FireEye (FEYE) rallied in October off the momentum from a take-over rumor. For investors who aren't familiar with FireEye, this is about the fifth takeover rumor within the last three years. Just like NortonLifeLock (NLOK) was able to find a buyer for its unprofitable enterprise division, I have no doubt FireEye will find a buyer if it has no choice but to pursue that route as the best way to return more value to shareholders. However, in the absence of that, we have to run the numbers on how safe it is to maintain a long position in FireEye.
In my last thesis, I explained why I was lowering my price target. FireEye has been trying to make the pivot into a cloud and platform play. Cloud because the revenue recognition model is easy to forecast while driving high annual recurring sales. Platform because it increases the average deal size of every sale if FireEye can bundle its security offerings when making a sales pitch. This is the bet that has assisted the takeover chatter in helping the stock achieve the bullish run in October.
On paper, management provided a guide on what this would translate into in the long term. A 12-15% revenue CAGR between now and 2024. A non-GAAP operating margin expansion to 18-22%, up from 0% to 1%, and an operating cash flow margin growth to 25-30% of revenue. That's like achieving peak employment or the 2% Fed target for the inflation rate. It's not impossible, it's simply tough to achieve, especially when you are playing in a crowded space with competitors like Zscaler (ZS) who are already executing on the model you are transitioning into.
While the margins are convincing given the expansion of the cloud security market which is driving a lot of businesses to move their workloads to cloud platforms, it is not clear how FireEye will not cannibalize itself during refresh cycles and greenfield pitches if it intends to keep both its appliance business and cloud business running side by side. Product and related subscriptions and services are still 52% of the entire business. Management dedicated a full page of the last earnings slide towards visualizing the shrinkage of the product appliances as a percentage of overall revenue. While the decline has been in the single-digit, the point of the exercise is to help investors manage their expectations in the coming quarters. The more familiar they are with this reality, the less the knee jerk reaction will be if the story remains the same next quarter. I've always expressed my skepticism about the network security product business, which is the driver of FireEye's revenue because those appliances struggle to compete with the high-speed performance of traditional firewalls. As a result, it's easy to understand why the win rate of large deals has been range-bound over the years. In a scenario in which revenue from the appliances which are responsible for the few large deals are being guided down, the platform, cloud sub, and managed service segment have to over-deliver to achieve the 12-15% CAGR management is guiding for.
Going forward, the current valuation is more of a reflection that the bullish scenario shared by management will play out. FireEye is still a growth play, so the $12/share valuation from my updated DCF won't sound like sweet music to everyone's ears. However, as the decline of the product appliance business unfolds, investors should prepare for the volatility ahead. My $12/share assumes single-digit revenue CAGR of 7% till 2024 and a FCF margin expansion from 0% to 15% by 2024 driven by the high margin cloud segment. This assumes a WACC of 12% to discount for volatility in the overcrowded SaaS market and growth till perpetuity of 2%.
Source: Author (Using management's long term guidance)
Using management's hypothetical scenario, we get a price/share of $27, assuming a WACC of 12%, growth till perpetuity of 2%, and the current net cash position on shares outstanding of 214 million.
With that model, management effectively controls the valuation narrative from a story perspective. When the company beats, the story narrative takes over, and the stock will respond with a sharp rally. When the numbers fall below expectations, the stock will plunge off pure facts and numbers due to the declining appliance business.
While it isn't wrong to place a bullish bet that FireEye will achieve these lofty projections, the sheer number of alternate scenarios that could play out for this best-case optimistic scenario to be achieved means investors should demand a considerable risk premium when placing their bets. Of course, the risk premium individual investors will demand will vary with respect to their risk appetite, and the current valuation suggests more investors are willing to lower their risk premium given the possibility of a takeover/plan-B materializing.
Source: Author (Daily Return Volatility)
The point of risk management is to avoid avoidable irredeemable losses not to maximize returns. I consider the maximization of returns a futile game because no one can time a market top. However, we all can predict the percentage of our portfolio that can be eroded if things turn south. With FireEye, the safest entry point for me is $12-15/share. I will be maintaining a HOLD rating at this price. Bear in mind that if management executes to perfection, $27/share is possible.
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Disclosure: I/we 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.