Qualys Stock: Profitable And Competitive, But Uncertainty Reigns (NASDAQ:QLYS)

Qualys headquarters building exterior. Qualys is a cloud security, compliance and related services company

Michael Vi

When we talk about protecting our laptops with antivirus solutions, Qualys (NASDAQ:QLYS) is not the name that normally comes to mind. As a matter of fact, this is a company primarily known for its cloud-based security and compliance solutions, and with price-to-sales multiples of 10x, which is above the median for the IT sector by 290%, this is a stock that remains popular among tech investors.

However, as shown by the difference in performance between the stock and the Invesco QQQ Trust’s (QQQ) downtrend (orange chart), Qualys, which had well resisted the volatility impacting the wider tech sector that started from the beginning of this year, lost ground in November. This suggests that the market is pricing uncertainty as to the future.

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Data by YCharts

Hence, my aim with this thesis is to understand the reason for the recent downside, as well as assess the stock’s prospects in an environment where inflation remains high on the one hand and economic slowdown risks have increased on the other.

For this purpose, I start with its partnership approach.

A Different Approach

There are different ways that a business can sell its products and earn income. As a SaaS or Software-as-a-Service security play, Qualys has established partnerships with leading cloud providers like Microsoft’s (NASDAQ:MSFT) Azure, Amazon’s (NASDAQ:AMZN) Web Services, and Google’s (NASDAQ:GOOG) Cloud Platform as pictured below.

State Street Advisors

Partnerships with hyperscalers (www.qualys.com)

Thus, in addition to MSPs (managed service providers) representing it and selling its products in various parts of the world, strategic partnerships with hyperscalers have involved deeper product-level integration.

Going into details, VMDR (vulnerability management, detection, and response) is a fundamental component of risk assessment programs, especially with cyber security concerns being high on the corporate agenda. Hence, hyperscalers like Microsoft’s Azure have to make sure that they include it, as logically speaking, detection of the malware comes before protection or removal. Now, previously customers had to install Qualys’ software separately but native integration means that it is already present in Microsoft’s cloud package right at the start of the server provisioning process.

Looking at the economics, by having a presence on the massive infrastructures of hyperscalers that span across all geographies, clients do not have to sign up for partnerships with individual MSPs. This also entails less administrative costs for Qualys, which is one of the reasons that the company is profitable, as I will further elaborate on later.

Another factor that differentiates it from competitors is technological strength with Qualys’ VMDR application voted the best solution at the 2022 SC Awards (as pictured above).

The Competition and Qualys’ Profitable Growth

Still, adopting a cautious tone, customers not wanting Qualys, can either opt for Microsoft’s own vulnerability assessment tool as I will detail later, or deploy other software like Rapid7 (RPD), Tenable, and Tripwire. Now, according to Gartner Peer Insights, both Qualys and Rapid 7 obtain the same overall score after evaluating for metrics like vulnerability signature, coverage of threats, reporting, and cloud support.

Interestingly, as seen by the CAGR revenue growth rate for the last three years below, it is Rapid 7 which is growing much faster or twice as much as Qualys. Now, does this mean that Rapid 7 is selling its product at a lower price?

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Comparison of Metrics (www.seekingalpha.com)

This appears to be possibly the case as evidenced by its gross margins of 68% being lower than Qualys’ 78%, implying that it may be selling its product solutions at a lower cost.

For this matter, the gross margin is obtained by dividing gross profit by revenue, while gross profit is total sales minus the cost of sales. Thus, Rapid 7’s lower gross profit implies that the company is either incurring a relatively higher cost of sales or selling its products at a lower price than Qualys in order to prioritize revenue growth.

The case for prioritizing revenue growth is also evidenced by the higher amount Rapid 7 is spending on SG&A (which includes expenses related to the sales effort) as a percentage of total sales. This amounts to 59.39% for Rapid 7 during its fiscal year 2021, compared to only 30.51% by Qualys for the same period. In fact, Rapid 7 is spending so much money on operational expenses that it is not profitable (see EBITDA margin above), in contrast to Qualys which, despite delivering lower revenue, growth is profitable.

Recent Price Action and Challenges

Therefore, in case you are a value investor focused on profitability metrics, this is the company you may want to invest in given that the Fed’s chairman has shifted to a more dovish tone. Going deeper, the reason is that higher interest rates are detrimental to tech companies as they bear some of the highest valuations both in terms of price to sales and price to earnings. Now, with higher rates, borrowing costs also increase, causing clients to reduce spending. This leaves tech with lower revenue and earnings growth prospects, which in turn puts into question their higher valuations.

Conversely, lower rates are good for tech, and this is the reason when Fed Chair Powell hinted at lower rate hikes, the Nasdaq posted a record upside of 4.56% on Wednesday. News of a less hawkish Fed was expected for some time due to some indications that inflation numbers had peaked, which explains why QQQ delivered a performance of 4.37% in the last month as shown in the green chart below.

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Data by YCharts

On the other hand, cybersecurity stocks have not benefited from the same level of enthusiasm as the technology sector as shown by their underperformance of nearly 20% compared to QQQ as per the above charts. For investors, I have also added CrowdStrike (NASDAQ:CRWD) which provides threat detection and cloud-based IT protection solutions. The company has suffered from slower ARR or annual recurring revenues and has guided lower revenues for its fourth quarter than initially expected. The reasons were “macro headwinds” and “longer customer buying cycles”.

The same was the case for Qualys which saw a deceleration in billing numbers with the CFO also mentioning that the company is feeling the effects of macroeconomic uncertainty during third-quarter financial results. As for Rapid 7, some Wall Street analysts are cautious about its long-term outlook due to doubts about its ability to optimize its platform for cross-selling, as well as short-term economic headwinds.

Therefore, it is the “macroeconomic uncertainty” theme that is the common issue impacting all three. This may appear controversial as with more cyberattacks, companies have been increasing related spending, which is also aligned with projections of the global IT security market to grow by 8.9% CAGR from 2022 to 2027. However, looking deeper, corporations are indeed spending on IT protection as cybersecurity remains a priority, but, at the same time, they are spending more wisely. One example may involve buying bundled products like Azure’s customers choosing Microsoft’s Defender for Endpoint, the software giant’s attack detection product that competes with Qualys’ VMDR.

Conclusion

Therefore, while the company may have a superior product, it is not immune to customers changing the way they buy products in view of higher inflation. Furthermore, there are challenges as the risks of a recession in 2023 have increased. Moreover, despite its stock falling, Qualys remains significantly overvalued with respect to peers from the IT sector which signifies that it does not constitute an opportunistic buy.

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Valuation grades (www.seekingalpha.com)

Therefore, unless you are a trader and want to benefit from the action of the U.S. central bank getting less hawkish in the future, it is better to wait for signs of improvement in the billing numbers during the fourth quarter results in February.

Finally, this thesis has shown that Qualys has a differentiated approach, namely with the way its VMDR is natively integrated with hyperscalers’ clouds. The company also has a more balanced profitable growth strategy, but, with high inflation and economic growth concerns, clients are altering the way they spend on cybersecurity. This is the reason why it is better to wait for how the penetration rate of its VMDR evolves as well as the rate of adoption of newer products like asset and patch management.

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