single tool. Very worryingly for Sourcefire, research from Gartner indicates these NGFW systems could subsume 50% of new IPS deployments by 2015. Sourcefire has reacted to this threat by introducing its own NGFW software, which it now offers alongside its IPS for a 10% price increase. While this can help FIRE retain some customers over the near-term, we believe Sourcefire will find it challenging to maneuver from an “IPS-first” business to one primarily known for its firewall. Sourcefire’s founder and CTO, Marty Roesch, has stated that, “we typically lead with Intrusion Prevention Systems” and “we don’t really see greenfield opportunities very often in a space like [Next-Generation Firewall]” (Q4 2012 Call). Mr. Roesch has also acknowledged that Sourcefire’s move to NGFW was mostly defensive in nature: “If you look at some of the market predictions, a fair amount of the IPS market will be delivered on NGFW markets and we don’t want to cede market [share].”
The next-generation firewall sector is extremely crowded with highly-regarded pure-play participants like Fortinet, Palo Alto Networks, and Check Point alongside networking giants like Cisco and Juniper. Given the momentum behind NGFW adoption, Gartner believes that end-market growth in the IPS market will begin to slow in 2013 before inverting to negative year-over-year growth in 2015.
Even in the midst of this market shift, Wall Street analysts have bent over backwards to justify FIRE’s current price. Some of the outlandish valuation metrics proposed by the Street include an 8% terminal growth rate (Wells Fargo, 11/16/12), a 6.7x 2013E revenue multiple (Stephens, 5/1/12), and assigning a 50% probability to FIRE getting acquired “in the next few years” (FBN Securities, 1/12/12). Morgan Stanley (2/22 report) uses a 21x “adjusted” 2014E free cash flow multiple, which would sound more reasonable if it didn’t exclude stock-based compensation expense without adjusting for the corresponding shareholder dilution. Management has done little to temper this reckless enthusiasm going into the new year. On the Q4 2012 call, Marty Roesch stated that FIRE continues “to see the opportunity to double the top line every 3 years,” a goal we believe is unrealistic given the transitory benefit of upsells, the market’s shift towards NGFW, and FIRE’s heavy reliance on federal spending (20% of 2012 sales). Moreover, our management-case discounted cash flow model, where FIRE’s operating margins reach management’s long-term goals, implies a fair value range of $17 – $26. This equates to a discount of 50% – 65% below Sourcefire’s current share price. With such a large disconnect between FIRE’s share price and intrinsic value, it should be concerning that FIRE’s GAAP earnings actually shrunk by 24% in 2012 due to skyrocketing equity-based compensation and buckling gross margins.
Recent commentary from Fortinet (FTNT) and Check Point (CHKP), two leading network security vendors, could foreshadow industry-wide weakness in the first quarter results. On a special investor call on April 10th, Fortinet was forced to lower its Q1 2012 revenue guidance from $138m – $141m to $134m – $136m, sending FTNT shares down 13% for the day. Fortinet attributed the weakness to slowing European spending and delayed capex at the large telecom customers. Sourcefire is meaningfully exposed to both end-markets. Check Point reported its Q1 2012 report on April 23rd, 2013 with a revenue print of $322.7m, at the low-end of management’s guidance ($320 – 332m) and below analyst expectations ($328m). Due to industry-wide weakness, CHKP doesn’t expect a resumption of growth until the second half of the year. This pair of read-throughs could be particularly dangerous for Sourcefire following the victory lap it took on its Q4 call, which reset growth expectations higher than the Street expected. At a 5.4x 2013E revenue multiple and 204x GAAP P/E, FIRE will have little margin for error on its April 30th earnings announcement.
Summary of Red Flags
We believe that Sourcefire is substantially overvalued for the following reasons:
- Next-Generation Firewalls Could Replace 50% of IPS Deployments by 2015. As the creator of the open-source Snort software, Sourcefire is deservedly praised for creating one of the industry’s most influential IPS products. But when it comes to mindshare in the firewall market, Sourcefire fails to even earn
