What Does the Future Look Like for FireEye and Other Cyber-Security Firms?

A few quarters ago, FireEye (MNDT) was trading at a beefy premium to its cyber-security peers, but now it can be bought at a significant discount.

In this clip, Chris Hill, David Kretzmann, and Anthony Arsta reach into the Market Foolery mail bag and answer some questions from a concerned investor about FireEye's recent performance, what it means in the context of the company's future plans and the cyber security industry as a whole, and also provide some advice for investing in this volatile segment.

A full transcript follows the video.

This podcast was recorded on Jan. 20, 2016.

Chris Hill: [email protected] is our email address. From Kent Turner: "I own shares of FireEye. This is a company that is declared an industry leader, but I'm beginning to have my doubts. I've held in with them thinking that things will soon reverse their decline and the stock price will improve. Are they a good company for someone to acquire? Are they headed to bankruptcy? Please help!" Two very different outcomes are. FireEye, as you mentioned, Tony, cyber security, really more of a pure-play cyber security company that really has seen its stock price whacked over the last year or so. Where is this thing going, David?

David Kretzmann: Well, the short answer is, no, they won't go bankrupt any time soon. This is a company, similar to Netflix, they're trying to capture a share of what's a very large and fragmented market, which is cyber security. Cyber security as a whole, globally, is anticipated to grow 10% annually to $170 billion in size by 2020.

So, that's a big market. And FireEye is really just plowing money into investing and scaling their business. So far, they haven't been consistent producing positive cash flow, much less free cash flow. So they're burning a lot of cash. But they do have a net cash position of $471 million, so they won't go bankrupt any time soon. The question is, can they get to a point where they have that scale and they're able to produce positive, consistent cash flow? That's really the big question with them over the next couple years. And I think it's hard to call them a leader. Like I said, this is a very fragmented space.

They're a $2.5 billion company. So they're sort of in the middle-tier, I'd say, when it comes to the size of companies in this space. But they do have some product partnerships with larger players like Checkpoint (CKP.DL), they have some product partnerships with smaller companies like CyberArk. So, I don't know. It is a challenging space to be in right now. It's very fragmented. There's a lot of competition. So we probably will see some consolidation. At a $2.5 billion market cap, they could be an acquisition target. As an example, Checkpoint Security, which is, like I said, a much larger company in this space, they have $1.3 billion in cash and no debt. So they could, conceivably, acquire someone like FireEye or Checkpoint, which there are actually already rumors about.

Tony Arsta: Yeah, it would make sense for some consolidation to take place in the industry, because there are so many competitors out there, between them and Palo Alto Networks, there's a few competitors that are, from what I can tell, trying to do the exact same thing. Basically, this is a stock that was trading at a tremendous premium six to 12 months ago, and is now trading at a tremendous discount to its peers. The story hasn't changed much. They said last summer that their goal was to be cash flow positive by 2019. So, you're looking at a company that is still a few years and a lot of revenue short of where they need to be to become a viable business.

If you bought the company at any point since its IPO, you trusted that long-term vision that it would take them, from the time of IPO, somewhere between three to six years to become a profitable company, and that they'd grow along the way as the industry grows along with it. And that story really hasn't changed. It is a difficult industry to be in. Maybe you want to invest in a few companies there instead of just choosing one you think will be the winner. But it's the same investment you made six or 12 months ago, just at a bargain price right now.

Kretzmann: Yeah. I mean, it's important to remember that, even though their growth has been decelerating, they still grew sales 45% in the most recent quarter. So, this is still a very quickly growing company. They are capturing market share, but like Tony said, it's really a matter of scaling over the next few years. So, that'll be a key thing to watch.

Hill: I don't know what number I was expecting to come out of your mouth, but when you said 2019, the first thing I thought was, "Gosh, I don't know if FireEye is a stand-alone company in 2019." I mean, if 2016 is anything like 2015 for this company, I could see someone going in ... and I don't know if it's-IBM, but I could see a tech behemoth saying, "We like you and we're making a godfather offer."

Arsta: That is possible. The other possibility, since this is such a service-driven business, is that with the decline in share price and employees being paid so much in stock options, is that they just lose all their talent. So, one of those outcomes would be good, one would not be, and I don't know which will happen.

Kretzmann: Yeah. And we can also take a step back here and recognize that on days like this especially, companies that aren't making money and don't have consistent cash flow, their stocks will often be much more volatile. So in the case of Netflix, they reported, by all measures, a pretty good quarter, but the stock is still down. FireEye, I think, is down 10% today. These are companies that aren't making money, and the money they do make isn't consistently positive. So, in the context of portfolio allocation, you probably don't want a huge chunk of your portfolio in these kinds of companies, especially if these volatile share prices get to you.

So, a company like FireEye, you might not want more than, say, 2% or 3% of your portfolio in that company. Or like Tony mentioned, you might want a basket of the cyber security companies, because there's not one clear winner at this point. So I think that's something to keep in mind with these smaller companies that are investing a lot of money, they're not profitable today, you have to recognize that their share prices will be volatile. The stories are exciting. They're often developing new technologies or platforms. But you have to recognize, yeah, those share prices will be volatile.