After reporting first-quarter results on Tuesday afternoon, FireEye (NASDAQ:FEYE) shares dropped another 11% in the after-hours session. Shares are now down 66% from their peak of $97, which might entice some investors to bottom dip. After all, FireEye has shown solid revenue growth, and its products certainly add some value-the company did discover attacks on Internet Explorer's vulnerability. However, pointing to a decline from a recent hike is a dangerous way to find value. Using that approach, one might have bought FEYE when it was down 35%, 45%, or 55%. While it can be helpful to have the context of past prices, investors need to decide if FireEye is an attractive stock at $33. After this quarter, the answer is no. FEYE is a stock you simply have to avoid.
During bubbles, investors often use new valuation techniques to justify prices. These investors downplay the importance of near-term earnings and cash flow in favor of revenue growth, active users, the potential addressable market, and other metrics. The important point to remember is that we own stocks to own a stream of cash flows. If a company consistently grows revenue but can never deliver profits, it isn't generating value for shareholders. Revenue growth is a means to grow profits not an end in and of itself. FireEye's earnings make it clear the company is years from turning a profit; if it ever does. While $97 was clearly an irrational price, current operations make $33 look like an irrational price as well.
On a non-GAAP basis, FEYE lost $0.53, in line with estimates while revenue of $74 million beat by $2 million (all financial and operating data available here). Now, let's give credit where credit is due; revenue was up a whopping 161% from a year ago. FireEye is a growth company because security is more and more important as more transactions and data are online and in the cloud. Bookings were also higher than expected at $99 million, which pushed deferred revenue to $213 million. While revenue was up 161%, operating expenses (on a GAAP basis) jumped an even faster 217%. Typically, high-growth companies grow revenues faster than expenses, this is known as operating leverage. FireEye is doing the opposite. In essence, the more it has grown, the further away from profitability it has gone.
On a non-GAAP basis (which essentially excludes stock based compensation), the company lost $71.4 million. Basically, for every dollar of revenue, FireEye lost $0.96. The company is spending twice as much as it is bringing in. The company is growing, but it is requiring enormous marketing and R&D spending to attain this growth. In the quarter, R&D spending was $42 million (57% of revenue) and marketing was $77 million (104% of revenue). When it is costing a company so much to acquire a dollar of revenue, it is unclear when that company will be able to generate profits.
In fact while this quarter compared favorably to analysts, it was guidance that really disappointed and emphasized how far FEYE is from turning a profit. FireEye expects to generate revenue of $405-$415 million, which is roughly in line with consensus of $407 million. However, non-GAAP guidance for a loss of $2.10-$2.30 was worse than the -$2.04 consensus. Gross margins will be solid at 70-73%, but R&D will consume 40-43% of revenue while marketing will consume 82-85% and G&A will be 19-22%.
In totality, operating expenses will be around 170-175% of revenue on a non-GAAP basis. That is a bit better than the first quarter but shows that FireEye is far away from profitability. Importantly, FireEye actually increased it R&D forecast, which was previously 36-39% of revenue. Being a security provider is extremely expensive because hackers are increasingly sophisticated in their attacks. In a sense, there is a cybersecurity arms race occurring, and FireEye is spending aggressively to maintain an advantage. Until it can generate a lot more scale, this spending will leave the company solidly in the red.
Now on the positive side, the company does have the balance sheet to continue to invest in the business with $441 million in cash and $143 million in short-term investments. FireEye is spending aggressively, but it has the balance sheet to fund this spending. Still in the quarter, operations burned through $22.6 million in cash, and purchases of property and equipment cost another $14 million. With its cash position, another secondary offering is unlikely, especially given the drop in shares. FireEye has the cash to afford its spending binge.
Just because a company can afford to spend a lot does not mean this spending will generate a strong return on investment. It is clear that to add scale, develop stronger technology, and market the brand, the company does have to increase spending a bit. In the first quarter though, spending growth was faster than revenue growth. Sales and marketing spending was up 169%; it is not unreasonable to expect revenue growth to be a bit faster than that. Sometimes, growth is not worth the cost of that growth. We might be in that situation with FireEye.
FireEye will lose over $2.00 this year and likely in excess in of $1.50 in 2015. To breakeven in 2016, I expect FireEye will need to double revenue in 2015 and increase revenues by 50-60% in 2016. Most analysts are looking for less than 50% revenue growth in 2015, which could push the breakeven year out until 2018. There is also the ever-present risk that a competitor develops a better product or a larger tech company decides to aggressively enter the space and outspends FireEye. While the security business is a powerful one in our increasingly digital work, there is no guarantee that FireEye will be a leader.
This quarter showed just how far FEYE is from turning a profit, and it continues to spend dramatically, outweighing the dramatic revenue growth. From 2014-2016, FEYE is poised to lose at least $4.50 with a chance of breaking even in 2017 or more likely 2018. At $33, investors are paying 11x revenue for a company that is years from turning a profit. To me, even this multiple is unjustifiable, and the only way buying FEYE will be a wise investment is if a large tech company decides to acquire it, which doesn't appear imminent. With no earnings support, this stock can continue to trade lower. Simply put, companies that lack the ability in both the short and medium term to turn a profit have very little value. FEYE will continue to lose money for many more quarters. Investors would be wise to sell shares and simply avoid FEYE.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.