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Who Be The Patsy? (Cestrian Stocks Bulletin #26)

Who Be The Patsy? (Cestrian Stocks Bulletin #26)
By Cestrian Capital Research, Inc • Issue #26 • View online
FireEye (FEYE) just sold its products division to a buyout shop. Stock dumped thereafter. Someone here is the patsy.

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If You Don't Know Who The Patsy Is...
… then you be the patsy. As the famous saying goes. Now, whilst everyone surrounding any major piece of M&A is always in a hurry to declare everyone a winner, that’s very often not the case. Very often someone has got the better of someone else. And that someone else be the patsy.
On Wednesday after the close, FireEye (FEYE) announced the sale of their products division to a buyout firm, Symphony Technology Group, for $1.2bn in cash. The same firm acquired the enterprise products unit from McAfee (MCFE) earlier this year - see that same link - and it is reasonable to assume the two entities will be combined, restructured and then sold on or re-listed, that being the business of buyout firms.
The sale confirms what has been obvious for some time, which is that the 2013 acquisition of Mandiant by FireEye for c.$1bn was in fact a reverse merger. It’s just that nobody told FEYE.
FEYE was a product business, Mandiant, services. Kevin Mandia, founder-CEO of Mandiant, wound up being appointed CEO of FEYE in 2016 and since that time the company has focused on the services side, with great success. A series of high profile hacks have been identified and diagnosed by FEYE, most recently the ‘CozyBear’ / ‘SunBurst’ incident affecting SolarWinds (SWI) software. Under CEO Mandia, FEYE has become the go-to player if you are a government or large enterprise under attack; the company will help you identify where the problem may lie and how to defend against it. All of this is of course services work. You can dress it up as recurring revenue if you like, and no doubt some of it is, but in essence it is high value professional services. This is Mandia’s DNA and it’s why in our opinion the company just jettisoned its product business and indeed its name. Expect to see Mandiant reborn on your broker screen soon.
The market positively vomited on the transaction. FEYE stock was down around 17% today, hitting what technical analysis bores will tell you is the 0.382 Fibonacci retracement level - translated into normalspeak, the stock has now given up about 40% of the gains achieved from its March 2020 low to its February 2021 high. Now, this is a condition affecting a number of high-beta tech names right now but FEYE was riding relatively high versus your go-to pandemic names like Fastly (FSLY), a function of the elevated levels of threat, awareness, and spending on cybersecurity matters at present. So this appears to be an unforced error.
Now the market often gets this stuff wrong. Nobody likes weird stuff and this transaction definitely looks like weird stuff. Product = good, services = bad, right? So, sell product, keep services = weird. Right? Sell. That was basically the reaction today.
Our take is a little different but there is a big rider here, to which we will turn in a moment.
Having watched Mandia for some time - we own FEYE stock in staff personal accounts - we know that he is absolutely focused on the services side of the business and has treated product as not really his problem (despite being the CEO). The sale logic has some truth to it - enable the services side to work independently of product sales - but that isn’t conventional thinking in technology companies. Conventional thinking is, use high value services to sell your product. On the CrowdStrike (CRWD) earnings call after the close today, CEO & founder George Kurtz was quick to point out that for every $1 CRWD achieves in professional services revenue, that activity generates $5.5 of recurring product spend. We listen to a lot of CRWD earnings calls (it’s pretty slow around here and hearing the chest-beating Kurtz explain yet again how CRWD is the envy of the world etc is slightly more interesting than preparing yet another valuation model) and we’ve never heard that metric cited. Our response was, (1) wow that’s good - it is - and (2) hm he’s having a pop at Big Kev for selling the family silver.
When the FEYE / Symphony deal was announced yesterday, we declared in our Cestrian Fundamentals subscriber chatroom that this was a great move by the company. Because it does enable Mandia to focus on what he does best - services. And because the demand for this stuff is off the charts right now - FEYE has said the services side is capacity-constrained, meaning, nobody can hire enough security professionals. And that means that pricing is going to go up, and that means gross margin - the bugbear of every IT services company everywhere - should go up. And that means EBITDA and cashflow margins should go up. All good. We also assumed this was part of the plan when Blackstone invested $400m in FEYE in a placement earlier this year. Sell product division to buyer X, ramp up services side … sell services side to buyer Y. Collect free money, head back to the office a hero. Easy.
With this in mind, we added to our FEYE stock holdings on the initial drop after hours on Wednesday and bought a little more right around the close today. Baby steps, because you never know how far something like this might fall, and you always want cash left over in case it keeps falling.
But as always when one is buying fear, the constant nag is there. (Unless you are a simpleton, you should always have a nag in your mind when buying or selling any securities. Because someone is on the other side of your trade, and who’s to say you’re sat at the smarter side of the table?).
The nag is, who’s the patsy here? Is it Symphony? Possible, but unlikely. Their stock-in-trade is revitalizing aging technology companies and whilst they no doubt have their share of failures, they most certainly have had winners. Is it Blackstone, on the wrong side of the trade? Again, possible, but unlikely. We assume that Blackstone money will show up somewhere on the buyside as well. Remember the buyer group is “a syndicate led by” Symphony so that means money from many corners will be involved, and since Blackstone has money of all flavors under management, they could show up in the equity, the debt, or any kind of magic-beans funny-money in between the two (preferred equity, super senior debt, warrants, all kinds of unholy admixtures are possible). Is it the FEYE shareholders who decided to dump the stock today, on news of a transformative sale in the middle of a major move up in cybersecurity names within a general rotation back to growth? Well, we think so. We think the selloff was short sighted. We think that although the remaining business looks to be trading at around 9-10x TTM revenue - punchy indeed for a services company - the growth rate will be strong for some time and if indeed buyer Y does come along to acquire New Mandiant (ticker: KEVS), they will probably overpay in a fit of desire to look all cool and cyber and that. So our guess is, this works out. Which is why we have been buying the stock whilst it is in the basement and still digging.
But, since we don’t know who be the patsy, is the patsy …. us?
Time will tell. For now we remain owners and likely continuing buyers of FEYE stock. We think Mandia has a point to prove, a whole buncha government and corporate clients on tap, and a wall of state-sponsored hackathons to fight and charge bigly for. Whether the new Mandiant remains independent or is sold to a larger federal contractor such as Booz Allen (BAH), Leidos (LDOS) or similar, we do not know. But we think good things can happen. And so for now, we are going to say, the sellers be the patsies and we can rest easy.
In a year or so, we’ll know for sure who the patsy was. Check back in with us then!
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DISCLOSURE: Cestrian Capital Research, Inc staff personal accounts hold long positions in CRWD, FEYE and FSLY.
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