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At a glance, FireEye (NASDAQ: FEYE) might look like a relatively solid buy for investors interested in the cybersecurity industry. Its sharp decline this year makes it cheap relative to rivals, with pessimism around CEO Keven Mandia's recovery plan producing its cheapest valuation since its 2013 IPO.
Yet there's room for more declines ahead for the stock as FireEye struggles with the major challenges of slowing sales growth and persistent net losses. Here are the main factors that would likely cause the stock to fall in the new year.
Sales growth doesn't rebound
FireEye's most recent quarter included a welcome surprise for investors. After several straight outings of shockingly weak revenue and billings growth, the software specialist modestly outperformed expectations for a change. Third-quarter revenue increased to $186 million, nudging past executives' $183 million target. Billings were $215 million, also just ahead of forecasts.
Yet that 13% and 2% uptick in revenue and billings, respectively, represent a disappointing growth slowdown. A year ago, FireEye's sales were rising at a 45% pace while billings were surging higher by 28%. Much of that decline can be tied to shifting preferences among IT managers who are opting for subscription-based cloud service spending over one-time product purchases. Rivals aren't seeing quite as dramatic a decline. Palo Alto Networks (NYSE: PANW) is expanding revenue at a 34% pace and is projecting nearly the same expansion rate for 2017.
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The good news is that investors have much lower expectations for FireEye going forward. Consensus estimates call for revenue growth to slow to 10% next year from 2016's projected 16%. Unless investors see signs of an imminent rebound after that, they are likely to punish the stock with further declines.
Free cash flow stays negative
When Mandia took over the CEO spot in May, the company shifted focus toward getting its spending more in line with its slowing sales growth. Thanks to headcount reductions and curtailed outlays on research and development, marketing, and sales support, FireEye has succeeded in sharply reducing operating expenses. It achieved breakeven adjusted operating margin in the second quarter, up from a 13% loss in the prior-year period.
Failure to keep a lid on costs could easily send the stock lower, given that FireEye has projected net losses for the foreseeable future. Executives point to the free cash flow metric, instead, which last quarter improved to a positive $14 million from a loss of $8 million. They are bracing for a cash burn of as much as $51 million for the full year (including $22 million in restructuring charges), but aiming to achieve positive free cash flow in 2017. If it begins walking back that forecast, though, the stock could stumble further.
Cuts end up pinching the business
There's also the risk that FireEye remains so focused on short-term earnings that it misses out on important growth opportunities. Research & development spending, after all, is down 8% over the last nine months and has declined to 43% of sales from 47%. Sales and marketing expenses have slumped as well. In contrast, Palo Alto Networks boosted spending in both categories to all-time highs as it expanded key parts of its U.S. sales network into the European market.
It's usually a good idea to cut costs whenever possible. However, FireEye is hoping to build a global next-generation security business, and that requires continuing investments in improving software capabilities and building out a robust sales infrastructure.
The slowing revenue pace has added pressure on management to whittle down its net losses. But the team has to balance that important goal against the risk of impairing FireEye's competitiveness in the industry at a time when deeper-pocketed rivals are ramping up their capital investments.
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Demitrios Kalogeropoulos has no position in any stocks mentioned. The Motley Fool owns shares of and recommends FireEye. The Motley Fool recommends 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.