Research firm Markets and Markets estimates that the global cybersecurity market will grow from $122.5 billion in 2016 to $202.4 billion in 2021, making it one of the hottest growth industries in the tech sector. That industry has been getting plenty of attention lately due to the WannaCry attack and new data breaches at Chipotle, OneLogin, K-Mart, and other companies.
However, cybersecurity stocks can also be hard to invest in, since many companies have confusing business models, flaky fundamentals, and high valuations. Today, I'll discuss two popular cybersecurity stocks I would avoid, and one which I would consider buying.
Why I'd never buy Palo Alto Networks
Palo Alto Networks (PANW -1.74%) provides next-gen firewalls, which strengthen traditional firewalls with network device filtering tools, to enterprise customers. On the surface, Palo Alto's growth looks robust -- its revenue rose 55% in 2015 and 49% in 2016, and is expected to grow another 26% this year. Wall Street expects its non-GAAP earnings to rise 55% this year.
However, Palo Alto still isn't profitable on a GAAP basis, due to hefty stock-based compensation (SBC) expenses. Those expenses rose 7% annually to $120.6 million, or 28% of its revenues, last quarter -- resulting in a GAAP loss of $0.67 per share. That was only a marginal improvement from its loss of $0.73 a year earlier, and indicates that Palo Alto isn't making a real profit despite growing its revenue at a torrid pace -- and that top line growth is decelerating. Moreover, Palo Alto trades at 7.7 times sales, which is higher than the industry average of 5.8 for application software makers.
That's why I won't touch Palo Alto -- it's an unprofitable company with decelerating growth and undisciplined spending which trades at an unjustified premium to the market.
Why I'd never buy FireEye
FireEye (MNDT) provides threat detection solutions, which attempt to intercept attacks before they breach a network's perimeter. Its revenue rose 46% in 2015, 15% in 2016, and is expected to grow just 2% this year.
That slowdown is attributed to the company pivoting away from slower-growth on-site appliances to subscription-based cloud services like Helix, which bundle together multiple services in a "platform"; and HX, a next-gen product which protects network endpoints from malware.
FireEye has never posted a GAAP or non-GAAP profit before, but its losses are narrowing by both metrics. Like Palo Alto, FireEye is also dragged down by heavy SBC expenses, which claimed 25% of its revenue last quarter. But unlike Palo Alto, FireEye is reducing those expenses with layoffs -- that's why its SBC expenses dropped 32% annually during that quarter. That move more than halved its GAAP loss.
FireEye also trades at a discount to the industry with a P/S ratio of 3.6, so its downside potential seems limited at current prices. Nonetheless, I would still avoid FireEye -- its sales growth is tepid and it remains unprofitable.
Why I'd consider buying Check Point Software
Check Point's flagship product, Firewall-1, upgraded traditional firewalls with "stateful inspection" features which track the operating state of network connections. It also sells ZoneAlarm, a popular firewall for mainstream consumers.
On the surface, Check Point's growth figures look dull. Its revenue rose 7% last year, and analysts anticipate 8% growth this year. However, the company is profitable by both non-GAAP and GAAP measures. Its non-GAAP EPS rose 13% to $4.72 per share last year, while its GAAP EPS rose 12% to $4.18. Check Point generates steady bottom line growth with disciplined spending and low SBC expenses, which used up less than 5% of its revenues during the year. Analysts expect its non-GAAP earnings to rise 9.5% this year.
Check Point's main weakness is its valuation. The stock trades at 11.3 times sales, which is well above the industry average of 5.8. However, its P/E of 27 remains much lower than the industry average of 111 for software companies.
The key takeaway
The cybersecurity industry is a hot one, but many top players have undisciplined spending habits like Palo Alto, sluggish sales growth like FireEye, high valuations, or non-existent profits.
Palo Alto and FireEye might be good plays for speculative investors, but I personally prefer companies with stable top line growth and growing profitability. That's why I'd avoid the first two stocks but consider buying shares of Check Point Software.