Tuesday , 16 September 2014
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Don’t Fiddle While FireEye (FEYE) Burns

Don’t Fiddle While FireEye (FEYE) Burns

Welcome to this week’s PTT Insider.

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OK, enough talk. Let’s dive right in…


by Josh Burwick – FireEye’s (FEYE) rising stock price brings back vivid memories of my tenure at Goldman Sachs during the Internet bubble. A stock would be deemed “cheap”, because it was trading at only 30x revenue (while its peers were trading at 40x). I thought those days were over. Yet, FEYE (a fairly recent IPO) now trades at roughly 30x 2014 revenue. As a former portfolio manager I can’t justify this on any metric. In my recollection, investors have never been able to make money on established companies trading at 30+ times projected revenue.

FireEye has the leading security solution to prevent Advanced Persistent Threats (APTs), the latest buzzword in security circles. APT’s are nothing more than sophisticated attacks that sneak into an organization, locate valuable information (e.g. credit card info) and send that info back to the perpetrator undetected. Existing security solutions like anti-virus and firewalls cannot effectively prevent APT’s.

With the front page news that Target was hacked leaving tens of millions of credit cards exposed, the call for a solution was loud. FireEye quickly emerged as the best solution on the market. Unfortunately, APT prevention is only a part of a corporation’s security platform. FireEye’s appliance does not mean a customer can forego endpoint protection, firewall, secure web gateway, or intrusion prevention. According to Gartner- “Advanced threat protection appliances are largely a complementary technology rather than a replacement of endpoint or signature based protection solutions”.

The target customer for APT appliances is high end enterprise, early technology adopters and government entities who want the latest and greatest security gadgets and have dedicated budget ready to deploy. Clearly over the last two years we have seen these buyers gobble up APT appliances aggressively in order to prevent themselves from being the next victim. As a result FireEye has seen their revenue skyrocket from $33 million in 2011 when APT’s started gaining notoriety to $162 million in 2013, a CAGR of 169%.

However, as is the case with most high growth companies, the law of large numbers, customer saturation, and increased competition starts to slow growth. Most recently, FireEye’s product and revenue growth decelerated to 59%/81% y/y vs. 79%/95% and 73%/108% in the June and September quarters, respectively. Of course, 70% growth is great, but putting it into context versus prior quarters of 100%+ shows a marked deceleration.

In fact, FireEye has been growing its sales force by 150% y/y to achieve much lower revenue (and decelerating) growth rates. That is not a recipe for success. Further, now that most large enterprises have deployed APT solutions to some extent, buyers are starting to show some buyer’s remorse. According to Gartner FireEye purchasers, “Similar to other security products that lack clear regulatory drivers, Gartner customers claim during inquiry calls that they have difficulties proving business value to management to justify the costs of these (Fire Eye) products”.

FireEye currently has the best APT appliance on the market but competition is picking up. Worse yet, that competition is coming strong from big industry stalwarts like Cisco (CSCO), Checkpoint (CHKP), Fortinet (FTNT), and Palo Alto Networks (PANW).

The Time Is Right

Timing is important when it comes to shorts. In my experience, the best time to initiate a short position is when all the shorts have given up (also known as capitulation). In this case, a recent short squeeze has run its course, precipitated by a secondary offering of 14 million shares. The secondary nearly doubles the float to 31.5 from 17.5 million post the IPO.

As it turns out, 8.4 million of those shares were sold by existing shareholders, including the founder. To make matters worse, FEYE priced the offering at $82, an 8.5% discount to its previous day’s closing price (2-5% is the norm). In my opinion, management realized that an 8.5% discount still represented a great price at which to cash out.

Investors seemingly caught on to this the following day. The stock “broke” the $82 deal price, closing at $81.04. It is well-known on Wall Street that a broken deal price is generally a very bearish sign. It indicates massive selling pressure that even the underwriters (in this case Morgan Stanley, Barclays, JP Morgan and Goldman Sachs) cannot handle.

Another sign that timing is on our side is the large acquisition of Mandiant. FireEye acquired Mandiant for $1 billion roughly 10x revenue, in a mostly stock deal ($106.5million cash and 21.5 million shares). Mandiant was a high profile leader in the incident response space. The problem with acquiring Mandiant instead of continuing the partnership is that there are few obvious synergies. Mandiant and FireEye target different buyers, end point protection and network operations, respectively. Acquiring Mandiant instead of continuing the partnership tells me FireEye realizes that their growth is decelerating and competition is heating up and the only way to ward it off is by buying growth.

Acquiring a company so shortly after going public is very rare and should cause one to ask “if growth is so spectacular in your core business, why are you taking on additional risk and management’s attention to pursue adjacent areas?” Of course, it’s not overpaying when you use overvalued shares that trade at 30x revenue to buy a “less overpriced” target for 10x. Using mostly equity, CEO Dave Dewalt must realize his valuation is absurd and wants to use his inflated currency to buy the many missing pieces of security that FireEye is missing.

Don’t be surprised if Dewalt does more and more acquisitions using his overinflated currency. The key question becomes “what companies are naïve enough to take an extremely overvalued currency like FEYE?”

What the Current Valuation Implies

At today’s market cap of $13 billion, FEYE trades at roughly the total addressable market estimated by IDC for all security products, in 2017. According to Gartner in 2013 the total security market revenue was $13.5 billion, broken down as follows: Firewall ($7.5 billion), Intrusion Prevention ($1.2 billion), Endpoint Protection ($3.4 billion), and Secure Web Gateway ($1.4 billion). FEYE’s assertion that Mandiant triples their total addressable market to $30-40 billion is laughable.

Morgan Stanley’s software analyst Keith Weiss (who I think is the best software analyst on the Street) estimates a bull case of $3.2 billion revenue (up from $162 million today), operating margins of 25% (from -72% today) to arrive at a 2019 free cash flow margin of 21% and discounting it back at 12.5% discount rate arriving at the ultra-bull case scenario of $94. In other words, if FireEye executes flawlessly for the next 5 years the stock is worth $94 today.

However, if it comes down to reality, the stock should be cut in half from current levels. In my opinion, the risk/reward is 4:1 in the favor of shorts. I have purchased FEYE puts to take advantage of the selloff I expect to see in the shares. That should take this name back to the $50 level (at a minimum) where it would still be trading at a hefty multiple for a point product.


by Mark Gomes –  PTT Research now has a huge and global base of subscribers with diverse skill sets. For those of you who do not have a professional Wall Street background, I will provide occasional lessons that will help you become a better investor.

For you more-experienced folks, keep in mind that some of my lessons will buck conventional wisdom. This is because conventional wisdom produces conventional returns. Over the course of 25 years, I learned (usually the hard way), that some things on Wall Street are not as most believe.

Pull out you notebooks, class. It’s time for today’s lessons:

Lesson #031614 – Learn To Accept New Ideas

“The human mind treats a new idea the same way the body treats a strange protein; it rejects it.” – P. B. Medawar

This quote effectively sums up why good picks often take a long time to take off.

Himax was a perfect example. When I first wrote about HIMX, many investors accused me of “pumping”, “lying”, and “fraud”. This is because it was easy for them to believe that a stranger was lying to them about a stock that was “poised to triple”. After all, we are bombarded with fraudulent (or at least negligent) analysis on a daily basis. In other words, it’s not a new concept. We’re used to it. It’s not fair, but it’s comfortable.

The truth was much harder to believe because it was a new concept. Heck, back then, most people didn’t even know what Google Glass was. How were they supposed to believe that Google was going to produce magical glasses and use some unknown company for the key component?

Well, most of those people missed out on a stock that went from 3 to 15. Thus, the lesson is simple – learn to accept new ideas. Change is inevitable. The key is to confirm the new truth(s) and quickly accept them as reality. The sooner you do, the greater the rewards when the truth finally hits the masses between the eyes (as it did when Google finally announced that Himax would indeed be their key supplier…four months after we selected it).

FYI, easier truths are out there to be identified. When Samsung and Android started taking the world by storm, we could all see it in our day to day lives. My girlfriend chose an Android over an iPhone, as did my brother. Before long, Android was the #1 selling operating system and shares of Apple were nearly cut in half.

Identifying and accepting this reality would have prompted you to sell (or even short) AAPL without anyone outside assistance. In fact, this is the forte of our Consumer Products & Trends analyst, Jamie Nuss. She has identified numerous trend shifts before the general public was ready to accept them (including the emergence of GMCR and KORS, along with the rise and fall of CROX and DECK). We’ll be hearing from her again before long.

Lesson #031814 – Play In The Smallest Ponds

I’ve said this before, so I’ll keep it quick. Warren Buffet got rich by investing in small stocks. The smaller the better. Why? Because bigger investors play with bigger stocks…and bigger investors tend to be smarter (or least have smarter resources). This makes the investing game more competitive as you move up the market cap scale.

In fact, Mr. Buffet would have stuck to smaller stocks if not for one problem – he became too rich to invest in small stocks (his average investment would completely acquire some of the companies we discuss!).

The lesson is simple: Be the biggest fish in the smallest pond that can accommodate your level of wealth. Small stocks have small-time competition, giving us a big advantage when we apply our professional methods (and budget) to analyzing them!

Lesson #031914 – Stay Patient

The Efficient Market Hypothesis says that security prices fully reflect all available information. However, this hypothesis is tragically flawed for one big reason — it takes the “dumb masses” longer to figure out what the intelligent few already know.

I have endured this for as long as I can remember. This is why my proclamation that HIMX would win GOOG and that AAPL should do business with PXLW were dismissed by many as fraudulent. In turn, that is why those stocks took “so long” to achieve fairer valuations.

The lesson here is simple: Stay patient. People will eventually figure it out (it may take until the truth is publicly broadcast by the companies themselves, but it’ll happen). Also, things may happen fast, but prepare for a long wait. As John Maynard Keynes once said, “markets can remain irrational longer than you can remain solvent.”




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