Checking In on FireEye Inc.'s Turnaround

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The cybersecurity company FireEye (NASDAQ: FEYE) is coming off a solid financial performance in the second quarter; the stock has climbed up from its low earlier in the year but is still significantly off its high of two years ago.

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This looks like a good time to revisit the five metrics fueling FireEye's turnaround which I covered in February. Here are the five metrics, and how I view the progress that's been made.

Little or no progress Good Progress Great Progress
  • No metrics in this category
  • Subscription growth offsetting product declines
  • Deferred revenue growth
  • Support and services revenue
  • Gross margin
  • Operating expenses

Let's cover these turnaround metrics in order from good to great.

Good: Subscription growth up 13% and product growth down 23%, year over year

Decreasing product revenue growth is part of FireEye's strategy to transition its customers to cloud-based subscription solutions. While the percentage of decrease looks larger than the increase in subscription growth, it's from a smaller base. In absolute dollars, subscription revenue gains offset product revenue declines for the most recent quarter by $400,000.

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While the 13% subscription growth was lower than the 38% growth posted for 2016, management is encouraged by a significant number of product refresh opportunities coming in the second half, enough to raise full-year revenue guidance by $10 million.

Frank Verdecanna, FireEye's chief financial officer, and executive vice president, explained on the quarterly conference call that a refresh is when a customer's product is anywhere from three to five years old; FireEye's customers have the opportunity to "just renew products, subscriptions, and support, or they can refresh to our new hardware that has some additional functionality and additional bandwidth capabilities." FireEye has been successful in these engagements, and Verdecanna said he is expecting "additional dollars from expanded deployments and additional products and subscriptions sold into that renewal."

While management made the positive move of raising revenue guidance for the full year, it's hard to put this in the "great" category, since subscription growth was substantially lower than the company had in 2016.

Good: Deferred revenue growth of 5%

While 5% growth in deferred revenue is not great, billings, which drive deferred revenue, came in on the high side of management's guidance at $172 million. The company has seen its contract length decrease from 28 months in Q2 of 2016 to 22 months this quarter, which also had an impact on these numbers. On the bright side, annual contract value increased by $2.5 million year over year. Management is maintaining its full-year guidance on billings.

This is a key number for investors to watch as the company continues its transition to subscription-based services. In the company's 10-Q, management indicates that they focus on this metric as it is "an important indicator of the health and visibility of trends in our business, and represent[s] a significant percentage of future revenue."

This one is in the "good" category because of positive growth, but not great, because the 5% growth was significantly lower than the 24% that the company reported in Q4 of 2016.

Great: Support and services -- 36% of revenue

Support and services revenue increased $10.1 million over Q2 of 2016, now making up 36% of total revenue as compared to 34% in 2016. Mandiant professional services had record revenue, up 19% from the previous year. This increase in services revenue shows that FireEye remains a trusted cybersecurity partner for its customers. As an added benefit, Verdecanna said these billings "resulted in pull-through of additional products and FireEye as a Service billings in the future quarters."

This performance gets a "great" rating, because revenue gains here help solidify FireEye's transition to becoming a comprehensive prevention company for its customers.

Great: Gross margin stable at 74%

The company remains focused on the bottom line, as shown by the continued stability of its gross margin. Gross margin even improved by 1% from the second quarter of 2016. Additionally, during the quarter, management "consolidated our services, support, and threat intelligence organizations into a single organization with a more streamlined cost structure."

This also gets a "great" rating because FireEye is delivering on an overarching priority for the company's CEO, Kevin Mandia, to rightsize its cost structure.

Great: Operating expenses down to 74% of revenue

Operating expenses are expenses not directly related to product costs. These include research and development, sales and marketing, and general and administrative costs. By working on rightsizing these costs, the company was able to reduce losses by more than $100 million in the first half, and achieved the "second-best operating margin ever."

This cost discipline has also improved the company's operating cash flow considerably. According to Verdecanna, "Operating cash flow of negative $11.5 million was better than the midpoint of our guidance range by more than $10 million."

Highlighting this achievement, he said: "I believe we achieved a cost and expense structure that balances the need ... to invest in future growth with the achievement of our non-GAAP profitability targets." It is great that FireEye is positioned strategically for growth and profit.

A Foolish takeaway

Overall, I would give FireEye a B-plus on its turnaround efforts. Its cost-management efforts have yielded quick results, and the services and support revenue is a positive growth driver for the business. While the revenue performance is meeting management expectations, it's not enough yet to claim victory.

The company has delivered on its complete product refresh, Helix, and its initial reception has been very positive. The product has only had one full quarter of sales, and with a long customer refresh cycle, it may take a while for this product to be beneficial to the top line.

Investors should look for the deferred revenue and subscription growth numbers to improve before we can call this turnaround "mission completed."

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Brian Withers owns shares of FireEye. The Motley Fool recommends FireEye. The Motley Fool has a disclosure policy.