Danger Zone: Imperva Inc (IMPV) by Kyle Guske II, New Constructs

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and Marketwatch.com

When the momentum in a stock runs out, the results can be ugly. After falling over 20% on May 6, 2016, this week’s Danger Zone pick has since rebounded and might have investors thinking now is the time to buy. Unfortunately, the fundamentals of this company reveal a different story. Growing losses, misleading non-GAAP metrics, and significant competition land Imperva Inc. (IMPV: $39/share) in the Danger Zone this week.

Businesses Don’t Succeed Because of Revenue Growth

Like many newer technology companies, Imperva impressed investors with robust revenue growth despite increasing profit losses. From 2011-2015, Imperva has grown revenue by 31% compounded annually while Imperva’s economic earnings, the true cash flows of the business, declined from -$13 million in 2011 to -$83 million over the last twelve months. Figure 1 highlights the discrepancy between revenue and economic earnings. See the reconciliation of Imperva’s GAAP net income to economic earnings here.

Figure 1: Revenue Growth Equates To Greater Losses

Imperva Inc (IMPV)

Sources: New Constructs, LLC and company filings

In addition to negative economic earnings, Imperva’s return on invested capital (ROIC) has been negative each year since IPO and is currently a bottom-quintile -18%. Not surprisingly, Imperva is burning through cash, losing a cumulative -$416 million in free cash flow from 2011-2015.

Non-GAAP Earnings Create A False Picture

As is increasingly well-known, non-GAAP earnings are not a reliable indicator of a company’s operations. Here are the expenses IMPV removes to calculate its non-GAAP metrics, including non-GAAP operating income and non-GAAP net income:

  1. Stock-based compensation expense
  2. Acquisition-related expense
  3. Amortization of purchased intangibles

By removing these costs, Imperva paints a wildly different view of its business compared to the true economics. For example, since 2011, Imperva’s non-GAAP net income has improved from -$8 million to $3 million in 2015. Meanwhile, Imperva’s GAAP net income has fallen from -$10 million in 2011 to -$49 million in 2015. Economic earnings have declined even further, from -$13 million in 2011 to -$68 million in 2015. See Figure 2.

Figure 2: Imperva’s Non-GAAP Creates Distorted Reality

Imperva Inc (IMPV)

Sources: New Constructs, LLC and company filings

The main driver behind higher non-GAAP results is exclusion of Imperva’s heavy use of stock-based compensation. In 2015, Imperva removed $51 million (22% of revenue) in stock-based compensation expense to calculate non-GAAP net income. 2014 was more of the same, as the company removed $37 million (23% of revenue) in stock-based compensation expense to calculate non-GAAP net income. Stock compensation is a real cost of doing business and should not be excluded when calculating net income.

Negative Profitability Creates Competitive Disadvantages

Imperva operates across multiple segments of the cyber security industry and faces significant competition across its business lines. IBM (IBM), Intel Security Group (formerly McAfee and now owned by Intel (INTC), and Oracle (ORCL) operate in database security. EMC Corp (EMC) and Symantec Corp (SYMC) operate in file security. Lastly, Akamai Technologies (AKAM) and F5 Networks (FFIV) operate in web application security. Imperva identifies each of these firms as direct competition, and each of them is significantly more profitable in regards to ROIC and NOPAT margin, per Figure 3.

Figure 3: Imperva’s Profitability Ranks Last Amongst Competition

Imperva Inc (IMPV)

Sources: New Constructs, LLC and company filings 

Bull Hopes Ignore Reality, Acquisition Risk To Bear Case

IMPV saw its price soar through much of 2015. Many high profile cyber attacks pushed the entire industry higher, including peers such as Palo Alto Networks (PANW) or Fortinet (FTNT), which saw similar increases in stock price. Now that the hysteria has died down, the fundamental case for Imperva looks rather weak. Much of the bull case rests on Imperva’s continued ability to grow its revenue without regard to profits. It is hard to see how Imperva will grow profits given how poor its margins are and how strong its competition is.

Particularly troubling for bull arguments is the pace at which Imperva’s costs are rising. Research & development costs, sales & marketing costs, and general & administrative costs grew by 32%, 34%, and 38% compounded annually from 2011-2015 – all of which are higher than Imperva’s 31% revenue CAGR over this same time.

Further undermining the bull case, the stock is already priced for perfection. The current stock valuation implies that Imperva will grow revenues at a significantly faster pace than the industry average and make major market share gains. For reference, the cyber security market is expected to grow by 10% compounded annually from 2015-2020, yet IMPV’s current valuation implies the company can grow revenues by 30% compounded annually for well over a decade. We’ll highlight Imperva’s overvaluation in greater detail below.

The biggest risk to our thesis is that a larger competitor or firm looking to grow its security business acquires Imperva at a value at or above today’s price. As we’ll show below, unless a competitor is willing to destroy shareholder value, an acquisition at current prices would be ill advised.

Acquisition Hopes Rest on A Buyer Wiling To Overpay

We don’t think Imperva is an attractive acquisition target at its current price. To begin, IMPV has liabilities that investors may not be aware of that make it more expensive than the accounting numbers suggest.

  1. $35 million in outstanding employee stock options (3% of market cap)
  2. $27 million in off-balance-sheet operating leases (2% of market cap)

After adjusting for these liabilities we can model multiple purchase price scenarios. Unfortunately for investors, only in the most optimistic of scenarios is IMPV worth more than the current share price.

Figures 4 and 5 show what we think Microsoft should pay for IMPV to ensure the deal is truly accretive to MSFT’s shareholder value. Microsoft could be a potential acquirer of Imperva to bolster cloud security and was once named as a possible acquirer back in 2014. We think Microsoft has limits on how much it will pay for IMPV to earn a proper return, given the NOPAT or cash flows being acquired.

Each implied price is based on a ‘goal ROIC’ assuming different levels of revenue growth. In each scenario, we conservatively assume that Microsoft can grow Imperva’s revenue and NOPAT without spending on working capital or fixed assets. We also assume Imperva achieves a 10% NOPAT margin, similar to competitors EMC and SYMC. Imperva’s current TTM NOPAT margin is -20%.

Figure 4: Implied Acquisition Prices For MSFT To Achieve 8% ROIC

Imperva Inc (IMPV)

Sources: New Constructs, LLC and company filings. 

Figure 4 shows the ‘goal ROIC’ for MSFT as its weighted average cost of capital (WACC) or 8%. Only if IMPV can grow revenue over 35% each year for the next five years while also raising its NOPAT margin from -20% to 10% is the firm worth more than its current price of $39/share. For reference, consensus estimates expect Imperva

1, 2  - View Full Page