Investors are expecting big things from Palo Alto Networks (PANW 2.90%) when it reports fiscal 2016 third-quarter earnings after markets close May 26. Though Palo Alto's share price is down about 16% year to date, shareholders have enjoyed a 7%-plus jump the past week leading up to its third-quarter news.
The question is whether Palo Alto stock warrants the positive expectations. The answer depends on whether Palo Alto is able to perform in three key areas. Considering its volatile trading history, anything short of spectacular will send its shares reeling. That said, if Palo Alto is able to demonstrate progress in those same critical aspects of its business, analysts' sky-high target price of $195.79 will be within reach.
Show me the money
It's no wonder Palo Alto has caught the attention of growth investors the past couple of years given its impressive run of seven straight quarters of 50%-plus revenue gains. However, Palo Alto's revenue growth streak is expected to slow this quarter. Palo Alto CEO Mark McLaughlin shared revenue guidance of $335 million to $339 million -- good for a 45% improvement and on the high end of expectations.
Anything short of meeting forecast sales and non-GAAP (excluding one-time items) earnings per share (EPS) of $0.41 to $0.42 will undoubtedly cause a sell-off of Palo Alto stock.
Analyst's have high expectations of $339.48 million in sales and EPS of $0.42, and after Palo Alto's impressive string of quarterly revenue improvement, even the slightest miss would be unacceptable.
Palo Alto's peers, including Fortinet (NASDAQ: FTNT) and Check Point Software (NASDAQ: CHKP) can't touch its sales growth. However, they are both growing, Fortinet is on a nearly yearlong string of 30%-plus revenue growth. Check Point CEO Gil Shwed's slow but steady approach to growing its business has translated to a meager -- at least by comparison -- 9% jump in quarterly revenue. Yet Fortinet stock is up 10% year to date, and Check Point's up 6%.
Despite its stellar top line, Palo Alto continues to report negative EPS each successive quarter. Incurring high one-time costs happens during a hyper-growth phase, usually to develop additional solutions and improve infrastructure, among other necessary outlays. The reason to monitor Palo Alto's overhead is what it's spending its revenue on.
Of Palo Alto's $334.7 million in revenue last quarter, a whopping $187.6 million -- equal to 56% of total sales -- went to sales and marketing expenses. The nearly 60% increase in research and development (R&D) spend last quarter, and the 58% jump in Palo Alto's cost of revenue are legitimate costs of doing business. But the fact it spends well over half its revenue to sell and market its services is disconcerting, to say the least. McLaughlin needs to show Palo Alto is improving its expense management -- beginning now.
One means of growing its top line without pouring more millions into marketing, and sales folks' pockets, is Palo Alto's burgeoning services unit. Unlike product sales, subscription services revenue requires less ongoing expenses and establishes a recurring revenue base -- something McLaughlin and Palo Alto CFO Steffan Tomlinson are focused on. And it's working.
Last quarter's 54% jump in total sales was largely due to Palo Alto's services group's whopping 61% improvement to $164.8 million from last year's $102.1 million. Palo Alto's product division pitched in a 46% gain in sales last quarter. The company's focus on subscription services and the recurring revenue opportunity it represents is spot-on, and worth a look when Palo Alto reports fiscal Q3 earnings.
It's not likely investors will settle for anything less than a spectacular Q3 from Palo Alto. To do that, Palo Alto needs to approach 50% top-line growth, show the Street it's getting its spending under control, and continue driving recurring services revenue. If not, it will be a long, uphill climb for Palo Alto shareholders.