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Deutsche Downgrades Palo Alto Networks: 3 Bright Red Flags to Worry About

By Rich Smith - May 27, 2016 at 11:07AM

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But I see no need to wave you off from the stock just yet.

Palo Alto Networks (PANW 2.90%) reported earnings last night, and already, the stock is plummeting. The company put up terrific numbers, though: 48% revenue growth and adjusted earnings per share up 83%. So what went wrong?

Well, you can blame the "adjusted" part of those earnings right off the bat, because according to GAAP calculations of profit, Palo Alto Networks actually lost money last quarter -- $0.80 per share -- and that was a wider loss than the company incurred one year ago. But even so, Palo Alto's numbers were superior to what analysts had been predicting, beating earnings estimates by 2%. You might think that would be good news.

Except that one analyst does not think it was good news. In fact, one analyst is downgrading Palo Alto Networks stock.

Here are three reasons why.

IDC Security sees the cybersecurity market growing at 7.1% annually over the next three years. Palo Alto Networks just grew revenue seven times that fast. So why is the stock down? Image source: Palo Alto Networks.

The higher you set the bar, the easier it is to trip

As reported on this morning, analysts at Deutsche Bank cut their rating on Palo Alto Networks stock from "buy" to "hold." Deutsche also slashed its price target on the stock by more than 25%, to just $150 per share.

Why? Well, there were three big red flags that Deutsche espied in Palo Alto's earnings report. We'll run them all down for you here now, beginning with ... the size of Palo Alto's supposed earnings "beat."

According to Deutsche, Palo Alto Networks beat earnings by "just 2%" in its fiscal Q3 earnings report Thursday. As Deutsche noted, however, Palo Alto "normally" beats earnings by anywhere from 5% to 7%. Thus, the margin of the stock's victory over analyst predictions was significantly slimmer than analysts themselves had been trained to expect -- and they're not happy about it.

Suspiciously well-timed revenue

Deutsche also appears to have found the revenue that produced Palo Alto's tiny profits beat somewhat alarming. Q3's numbers, says the analyst, were "back-end loaded" and the company's robust billings "all came" late in the quarter.

Now, Deutsche didn't come out and accuse Palo Alto Networks of finagling its numbers -- but that does seem to be the implication. At the very least, a preponderance of revenue and billings cropping up just before the company was about to report its numbers suggests Palo Alto may have pulled forward payments for services -- payments that should have occurred in fiscal Q4 2016 may have been made in Q3 instead.

If that's the case, then these same payments will necessarily not happen in Palo Alto's current fiscal Q4.

Siphoning off future growth

And here's the real, big-picture worry that grows out of all the above: Deutsche notes that while subscription revenue grew a very healthy 69% in Q3, growth in product revenue "decelerated to 33% from 46%-47% in prior quarters." What's more, management's "4QF16 revs guide implies further deceleration (to 37% total revs growth and 20%-25% product revs growth)."

If these are indeed the kinds of numbers Palo Alto Networks is setting itself up to report at the end of this current fiscal fourth quarter, it will lend further credence to the suspicion that revenue that should have happened in Q4 was in fact pulled into Q3 to help salvage the quarter. As this effect cascades over time, Deutsche warns that Palo Alto Networks "could create an overhang that may last several quarters."

Why that matters

With a forward P/E ratio of 50 times earnings, Palo Alto Networks is obviously priced with very high expectations for future earnings growth. Deutsche's warning that such growth will be weaker than investors are depending on therefore imperils the stock's valuation -- and in fact, Palo Alto Networks stock has already lost nearly 13% of its market capitalization since reporting Q3 numbers on Thursday.

But does that make the stock a sell?

I don't think so, and in fact, even Deutsche Bank isn't telling investors to sell Palo Alto Networks stock just yet. All Deutsche is doing is reining in its optimism a bit, and downgrading to "hold," based on a likely slowing of growth rates from hyper-growth to mere super-growth speeds. But as long as the company keeps growing, there's still an argument to be made for buying this stock.

Here's why: Although Palo Alto doesn't currently produce GAAP profits (its 50 P/E is a forward P/E, after all), the company is generating positive free cash flow, and quite a lot of it. Data from S&P Global Market Intelligence confirm that Palo Alto Networks generated nearly $514 million in positive free cash flow over the past 12 months. That's enough cash profit to give the stock a price-to-free cash flow ratio of just 22.2.

That's ridiculously cheap if Palo Alto succeeds in hitting analyst estimates of 42% long-term profits growth. But it's also plenty cheap to justify buying the stock if Palo Alto grows only half as fast as analysts (still) think likely.

So, long story short? Despite the guidance disappointment, and despite Deutsche's downgrade, I suspect that for long-term investors, Palo Alto Networks remains a buy.

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