FireEye (NASDAQ:FEYE) posted third-quarter revenue above management's guidance. Also, given the strong growth of its cloud business, the cybersecurity vendor seems to be successfully shifting away from the secular decline of its legacy hardware business to a growing cloud-based subscription model. But the company has an important issue: Despite its revenue growth, it's still generating significant losses under generally accepted accounting principles (GAAP).
Legacy vs. emerging businesses
Since FireEye had communicated a preview of its third-quarter results during its Analyst Day a few weeks ago, its top line above management's guidance range of $217 million to $221 million didn't surprise investors. Revenue reached $226 million, up 7% year over year.
Billings of $249 million stayed slightly below the midpoint of the guidance range of $245 million to $255 million, which still represented a solid 13% increase compared to last year. Since billing is a leading indicator of revenue, its double-digit growth indicates the company is poised to keep on growing revenue over the next several quarters.
But these results hide the diverging progress of the company's three segments.
FireEye is facing the decline of its legacy business, which consists of selling on-premise hardware devices that deal with advanced cybersecurity threats. With the development of cloud computing, FireEye's legacy offering is less and less relevant for companies that have a part of their on-premise computing infrastructure in the cloud. The corresponding segment -- product and related subscription and support -- decreased by 7.2% year over year. And the 9.9% drop in billings indicates this downward trend is likely to continue.
But the company is growing its cloud business to offset the decline of its legacy portfolio. Its second segment (cloud subscription and managed services billings), which includes the company's cloud-related offerings, grew by 27.4% year over year.
Also, over the last several years, the company has been developing a consultancy business that helps its customers deal with cybersecurity threats. This business, which corresponds to the professional services segment, leverages FireEye's portfolio. For instance, customers can contact FireEye's consultancy with a single click from the company's software solutions. Since this service is also integrated with the company's cloud offering, it captured the cloud-related tailwinds and grew 28% during this third quarter.
Given the opposite growth trajectory of its businesses, the company's legacy product segment is on the way to represent less than half of the company's total revenue. During the third quarter, the company's product segment decreased to $117.8 million while its two other segments together reached $108.1 million.
The GAAP vs. non-GAAP profitability issue
But apart from its growing cloud business, the company's profitability remains a significant concern.
Management highlighted that non-GAAP earnings per share of $0.02 reached the high end of its guidance. But this non-GAAP metric excludes, among other items, share-based compensation (SBC), which remains a significant noncash cost to the shareholders. During the third quarter, SBC of $36.7 million represented 16.2% of the company's revenue. As a consequence, the weighted average diluted shares during the third quarter increased by 10% compared to last year, which diluted shareholders in a meaningful way.
Ignoring SBC is a common practice for cybersecurity stocks. But you should take FireEye's GAAP results into account to get a more accurate representation of the company's performance. And FireEye posted a GAAP loss of $65.5 million during this quarter, compared to a GAAP loss of $50.0 million one year ago.
These GAAP losses are due to a couple of factors:
First, the company's consultancy service implies a lower gross margin compared to a software-based business. The corresponding professional services segment's gross margin of 45.9% during last quarter dragged down the company's GAAP gross margin of 65%.
Then, the company also has to sustain high research and development (R&D) and sales and marketing (S&M) expenses to support the growth of its cloud businesses. During the last quarter, the company spent 74% of its revenue to cover its R&D and S&M expenses.
Besides third-quarter results above expectations, management announced during the company's Analyst Day an ambitious goal of increasing the company's operating margin in the range of 18% to 22% by 2024.
But again, this non-GAAP metric excludes significant costs such as SBC. Thus, despite the impressive revenue growth of FireEye's cloud business, investors should stay on the sidelines as long as the company's high costs involve GAAP losses.