Are You Secure With Secure Computing?

Deutsche Securities has one of the better records among the Wall Street analysts we track in Motley Fool CAPS. Kudos, sirs.

But, honestly, I question your decision to cut your price target for Secure Computing (Nasdaq: SCUR  ) to five bucks a share. You're kidding, right?

Seriously, Deutsche, I'm asking. Secure, tops among firewall makers and one of the creators of the digital security industry as a unit of Honeywell (NYSE: HON  ) in 1984, has produced $0.33 per share in adjusted free cash flow over the trailing 12 months. (By "adjusted," I mean adjusted to exclude the beneficial impact of stock options exercises.)

Thus, by your math, Secure Computing deserves to trade for roughly 15 times cash flow. That's crazy. Here's why:

Metrics*

2007

2006

2005

2004

Cash from operations

$52.0

$35.2

$27.6

$14.0

Stock-based compensation

($16.0)

($10.6)

$0

$0

Capital expenditures

($12.0)

($11.8)

($2.5)

($1.6)

Adj. free cash flow

$24.0

$12.8

$25.1

$12.4

Source: Capital IQ, a division of Standard & Poor's.
*Numbers in millions.

Even after subtracting the effect of options, cash flow has nearly doubled over the past three years. Annualized, it has improved by more than 24% a year.

I'll take that option to buy
And that's likely a conservative figure. Secure hasn't merely diluted shareholders, as is often the case when employees exercise stock options. Instead, acquisitions helped to fuel the exercises. Secure spent more than $550 million in 2006 for CyberGuard and CipherTrust.

Should we really penalize the company for exercising options from these value-creating acquisitions? I can't see how. The very act of buying CipherTrust provided Secure with TrustedSource -- a global digital-threat-monitoring system that's integrated into every Secure product. To me, it's the company's single greatest advantage in the ongoing battle against larger competitors such as Cisco (Nasdaq: CSCO  ) , CheckPoint (NYSE: CKP  ) , and Websense (Nasdaq: WBSN  ) .

And it's never been more relevant than it is right now. According to a recent report from the Pentagon and Defense Secretary Robert Gates, the U.S. must commit to investing in new and innovative ways to defend against cyber-threats.

Isn't this exactly at odds with your take that government spending on digital security will decline? I realize that there are reasons to mistrust the Pentagon, but when a federal document stresses the need to boost -- not reduce -- digital security, I think it's fair to question your thesis.

I also think it's fair to question your thesis when headlines like these can be found daily:

  • "Self-taught hacker admits worldwide attacks," The New Zealand Herald
  • "NATO boosts cyber-attack response force: senior official," AFP news agency
  • "Cyber Crime: Govt plans early warning system," Economic Times, India

Cyber threats are increasing, sirs, and like the Internet, they're global in nature.

Thus my thesis for adding Secure Computing to the Rule Breakers portfolio remains intact. This is a rebellious business that's changing the nature of digital security, stressing offense (seek and destroy threats before they strike) over defense (deflect attacks as they come). It's a compelling model that is rapidly winning customers -- many of which are agreeing to multiyear deals, leading to huge gains in cash flow.

But let's say you're right, and Secure does plunge further. If so, and if the essential thesis for investing hasn't materially changed, then I'll simply do what I must as a Foolish investor: Buy more shares.

Downgrade that.


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