Cybersecurity software company FireEye (NASDAQ:FEYE) has been in a turnaround situation since Kevin Mandia took over as CEO a little over a year ago. While I previously covered five metrics to measure the status of the company's turnaround, there's really just one that investors should watch: deferred revenue. Read on for a review of deferred revenue, why it's important to the company, and some of the key drivers of the number.

What is deferred revenue?

The best way to explain deferred revenue is using the example of a magazine subscription. Let's say that you sign up for a one-year subscription to a magazine for $12. The magazine company will get $12 of cash from you to start the subscription, but will put that $12 into deferred revenue. During the next 12 months, as you receive the magazine, the company will recognize one dollar of revenue every month, and reduce deferred revenue by the same amount. If you extend your subscription for another year, the process starts over again.

FireEye has been transitioning from a model of selling customers a product where the revenue is recognized when the product is sold, to a subscription-based service in the cloud where the revenue is recognized over the life of the contract. Deferred revenue is a great way to look at the success of this transition.

A person in a black hoodie in a dark room, hunched over a laptop with the only light coming from the computer's screen.

Image source: Getty images

Why is deferred revenue important to FireEye?

FireEye emphasizes the importance of deferred revenue in its annual report, saying it "is an important indicator of the health and visibility of trends in our business, and represents a significant percentage of future revenue."

As FireEye has been purposely transitioning away from product sales, it has significantly increased its deferred revenue. All of the other revenue outside of product sales is classified in its subscriptions and services revenue, which contributes to deferred revenue.

Two charts. First, a bar chart of deferred revenue growing from $30 million in 2011 to $654 million in 2016. Second, a line chart showing percentage of revenue from product going from 74% in 2011 to 21% in 2016.

Data from FireEye 10-K filings. Charts and calculations by author.

Having a significant portion of your revenue coming from subscriptions enables the company to have a more stable revenue stream and allows the company to more easily plan its spending to match the expected revenues, which provides a more predictable profit stream.

Drivers of deferred revenue

There are three key drivers of deferred revenue for investors to watch: average contract length, new product sales, and a new accounting standard called ASC 606.

Average contract length has been decreasing from its high of 31 months in the first quarter of 2016 to 22 months in the second quarter of 2017. Management explains this shift as a strategic one where service contracts that were sold along with on-premise devices (products) were usually two to four years with an average close to three years. Currently, FireEye management said the contract terms are normalizing to be from 20 to 24 months, so the average of 22 months should be a sustainable number going forward.

Two charts. Bar chart showing deferred revenue by quarter from Q2-2015 of $410 million, peaking at Q4-2016 at $654 million, down to $619 million in Q2-2017. Line chart showing average contract length peaks at 31 months in Q1-2016 and steady downward trend every quarter to 22 months in the two most recent quarter.

Image source: FireEye's Q2-2017 earnings Ppesentation.

The company has reported a significant "refresh" opportunity in the second half of 2017. Over 6,000 customers have NX appliances (products) coming up for renewal in 2017 and 65% of them are in the second half of the year. Now that the company's new flagship product, Helix, is available, there's considerable opportunity to upgrade customers to the new subscription-based platform, which should further increase deferred revenue.

Lastly, starting in the first quarter of 2018, the company will be converting to the ASC 606 revenue accounting standard. This will classify product sales attached to subscriptions as "ratable" or included in deferred revenue. While FireEye has not said how this will impact future revenue streams, this should move a bulk of the company's revenue to the deferred revenue model, as most products are sold with an associated service contract.

FireEye's deferred revenue peaked in the fourth quarter of 2016 and the recent decline has primarily been in its non-current deferred revenue (greater than 12 months out), mainly driven by the decrease in average contract length. In the most recent quarter, overall deferred revenue only grew 5% year-over-year, which was a far cry from what it has been in the past.

As the contract length stabilizes, and the opportunity to transition customers to subscription-based products is realized, deferred revenue should respond positively. This growth in the coming quarters and years will be the one number I'm watching to determine the health of my investment in FireEye.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.