I ran a quick screener on companies that have a Return on Equity (RoE) of 25% and a Net Income margin of 20%. These are 2 metrics that can possibly give a good measure of how the company will do going forward in case of a downturn. The results were, as I imagined, very lopsided, with technology stocks pretty much taking the top spots – especially the Big Tech companies that have just gone from strength to strength in the past year with soaring profits and revenue growth.
When I dialed down into the Cybersecurity space, Qualys (QLYS) stood out along with Check Point Software Technologies (CHKP). CHKP is a much bigger company and is reaching a stage of growth normalization. Although it has an RoE and Margins that are better than most S&P 500 companies, its growth in the past 5 years has been less than 10%.
Most of the other companies in the cybersecurity space, especially the big players, seem to have a lot of revenue but not much earnings, which is why I was attracted to Qualys. I believe Qualys is the stock for the future in this space, where there are many players with high revenue growth but very few with high profit growth.
Initial Valuation: Price Multiple for Qualys
The valuation of QLYS is rich and currently stands at 43.9PE. Although i look at the P/E first, i also like to dive in a little deeper on this metric. I have a different take on P/E valuations. I like to see if the P/E of a company is greater than the earning growth of the company in the previous 12 months. If that is the case, the P/E is still justified. After all, a company growing at 50% yoy with a 50P/E can still give good returns to its investors over a period of time as long as it can continue the earnings growth momentum.
Here’s an example: The price of a stock is calculated as P/E divided by EPS. If a stock trades at 100USD and the stock has an EPS of 2USD, the corresponding P/E is at 50. Now, if the EPS grew by 50% to 3USD, and the price stays at 100USD, the PE drops to 33 and continues to become cheaper. On the other hand, if the stock were to run up by 50% due to the increase in earnings then goes to 150USD, it maintains the P/E of 50. If it maintains the lofty P/E, the investor will get a 50% increase in his/her investment so long as there is underlying earnings growth that’s higher or on par with the P/E the stock is trading at.
Initial Valuation: Growth Metrics for Qualys
In a COVID-19 induced world where we have a very few companies that seem to have revenue growth (IT and IT Services), all of them that offer this “service” of growth are richly valued. Therefore, to justify my views on Qualys I would like to focus on earnings growth rather than revenue growth.
If we chase revenue with no profit, at some point cash will be required by the company and it will lead to dilution of stock. If we chase profit growth instead, there is a good chance the company will generate enough profit (money) to take care of any expenses to fuel growth for the future. With a healthy balance sheet, debt would be an easier option when you need money rather than trying to dilute your equity holdings.
Reasons for Growth in Qualys:
Already servicing 66% of Fortune 500 companies, they have attached themselves to the biggest and fastest growing names in town like Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX), and Amazon (NASDAQ:AMZN), among others. Apart from software companies listed above the broad range of customers also gives confidence, without any over reliance on a single sector. Some of these sectors and clients include retail (Home Depot (NYSE:HD), Macy’s (NYSE:M)), Automotive (GM (NYSE:GM), Nissan (OTCPK:NSANY)), Financials (Ally (NYSE:ALLY), Goldman Sachs (NYSE:GS)), etc.
They also have a broad delivery channel : They sell directly to their customers/end users and also reach the end users indirectly through consulting service companies like IBM (NYSE:IBM), Infosys (NYSE:INFY), Deloitte, etc. This kind of channel sales will keep the company in good standing even if a downturn occurs.
Focus on Revenue per Customer:
(Source : Q3 Results Presentation – Company Slides)
From 2013 to 2019, the number of customers has grown steadily, but it’s very refreshing to see that the revenue per customer has increased much faster in the last 5 years. This shows that there is widespread adoption of multiple products that the company is making within its customer base. Below is another slide from the management commentary that illustrates the same point. With the doubling of customers in 4 years, sales has been increasing more than 2.5 times.
(Source : Q3 Results presentation – Company Slides)
EBITDA has doubled from 2016 ($68Mil) to 2019 ($138Mil) and the EBITDA margin has increased to 43% from 34% in 2016. The growth in the EBITDA number and also the margin shows that the company is not increasing margin by simply reducing costs associated with SG&A or headcount reduction. Instead it is coming from increased sales of higher margin products being sold. The first three quarters of 2020 have already given an EBITDA of $128Mill at 47% margins. This is an industry leading margin they have achieved over the past few years, and this shows the margins have still not peaked. I think the margin increase is due to incremental business on the “Cloud Platform,” which is easy to maintain and not have incremental spending. So adding more business and sales is giving disproportionate amount of margins, which is going to continue to keep increasing for the next few quarters until growth rates come to normalization.
Below are the list of apps they run on their platform. The number of apps has increased from 4 to 20 (see previous picture) and helped increase EBITDA and revenue/customer. We also know from management commentary that they are working on at least 6 more apps that will hit the market in the next year or so. This should again drive sales and margins, which will lead to higher EBITDA margins.
Net Profit for the first 3 quarters of this year is already at the level they were for the full year of 2019 ($68Mil). With another quarter to go, it could be a yearly growth of about 20-25% at the very least.
Revenue split across regions show they have approx. 36% revenue coming from outside the U.S. This is is good diversification. Any fluctuations in USD (strength or weakness in the dollar) values can be minimized if their business can bring in money from inside the U.S. as well as export markets.
Although earnings have grown in supercharged manner, revenue growth in the last 4 years has been “only” 60% (compared to almost 100% in earnings and cash flows). But as explained before, the base platform is set and incremental revenue on their platform will lead to disproportionate profits. And that profit is what we are focusing in this article.
Cashflows, Debt and Cash/Share:
Similar to their Profit & EBITDA numbers, Cashflows for Qualys have been excellent. Free cash has increased from 45Mill to 141Mill in 4 years from 2016 to 2019 and has already reached 118Mill for the first 3 quarters of this year. All these at a healthy 44% free cash flow margin (free cash flow/revenue).
Debt for Qualys remains very manageable at 60Mil. This debt is easily serviced by the cash flows that they generate. As you can see, they have generated more cash in 6 months months than the debt they have in the books. In addition to this, they have a cash (and cash equivalent) balance of 360Mil currently.
Future Valuation and Price Target
The management stated the market for cybersecurity is going to grow at 12% CAGR from 2016 to 2021. In 2021 the market will be around 21B. Currently, Qualys sales are approx. 320Mill and are growing faster than the addressable market. If Qualys captured ~5% share of this market in the next few years it will give them 1Bill in revenue. This would mean a 3X in sales over the next 3 years. Even if we account for 700-800Mill in revenue, the earnings on this will be around 180-200Mill USD.
Considering 40Mill shares outstanding, they could clock out an easy EPS of 5. I would not hesitate the put a high P/E of 50 to this stock at this point. This will put my overall price target for this company at 50* 5 = 250 USD in the next 3 years.
Furthermore, based on the run rate they are going at, the company will be generating more than 120-150Mill in free cash each year at the very least. This corresponds to 3-4USD of cash/share added each year to the books. It is already sitting at around 8USD cash/share as of today. I will not be surprised if the company turns to acquisition in the next few years to bolster growth even further. If cash keep accumulating for the next 3 years, they should have a cash balance of approx. 750 Mill (almost 18.75USD/share of cash).
Explanation on assumptions:
P/E assumption seems high, but high growth companies have often justified a P/E north of 50 – especially with earnings growing at such a pace. Considering, the current interest rate scenario at almost 0%, we will see many companies at these valuations.
Sales growth assumed is faster than the growth in the past, and this is to take into account more apps coming on board and more customers coming into Qualys Platform. If Qualys can increase revenue/customer with new apps these growth rates can be sustained. Also, 700-800Mill in sales will put Qualys at less than ~5% of market share, which is reasonable.
Management commentary alluded to this year being extraordinary due to COVID-19 related uptick in sales. I believe a lot of this sales will actual stay in place even after COVID-19, and the management is trying to play safe by guiding low and delivering over.
Cash generation will continue to be robust and should lead to about 15-18 USD of cash/share over the next 3 years. I expect an acquisition from Qualys to reach sales growth targets. If not, I believe management will start giving out a small dividend, which will in turn be positive for the stock.
Economic cycles will play a role in these assumptions and a downturn in the market cannot be eliminated. However, I believe Qualys is better placed to come out of a downturn, if any. The business is generating significant cash and it should be put to correct use going forward. If any mismanagement of cash takes place, it will be a huge negative for the company. The cash should be used to buy future growth or reward shareholders.
Qualys is unlike any of the other cybersecurity plays out there. Just the cash generated by the company should be enough to keep this company valued at such a rich valuation. This may be the best way to play the growth in cybersecurity space. I rate this stock a strong buy with upside potential of USD 250/share over the next 3 years.
Disclosure: I am/we are long QLYS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.