The stock of FireEye Inc. (NASDAQ:FEYE) spent the first part of this year scrambling up its price chart to a near 75% gain through the middle of June. In the handful of months since, however, shares have simply collapsed. Including the Q3 2015 post-earnings plunge on Thursday, the "FEYE" symbol is now down nearly 30% for the year.
To get some kind of perspective on this drubbing, and understand what might be in store for FireEye in the near term, let's compare FireEye's valuation to two well-known names in the security sphere: Palo Alto Networks Inc (NYSE:PANW) and Splunk Inc (NASDAQ:SPLK).
Below is a chart showing each company's valuation on a one-year forward price-to-sales (PS) basis. It's clear that Palo Alto and Splunk share an almost identical pricing relative to sales, while FireEye is not nearly as dear to the market:
It's important to note that these three security stalwarts share a remarkably similar financial model. Each company is posting high double-digit revenue growth on a quarterly (and annual) basis, each runs at a loss in order to gain market share, and each doles out stock compensation liberally, which increases GAAP losses but reduces the amount of cold, hard cash needed for payroll expenditures.
Of the three, Splunk is the most diversified, with several revenue streams that exist outside the security industry. Palo Alto Networks is the largest by revenue, as we'll see below. Since each organization operates on a negative margin, the market values them in part based on their perceived revenue growth potential(s), as expressed by the PS ratio.
What other factors do investors use to differentiate between the three companies when figuring a thumbnail valuation? While many qualitative factors are involved, such as FireEye's unique virtualization platform, or Splunk's many "use cases" outside of the security market, I believe investors are eyeing a few prominent guiding measures.
Billings growth is one -- what's the ongoing growth potential that is laid bare when revenue and deferred revenue are evaluated together? You can read why billings proved a major catalyst in Splunk's decline after its earnings report here, in the companion piece to this article.
Operating margin and operating cash flow are two other key indicators relevant to this industry. Many cyber security investment candidates sport negative operating margins. But the more attractive companies remain at least within a stone's throw of positive territory. They also find a way to generate ample operating cash flow.
Scanning these few metrics together yields eye-opening inferences. The numbers in the following table are based on the most recently filed quarter (MRQ) as well as trailing-12-month (TTM) data:
|Palo Alto Networks||Splunk||FireEye|
|Growth in Billings (MRQ)||69%||43%||28%|
|Operating Margin (MRQ)||(12%)||(44%)||(74%)|
|Operating Cash Flow (TTM)||$350||$118||$27|
|Operating Cash to Revenue (TTM)||38%||22%||5%|
Most notably, FireEye's growth in billings significantly trails its two peers in the most recent quarter reported for each company. And while all operate in the red -- in the interest of scaling up revenue and grabbing market share -- FireEye has the worst operating margin (by far) of the three.
Finally, due to that relatively poorer operating performance, FireEye doesn't generate the magnitude of cash its competitors do for each dollar of sales. In fact, FireEye only turned cash flow positive this year.
What the snapshot tells us
Based on this admittedly birds-eye view of FireEye relative to two well-regarded companies operating in the same market, we can draw the conclusion that the sell-off, which dropped FireEye to a 45% discount to Palo Alto Networks and Splunk on a PS ratio comparison, was probably adequate. Moreover, it's also likely that the stock at this point is neither oversold nor dramatically undervalued.
Essentially, investors in FireEye are forking over about half of what they'll pay for the revenue of Palo Alto or Splunk. That's because FireEye's growth prospects seem much weaker, its losses significantly larger, and its conversion of sales to cash flow anemic in comparison with these two similar companies. For FireEye to receive a higher PS multiple from the market, it will need to start improving the core metrics we've reviewed above -- and soon.