Better Buy: Palo Alto Networks Inc. vs. FireEye Inc.

By Markets Fool.com

Palo Alto Networks (NYSE: PANW) and FireEye (NASDAQ: FEYE) are frequently mentioned in discussions about high-growth cybersecurity companies. Back in May, I compared thetwo companies and concluded that Palo Alto's stronger sales growth made it a better pick than FireEye.

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Since that article was published, Palo Alto shares have risen 9% while FireEye shares have plunged 15%. As I mentioned in previous articles, I'm nota big fan of Palo Alto, but is it still a better pick than FireEye today? Let's reexamine the two companies' core businesses, growth trajectories, and valuations to find out.

Image source: Getty Images.

What do Palo Alto and FireEye do?

Palo Alto provides next-gen firewalls which protect companies from external attacks. It serves over34,000 customers in over 140 countries in multiple industries. That customer base includes 85 of the Fortune 100 and over half of the Global 2000. It was ranked as an enterprise firewall leader by Gartner for the past five years.

FireEye offers real-time threat detection solutions which intercept attacks before they breach traditional barriers like firewalls and antivirus platforms. The company serves over 5,000 customers across67 countries, which includes nearly half the Forbes Global 2000.

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Both companies are well-poised to profit from the surge in data breaches over the past few years. The Identify Theft Resource Center reports that almost 178 million personal records wereexposed in data breaches in 2015, while Research and Markets estimates that the cybersecurity market will grow from $122.45 billion todayto $202.36 billion by 2021.

How fast are Palo Alto and FireEye growing?

Palo Alto's revenue rose 41% annually to $400.8 million last quarter, versus 48% growth in the previous quarter and 59% growth in the year ago quarter. FireEye's revenue rose 13% to $186.4 million last quarter, versus 19% growth in the previous quarter and 45% growth a year earlier.

Analysts expect Palo Alto's revenue to rise33% this year, compared to 49% growth last year. FireEye's top line is expected to grow16% this year, compared to 46% growth in 2015. Those numbers, while impressive, indicate that growth at both companies is slowing down due to slower enterprise spending and tougher competition.

Both Palo Alto and FireEye are threatened by larger diversified players like networking giant Cisco, end-to-end security giant Symantec, and IT services players like IBM. All these larger companies are bundling their own cybersecurity solutions with their other products and services, which could make it tough for smaller players like Palo Alto and FireEye to offer competitive prices and scalability.

Non-existent profitability

Profitability is a sore spot for both companies. Palo Alto is profitable on a non-GAAP basis, but its high stock-based compensation (SBC) expenses (28% ofrevenues last quarter) have kept its GAAP earnings deep in the red. FireEye isn't profitable by either metric, and its SBC expenses consumed 25% ofits revenue last quarter. Both companies rely heavily on SBC to fund the expansion of their sales and marketing teams, which they use to reach more enterprise customers.

Palo Alto's GAAP net loss widened year-over-year from $46 million to $54.5 million last quarter, but its non-GAAP net income rose 85% annually to $46.2 million. FireEye's GAAP net loss narrowed from $135.5 million to $123.4 million, thanks to layoffs and other cost cutting measures. Its non-GAAP net loss narrowed from $56.8 million to $29.4 million -- indicating that FireEye is trying much harder than Palo Alto to get its costs under control. But as I mentioned in a previous article, scaling back its operations in the face of tougher competition could hurt FireEye's sales growth in the long run.

Analysts using non-GAAP earnings expect Palo Alto's earnings to improve about 67% this year and 37% next year. FireEye's earnings are expected to improve 29% this year and 58% next year, thanks to its shift from lower-margin appliances to higher-margin subscription cloud services like FaaS (FireEye as a Service).

The valuations and the verdict

FireEye currently trades at 3.3 times sales, which is lower than the industry average of 5 for software companies, as well as Palo Alto's P/S ratio of 10. However, that premium isn't surprising since Palo Alto is growing its revenue about twice as quickly as FireEye. FireEye's enterprise value of $1.7 billion also makes it a more affordable takeover target than Palo Alto, which has an enterprise value of $12.5 billion.

It's a close call, but I believe that FireEye's cost-cutting measures, lower valuation, and takeover potential now make it a better buy than Palo Alto, which is still struggling with rising expenses and shackled by its high valuations.

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Leo Sun owns shares of Cisco Systems. The Motley Fool owns shares of and recommends FireEye and Gartner. The Motley Fool recommends Cisco Systems and Palo Alto Networks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.