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Next Wave Portfolio—An Update on Qualys

By Rob DeFrancesco on October 19, 2015

I remain positive on Next Wave Portfolio holding Qualys (QLYS) for the long term based on a number of factors, and believe the recent sharp pullback in the stock provided a more attractive entry level from a risk/reward perspective. Shares of the provider of cloud-based enterprise security solutions fell to a low of $25.32 on August 24. Since then, the stock has rebounded 35% to trade back in the mid $30s. It still remains well below its 52-week high of $55.47.

Qualys is the leading provider of vulnerability management (VM) software, which continuously monitors IT infrastructure to make sure all assets are safe from hackers. With the Qualys platform, organizations are able to quickly and cost efficiently assess the security of all of their IT systems on a global basis (even uncovering any forgotten devices operating on the network), then repair any vulnerabilities before they lead to breaches. The Qualys VM solution is known for being easy to install, fully scalable and highly accurate.

Qualys is focused exclusively on the enterprise (large corporate) sector. These are the customers with big (and growing) security budgets. They’re also the accounts that tend to do a lot of follow-on buying after the initial subscription order. Included among the Qualys customer base: 65% of the Fortune 50, nearly 40% of the Fortune 1000 and 24% of the Global 2000.

The VM market is growing about 19% annually. Qualys controls 20% of the market, while the next two largest vendors (Rapid7 and Tenable) control about 20% combined. Given that 60% of the market is in the hands of legacy vendors (offering solutions that lack performance and advanced features) and much smaller players, there is plenty of opportunity for Qualys to continue to gain share. For example, Qualys has had a lot of success winning accounts from the McAfee security unit of Intel (INTC), which no longer offers a standalone VM product. Customers these days prefer to have a best-of-breed VM solution, and Qualys is at the top of the list.

In addition to its core VM solution (accounting for 79% of total revenue in the latest quarter), Qualys offers other applications on the platform—including policy compliance (for internal and external regulations), PCI compliance (for securing credit card information), Web application scanning and a Web applications firewall.

The new Cloud Agent Platform (CAP) enables Qualys to bring its VM and policy compliance offerings to endpoints on the network, opening up a whole new addressable market. CAP is made up of easily deployable 2MB lightweight agents for on-premise servers, dynamic cloud environments and mobile endpoints. One of the best features of CAP is that it’s centrally managed, giving users total visibility across the IT asset spectrum.

More than 100 Qualys customers are now in beta tests with the new solution (the hope is they will like CAP enough to work it into their 2016 security budgets), while there are already some revenue-contributing customers (including Visa and Cisco Systems). Management expects CAP to start contributing to revenue in a meaningful way in 2016. While there is no way to tell how CAP will be received across the entire customer base, the good news is the deals could be large (in the six figures) because endpoint deployments tend to be quite big at the enterprise level.

Qualys has roughly 8,000 customers across a diverse set of industries. Here are the top 10 verticals (ranked by percentage of revenue contribution): financial services (19%), services (16%), technology (14%), retail (7%), media/communications (6%), manufacturing (6%), healthcare (6%), government (5%), education (4%), insurance (3%).

Within the government sector, most of Qualys’ business is with state & local governments, along with some foreign governments. The U.S. federal government represents just 1% of Qualys’ total revenue. Many security companies today generate a much higher percentage of their sales from the U.S government, so Qualys is definitely underrepresented and can build out its business from here. The company’s recent hiring of an experienced general manager for the U.S. federal market should help drive more sales in the vertical, especially now that there is an increased emphasis on cybersecurity and cloud-based offerings under the Obama administration.

About 60% of Qualys’ customers have purchased more than one of the company’s solutions, up from 54% in 2014 and 30% in 2013. On average, customers spend twice what they started with (in terms of subscription fees) by the fifth or sixth year with the company. By the 10th year, it’s up to 3x. Not surprising, larger customers spend even more. A survey of Qualys’ 500 largest accounts in 2014 (contributing about 55% of total revenue/average annual subscription of $150,000) revealed those customers are spending 4 times their initial purchase by the 10th year. For the 100 largest accounts (25% of total revenue/average subscription of $350,000), spending doubled by the third year, tripled by the seventh year and was nearly 5x by the 10th year.

It’s important to keep in mind that Qualys generates 100% of its revenue on a subscription basis (via annual billings paid up front), which is good for cash flow visibility. In fact, 88% of each quarter’s revenue comes off the balance sheet (amortization of current deferred revenue), while 10% is generated by customer renewals and 2% from new accounts. Going into each year, 52% of revenue comes off the balance sheet, with customer renewals at 41% and brand new business at 7%. Qualys maintains a hefty renewals sales force, representing about two thirds of total reps.

Qualys continues to grow faster than the overall VM sector, indicating market share gains. For 2015, the consensus revenue estimate of $165.5 million represents growth of 23.9%. With the 2016 consensus at $205.2 million, analysts on average expect growth of 24%. If CAP gains traction more quickly than expected across the customer base, next year’s top-line growth rate could surprise to the upside.

On an earnings basis, EPS for 2015 is expected to be up 19% to 55 cents. For 2016, the consensus EPS estimate of 71 cents indicates growth acceleration to 29% (thanks in large part to operating leverage in the model).

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