Which Security Stock Looks Secure in a Speculative Industry?

Source: FireEye

As cyber attacks remain a growing threat, the reasons to own enterprise security stocks may seem clear. Companies like FireEye , Proofpoint , and Palo Alto Networks  have been Wall Street favorites, with the latter recently catching a bullish upgrade as the top-in-class investment. Albeit, should you be so bullish?

Not all security is created equally
Like most industries, investors have a tendency to group together enterprise security stocks, believing that one is just as good as the other. But, the noted companies have unique approaches that all serve different areas of the industry.

Palo Alto is the largest of the three, offering advanced malware protection and next-generation firewalls that work on both traditional and physical servers, and also virtualized and cloud environments.

FireEye sells appliances that alert customers of advanced persistent threats, those that basic security software can't detect. However, FireEye's products can't eliminate the threat, which consequently creates the need for additional security products.

Proofpoint is an up-and-coming player that sells products to protect against malicious links and emails. One of its key products is Targeted Attack Protection, which saw year-over-year growth more than double last quarter.

A recent surge in demand
A rise in corporate cyber crime has executives willing to invest in protection. In a recent survey of Chief Security Officers, 43% plan a major firewall refresh in 2014 versus just 23% last year, which suggests accelerated growth for security companies.

Moreover, Palo Alto posted a solid fiscal third-quarter report last month, where it beat analyst expectations and grew revenue by 48.8% year over year. The company's services revenue, which includes cloud security subscriptions, outgrew total revenue with growth of 64% year over year.

Proofpoint also posted a solid quarter in May with revenue growth of nearly 40%. This quarter beat Wall Street expectations and sent shares soaring double-digits. FireEye is the fastest-growing security company in the space, in part due to several big acquisitions like Mandiant. However, analysts still believe FireEye can generate more than 50% annualized growth for the next three years.

You're going to pay to play
While explosive growth surrounds this industry, the key question remains how much investors are willing to pay for exposure. FireEye, in particular, trades at nearly 30 times sales, meaning investors are taking big bets that the company will eventually grow to support its $6 billion valuation.

Furthermore, the company is far from profitable, spending $2.18 in operating costs for every $1 in revenue. Hence, there are serious questions about whether the company can ever produce profits to compliment long-term growth concerns.

Proofpoint's nine-times-sales multiple is not nearly as ridiculous as FireEye's, nor is its operating margin of negative 21%. Until recently, Proofpoint hasn't had the growth of its peers, but if its new-found growth is sustainable, the company could be a good investment.

Lastly, Palo Alto looks expensive at 12 times sales, but as the need for cloud-based security increases, with firewalls being a fundamental piece of any company's security pie, Palo Alto is a company that could thrive long-term. Specifically, Palo Alto's firewalls are unique because they interact with the cloud and virtual technologies, both of which are increasing in popularity.

Therefore, while FireEye's advanced persistent threats and Proofpoint's email-like security products are a luxury, firewall protection remains a necessity for both consumers and enterprises that store delicate information. As a result, this fact favors Palo Alto as a long-term security stock that could meet and surpass high expectations.

Foolish thoughts
According to Morgan Stanley, one in four chief security officers in the enterprise space will use Palo Alto as either a primary or secondary firewall vendor at the time of their next refresh. Currently, Palo Alto has a 2% market share as a primary vendor, giving it the opportunity for significant long-term growth.

Moreover, the fact that many of the company's current customers will soon be forced into product refreshes should bode well for the company. With all things considered, Palo Alto looks secure in an industry that is still very speculative, making it a clear investment favorite.