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FireEye's Significant Challenges Despite its Growing Cloud Business

Herve Blandin, The Motley Fool

Since the publication of its second-quarter results one month ago, FireEye's (NASDAQ: FEYE) stock price is staying close to its 52-week low. The cybersecurity vendor reported revenue above expectations for the 10th quarter in a row, but lower margins and weak guidance disappointed investors.

Despite its revenue growth, FireEye is facing a difficult transition. Legacy activities, which consist of selling specialized security devices, are declining. But the company is trying to offset this trend with a growing cloud business. Let's take a look at the challenges associated with this transition. 

The declining legacy business vs. the growing cloud portfolio

Several years ago, FireEye had a distinctive business model in the cybersecurity landscape. Its specialization in dealing with advanced threats allowed the company to sell expensive hardware that customers hosted on their premises. But, due to the development of cloud computing, this offering has become less and less relevant. As an illustration, during the latest earnings call, management explained it was surprised by the drop in subscription and support revenue related to legacy appliances. Many small customers didn't renew their expiring appliance contracts and revenue from the product  segment -- which includes the sale of on-premise solutions and their related services -- decreased 4% during the previous quarter.

Management has been developing a cloud-based portfolio to offset the decline of its legacy business, and it seems to be paying off. The 27% growth of the "platform, cloud subscription, and managed services" category more than offset the decline of the revenue from the legacy hardware business. As a result, total revenue increased by 7.36% year over year. And management expects revenue growth to continue over the next few quarters.

Hacker in a hoodle representing a cybersecurity threat.

Image source: Getty Images.

Declining market share

Given its mid-single-digit total revenue growth, FireEye is still losing market share. Allied Market Research expects the cybersecurity market to grow 11.9% annually from 2018 to 2025 -- a healthy amount faster than the company's current growth rates.  

In addition, FireEye's competitors have reported much better growth rates during their latest quarter, confirming the company's relative weakness. Fortinet and Palo Alto Networks, two competing companies, reported revenue growth of 18.22% and 22.44%, respectively.


Margins under pressure

FireEye's growing cloud segment involves higher hosting costs. As a result, gross margin has decreased from 75% to 72%. It's also generating losses. And though its losses have declined since 2015, it still lost a substantial $241.1 million over the last twelve months.

And considering sales and marketing expenses represented about 48% of the total revenue during Q2, FireEye's revenue growth doesn't seem to be that spectacular. Palo Alto is also managing a growing cloud portfolio to offset a challenging legacy hardware business. But, as a comparison, it generated 22% total revenue growth while sales and marketing expenses represented about 46.3% of its revenue during the last quarter.

  As FireEye transforms its business from a niche hardware-based security player to a cloud security vendor, it will be facing intensifying competition from legacy hardware security vendors that are also trying to enhance their portfolios with cloud-based offerings.

Conclusion

By offering cloud-based solutions, FireEye is taking the right steps to adapt to the cybersecurity market. But the decline of its legacy hardware business partly offsets the strong growth of its cloud portfolio. And, besides losing market share, the company is operating at losses due to its high sales and marketing expenses and the higher hosting costs associated with cloud services. 

With this context, the decline in the stock price isn't surprising. But, considering the weak growth and the losses, the price-to-sales ratio of about 3x is still high. Looking forward, I will watch for the strong growth of the cloud business to continue. And the company must show it can generate profits -- while still growing -- by reducing its sales and marketing expenses as a percentage of revenue.

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Herve Blandin has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Palo Alto Networks. The Motley Fool recommends FireEye and Fortinet. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com