If you look closely, there are signs of progress at FireEye (NASDAQ:FEYE). The cybersecurity company has been a disappointment, admittedly: FireEye stock once traded above $90, and now changes hands at $16. But FireEye generally has performed well in the past couple of years, and there’s reason to see further improvements ahead.
Growth in billings (which back out deferred revenue changes) shows demand is increasing, particularly as the company shifts from appliances to software. Operating margins are exceedingly thin, just 3% on an adjusted basis in 2018, which means earnings can jump sharply with even modest expansion.
An ~80x multiple to the midpoint of 2019 EPS guidance makes it seem like FEYE stock is pricing in massive growth, but that’s not quite the case. Margins can easily double or triple, which alone can move earnings substantially higher in coming years.
But even with that case, and even with FireEye stock basically flat YTD, it’s difficult to get too excited. Margin expansion looks priced in. So does decent billings growth. That’s particularly true when considering stock-based compensation and the fact that investors shouldn’t be willing to trust FireEye just yet.
The Case for FireEye Stock
On its face, FireEye stock looks ridiculously expensive. Multiples of 4x+ EV/revenue and ~80x earnings hardly seem fitting for a company that at the midpoint of guidance expects billings to grow 7%+ in 2019 – and revenue just 6.5%.
Indeed, that guidance was disappointing, and it was the key reason why FEYE fell 12% after Q4 earnings back in February. But even with modest top-line growth, there’s still a case that FireEye stock can grow into its valuation. Operating margins last year, as noted, were just 3%.
That was a 300 bps improvement over the ~flat figure posted the year before. Full-year guidance projects margins this year of 5-6% – continuing the positive trend.
Combine a move to 9-10% margins along with revenue growth and FireEye earnings double in relatively short order. Indeed, FEYE stock jumped last month when JPMorgan Chase (NYSE:JPM) analysts upgraded the stock for similar reasons. The firm saw revenue growth accelerating thanks to product improvements – which should leverage operating expenses and continue margin expansion.
JPMorgan also pointed out that the shift to software impacts reported revenue and earnings, since upfront sales are recognized over the course of the contract. The firm said billings and cash flow were better metrics. Indeed, FireEye’s free cash flow guidance for 2019 suggests generation of $50-$60 million. That’s a more reasonable 58x P/FCF multiple at the midpoint.
Double that thanks to margin expansion, and continue high-single-digit billings growth into the future, and FEYE can grow into, and beyond the current valuation. The firm gave FireEye stock a price target of $20, which is line with the average Street target at the moment, and suggests over 20% upside.
The Case Against FireEye Stock
There are reasons for caution, however. For one, it’s not guaranteed that margins are going to expand continuously or at least at the same rate as seen in 2018 and 2019. Management did say on the Q4 conference call that it expected headcount to stay relatively flat this year.
That’s not necessarily going to be the case going forward. FireEye isn’t guaranteed to get two or three points of operating leverage each year. If it doesn’t, earnings growth might not be good enough. To drive upside, FireEye has to at least get EPS moving toward the $1 level. It’s guided to just $0.17-$0.21 this year. Something like 200-300% growth is easily priced in already, and if margin expansion slows, that type of growth is going to take several years.
The second issue is that cybersecurity is a tough space with no shortage of options. Indeed I called out 5 cybersecurity stocks for investors of varying styles earlier this month. Palo Alto Networks (NYSE:PANW) is the clear industry leader. ProofPoint (NASDAQ:PFPT) is the hot young growth stock. Carbonite (NASDAQ:CARB) offers a turnaround story of its own.
There are plenty of reasons to like the sector but the plethora of options suggests investors can find an easier, better-priced bull case than the one offered by FEYE.
Finally – as is so often the case in tech – there’s the issue of stock-based compensation. FireEye is targeting operating margins of 5-6% next year, and $50-$60 million in free cash flow. Stock-based compensation last year was $153 million, over 18% of revenue.
Even if that figure falls in 2019, it significantly colors non-GAAP results (from which the compensation is excluded). Is FireEye really generating mid-single-digit margins? Is it really generating $50M+ in free cash flow? Or is just accomplishing those feats by diluting shareholders?
Good, but Not Great
The underlying story when it comes to FireEye makes some sense, admittedly. Margins should get better. Billings growth should continue – and may even accelerate.
But even with FEYE lagging the market so far this year, the valuation really isn’t compelling. There’s still a lot of work left to do in terms of building margins and a long time for investors to wait. Competition is going to be intense, and it’s tough, as yet, to call out FireEye as a clear leader. Given all that, in a hot sector, it seems like there are better choices out there.
As of this writing, Vince Martin has no positions in any securities mentioned.