The analyst from investment firm Maxim Group who reiterated his buy rating on Palo Alto Networks (PANW 1.43%) stock last week is hardly alone. Yes, his $215 price target is on the high side, even in the context of nearly across-the-board bullish sentiment. But consensus target estimates from the 37 analysts covering Palo Alto are still a lofty $188.78 a share, equal to a nearly 50% jump from Monday's closing price of $128.16.
The question is, why is this analyst, along with many of his brethren, so excited about Palo Alto? It appears most pundits are of the mind that Palo Alto's near-term questions surrounding slowing top-line growth and spending are just that -- anomalies that will "normalize" given time -- and there are numerous rationalizations to justify Palo Alto's high expectations. So who's right: the bullish analysts or investors who have continued to apply pressure to Palo Alto stock?
Image source: Palo Alto Networks.
The analyst case for Palo Alto
Palo Alto's string of quarters reporting 50%-plus revenue growth came to an end in the third quarter, though at 48% above last year's fiscal Q3, there was little to complain about. The sales growth slowdown -- both during the most recent quarter and the expected 36% to 37% top-line growth forecast for the current quarter -- was largely due to macro issues, according to CEO Mark McLaughlin.
The bullish Palo Alto analyst notes that a tough sales environment in the Asia-Pacific region, notably Australia, was one culprit. Of the 11% of Palo Alto's revenue derived from Asia-Pacific, Maxim Group estimates that 30% to 40% comes from Australia. If the region had performed as it had in prior quarters, Palo Alto would have enjoyed a 52% jump in sales.
The poor guidance for the current quarter, along with Palo Alto's weak days sales outstanding (which measures a company's average period to collect accounts receivable), was viewed as a positive by the analyst -- and is clearly not a concern for others, given Palo Alto's price target -- suggesting that McLaughlin and team have a realistic perspective. Strong billings growth of 61% year over year and a near doubling of free cash flow were also cited as bullish indicators.
Not so much
Similar to its peer Fortinet (FTNT 0.46%), Palo Alto has demonstrated revenue growth over the course of the last couple of years that has been nothing short of spectacular. Fortinet's on a string of 30%-plus quarterly sales improvements, which it attained again last quarter. Fortinet's revenue of $284.6 million was a 34% year-over-year jump. In Palo Alto's case, revenue gains were what had so many pundits singing its tune.
But with last quarter's 48% increase, and expectations of just 36% to 38% in the current quarter, Palo Alto's saving grace is coming to a halt. That, combined with soaring overhead, is disconcerting, to say the least. Cost of revenue climbed $30.5 million to $94.9 million in Q3, and operating expenses skyrocketed 50% to $309.9 million.
Palo Alto was once again in the red by $70.2 million last quarter, well above fiscal 2015's Q3 loss of $45.9 million. Fortinet's spending also rose last quarter, which was why it, too, reported a loss. However, at just $0.02 per share, Fortinet's shortfall was a blip on the screen compared to Palo Alto's $0.80 per share loss.
The bottom-line
The bullish analysts covering Palo Alto certainly make valid points in support of a target price as high as $215. However, for investors who prefer stocks with sound fundamentals or prospects for sales growth, Palo Alto falls short.
Even if Palo Alto continues to drive top-line improvements -- albeit less impressively than in the past -- this raises another concern.
An astounding 58% of Palo Alto's sales last quarter, equal to $202 million, went to fund its sales and marketing efforts. These aren't one-time costs associated with developing a new product, expanding office space, or hiring much-needed expertise. No, Palo Alto's sales and marketing outlays will continue to eat away at bottom-line results, and that's a scary proposition, given its slowing revenue growth.
