Palo Alto's Steadily Gaining Respect

Shares of Palo Alto Networks (NYSE: PANW  ) were trading down 4% on Friday following the company's second-quarter earnings report. Although the network security company beat consensus estimates, the market didn't like the company's forecast for this current quarter, even though it was in line with estimates. But the Street had already received guidance from rivals like Cisco (NASDAQ: CSCO  ) and Check Point Software (NASDAQ: CHKP  ) , which weren't any better. Fairly or unfairly, this is the plight of momentum growth stories like Palo Alto -- where it's always about the next quarter.

Another dominant performance
Downbeat guidance or not, the company delivered the goods. And speaking of momentum, there's not much more a company can do than 70% year-over-year revenue growth. Palo Alto posted sales of $96.5 million, which topped Street estimates of $93.3 million. Product revenue soared 60% year over year and advance 12% sequentially. Service revenue, which accounts for 36% of total revenue, was the story -- jumping 91% year over year and 13.5% sequentially.

What's more, the company added an additional 1,000 new customers in the quarter, which brings its total to 11,000.This tells me that Palo Alto is significantly outperforming Cisco in some very important areas, particularly in security services, where Cisco posted just 1% revenue growth. However, Palo Alto is not making this easy. For that matter, it is outperforming market leader Check Point, which just grew just 3%. While Check Point cited (among other things) weak European demand for its struggles, Palo Alto posted 25% growth in international markets.

The company also posted year-over-year and sequential growth in all geographic markets. Equally important, even though the Palo Alto is not as big as Cisco or Check Point, a 92% jump in deferred revenue means that Palo Alto has been aggressive. Likewise, that billings surged 81% year over year and 12% sequentially means that Palo Alto is not feeling the sort of macro or pricing pressure that young companies are normally subjected to.

Still building infrastructure
In that regard, there were strong improvements in profitability, with yet some opportunities. Non-GAAP gross margin of 72.2% arrived in line with prior guidance. But gross margin was a bit soft -- shedding 70 basis points year over year and 40 basis points sequentially. But I'm willing to excuse this. The company is fighting for position and market share, evidenced by the 14% increase in research and development expenses.

Likewise, Palo Alto invested in several product development and sales improvement initiatives; sales and marketing expenses grew by $3.6 million. These increases took product margin down a bit to 73.4%, which is down 10 basis points year over year and 80 basis points sequentially. But management warned the Street in the first quarter of product gross margin fluctuations due to new product releases. In this case it was the launch of the PA-3000 series security hardware, which bought in higher cost of goods sold.

Moving forward
Palo Alto showed tremendous growth. Although profitability is not where investors would like it to be, it seems silly to worry about this operational aspect today. Aside from the PA-3000 launches, Palo Alto has been actively ramping up its hardware and software, including an updated operating system called PAN-OS 5.0 that was released last November. This arrived in addition to a VM-series that integrates with VMware's the vSphere.

However, the Street chose to focus on guidance, which wasn't that bad relative to expectations. The company is projecting third-quarter revenue in be in the range of $100 million to $104 million. This represents growth of 52% to 58% year over year, while projected non-GAAP earnings per share of $0.05. This assumes continued investments for growth and market share.

The company continues to raise the bar and is among a small group (which includes Aruba Networks) that is well positioned to outperform for many years to come. Consequently, Palo Alto should attract a lot of attention as an acquisition target. I still place Cisco at the top of my list of suitors. I would be surprised if this company is still operating as an independent in 12 months. To that end, I would be buying this stock on any sign of weakness.

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