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FireEye Inc. (FEYE) – Short Thesis

FireEye Inc. (FEYE) Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and Marketwatch.com

Investors are always on the lookout for a bargain, particularly for quality companies. Just because a stock has seen a large price decline does not mean it has become a bargain. This week’s Danger Zone pick is down over 50% in the past two years. Unfortunately, many investors saw this decline as a time to buy, and the stock is up 30% since mid-May. With shares now greatly overvalued plus large profit losses and strong competition, FireEye (FEYE: $17/share) is this week’s Danger Zone pick.

Aggressive Spending Equates to Soaring Losses

FireEye’s economic earnings, the true cash flows of the business, have declined from -$40 million in 2012 to -$587 million over the trailing twelve months. Such large losses contrast FireEye’s revenue, which, since 2012, has grown by 96% compounded annually to $623 million in 2015 and $666 million over the last twelve months. See Figure 1. See the reconciliation of FireEye’s GAAP net income to economic earnings here.

Figure 1: Disconnect Between Revenue and Economic Earnings

[drizzle]NewConstructs_FEYE_RevVsEconEarnings_2016-06-27

Sources: New Constructs, LLC and company filings

The aggressive revenue growth has hurt FireEye’s margins and return on invested capital (ROIC). NOPAT margin is -62% and ROIC is a bottom-quintile -24% over the last twelve months.

Misleading Non-GAAP Earnings Rise While Profits Fall

The dangers of non-GAAP earnings have been made clear. Companies routinely remove normal operating costs to create a more positive picture of business operations. Here are expenses FEYE has removed when calculating its non-GAAP metrics, including non-GAAP operating margin and non-GAAP net loss:

  1. Stock based compensation expense
  2. Amortization of intangible assets
  3. Acquisition related expenses
  4. Restructuring charges

These costs can be significant, particularly stock based compensation expense. In 2015, FireEye removed $222 million (36% of revenue) in stock based compensation expense to calculate its non-GAAP net loss. By removing this cost, along with the others, FEYE is able to report non-GAAP results that, while not positive, are improving year-over-year while the true profits are declining. Non-GAAP net loss improved from -$280 million in 2014 to -$248 million in 2015. Meanwhile, GAAP net loss declined from -$444 million to -$539 million and economic earnings declined from -$521 million to -$576 million over the same time. This discrepancy, dating back to 2012, can be seen in Figure 2.

Figure 2: FireEye’s Non-GAAP Overstates Profits

NewConstructs_FEYE_NonGAAPvsEconEarnings2016-06-27

Sources: New Constructs, LLC and company filings

Negative Profitability Creates Competitive Disadvantages

The security industry is highly competitive and FEYE faces significant challenges from each of its competitors. As noted in the company’s 10-K, competition comes from Cisco (CSCO), Juniper (JNPR), Intel (INTC), IBM (IBM), and Palo Alto Networks (PANW), among others. Figure 3 makes it clear that FEYE’s competition have higher margins and ROICs. With such negative profitability, FireEye has competitive disadvantages in the form of less capacity to invest in product development and less pricing flexibility.

Figure 3: FEYE’s Profitability Well Below Competition

NewConstructs_FEYE_ROICcomparison_2016-06-27

Sources: New Constructs, LLC and company filings 

Bull Hopes Rest On Illusive Profitability or A Takeover

Just because FEYE trades below IPO price does not mean it is undervalued. Instead, it speaks to the over-optimism that FEYE received upon going public. As often occurs, the bull case for FEYE rests on the company continually growing revenues at a rapid clip, but “eventually” getting costs under control and becoming highly profitable. Unfortunately, FEYE has provided no signs that profits are near, and costs continue to grow nearly equal to or faster than revenue growth.

From 2012-2015, FireEye’s research & development costs, sales & marketing costs, and general and administrative costs have grown 157%, 92%, and 110% compounded annually respectively. At the same time, cost of revenues has grown by 136% compounded annually. As noted earlier, revenue has grown 96% compounded annually over the same time.

More recently, in 1Q16, revenue grew by 34% year-over-year. However, cost of revenues grew 37%, R&D grew 31%, and general and administrative costs grew 30% year-over-year. In order to buy into the bull case, one must believe FEYE can significantly cut costs in order to improve margins, while simultaneously growing revenue to maintain the “growth story” initially sold to the market.

With growing losses, one has to wonder whether FireEye investors are hoping for a buyout offer from a larger firm or competitor. However, as we’ll show below, this opportunity may have already passed, and without hopes of acquisition, FEYE presents significant downside risk.

FEYE May Have Missed Its Takeover Opportunity

The biggest risk to our thesis is that a larger competitor acquires FEYE at a value at or above today’s price. However, this risk may be minimized since, as reported by Bloomberg, FireEye recently rejected several takeover offers, believing that the purchase price did not properly value the firm. Bloomberg notes that the sales process is no longer active. Unfortunately for investors, we’ll show below that FireEye may have been better off accepting a buyout because unless a competitor is willing to destroy shareholder value, an acquisition at current prices would be unwise.

To begin, FEYE has liabilities that investors may not be aware of that make it more expensive than the accounting numbers suggest.

  1. $91 million in outstanding employee stock options (3% of market cap)
  2. 46 million in off-balance-sheet operating leases (2% of market cap)

After adjusting for these liabilities we can model multiple purchase price scenarios. Only in the most optimistic of scenarios is FEYE worth more than the current share price.

Figures 4 and 5 show what we think Cisco (CSCO) should pay for FEYE to ensure it does not destroy shareholder value. Cisco has been mentioned as a takeover candidate since the firm has been bulking up its security offerings in recent years and FEYE could round out Cisco’s offerings. However, there are limits on how much CSCO would pay for FEYE to earn a proper return, given the NOPAT or free cash flows being acquired.

Each implied price is based on a ‘goal ROIC’ assuming different levels of revenue growth; 25% and 30%. These revenue levels are equal to or higher than the consensus estimate for 2017 (25%). In each scenario, we conservatively assume that Cisco can grow FEYE’s revenue and NOPAT without spending on working capital or fixed assets. We also assume FEYE achieves a 10% NOPAT margin. This margin is below CSCO’s NOPAT margin (20%), which is boosted by Cisco’s numerous profitable business segments, but well above FEYE’s current NOPAT margin of -62%. For reference, FEYE expects 2016 operating margins to equal -22% to -24%.

Figure 4: Implied Acquisition Prices For CSCO To Achieve 7% ROIC

NewConstructs_FEYE_AcquisitionScenario_7ROIC_2016-06-27

Sources: New Constructs, LLC and company filings. $ values in millions except per share amounts. $ value destroyed equals the difference between implied price and current market price plus net assets/liabilities. 

Figure 4 shows the ‘goal ROIC’ for CSCO as its weighted average cost of capital (WACC) or 7%. Even if FireEye can grow revenue 30% compounded annually with a 10% NOPAT margin for the next five years, the firm