statement says little about the underlying strength of this business.

Cash flow, on the other hand, says plenty. Through the first six months of the year, $18.6 million, or 15%, of Secure's $124.2 million in total revenue has flowed to its coffers as free cash flow, up 41% over last year's $13.2 million.

Let's zoom in on what that means. First, the balance sheet is stronger. Debt is down 25% since December. Cash and investments are up slightly over the same period.

Second, more cash means more money for growth-generating activities. At Secure Computing, that means adding staff. Senior VP and CFO Tim Steinkopf told analysts last week that he expects Secure's headcount to grow by 6%, to 1,000 employees, by the end of the year.

Finally, with more cash, Secure can afford to fund the research and development needed to combat fire-breathing competitors such as CheckPoint (NYSE: CKP  ) , Cisco (Nasdaq: CSCO  ) , Websense (Nasdaq: WBSN  ) , and, now, Google (Nasdaq: GOOG  ) . R&D as a percentage of non-GAAP revenue was 17.4% during Q2.

Don't underestimate that last point. The stakes for failure in the security industry are enormous. One data breach could cripple sales for at least a few quarters and perhaps a year or more. Spending to improve product quality is as much a matter of keeping existing customers happy as it is winning new ones.

Sound risky? You bet it is. Fortunately, Secure's products are, well, secure. The Sidewinder firewall has never been breached and is still trusted by several federal agencies. And its TrustedSource technology, which is integrated with the bulk of Secure's digital lockboxes, proactively seeks out the Web's worst to keep networks safe.

In other words, despite appearances to the contrary, Secure Computing is a very healthy, very well-positioned business that's growing very quickly.

Don't invest in unprofitable companies? Keep those thumbs to yourself, bucko.

You're cleared for related Foolishness:

How great is growth? Eleven of the dozens of stocks in the market-beating Motley Fool Rule Breakers portfolio, which includes Secure Computing, have more than doubled. Discover their identities with a 30-day free trial to the service.

Fool contributor Tim Beyers owned shares of Secure Computing at the time of publication. Find Tim's portfolio here and his latest blog commentary here. The Motley Fool's disclosure policy would like to tell you about its days running black ops against stock operators, but then it would be breaking cover. Sorry.


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