Based on the beating its stock price took out-of-the-gate following fiscal third-quarter earnings results, it's safe to say Palo Alto Networks (NYSE:PANW) investors and pundits were not amused. The problems with Palo Alto's recent quarter range from increased spending to poor guidance and slowing revenue growth. And to make matters worse, it's a healthy dose of all three.
Despite landing on the wrong side of the earnings fence, Palo Alto responded positively in one of its primary initiatives: boosting its source of recurring revenue. However, as noted in a recent article leading up to the May 26 announcement, Palo Alto investors' patience was only going to be tested for so long. At some point the company needs to perform beyond growing its top line, and it's running out of time.
Just the facts
CEO Mark McLaughlin tried to temper expectations after reporting Palo Alto's second-quarter results by forecasting a 43% to 45% revenue improvement in Q3, ending its nearly two-year-long streak of reporting 50% or more quarterly sales growth. Palo Alto didn't quite reach the remarkable 50% revenue jump this past (fiscal third) quarter, but delivered a pleasantly surprising 48% gain, to $345.8 million. Analysts had expected sales of $339.48 million.
On the earnings-per-share front, Palo Alto hit its high-end forecast of $0.42 on a non-GAAP (excluding one-time items) basis, which also matched pundits' expectations. Fiscal Q3 billings rose a whopping 61% last quarter, to $486.2 million, which would seemingly be a positive sign of what is to come in the current fiscal Q4. But it is not to be.
If not reaching 50% revenue growth is partly to blame for Palo Alto's stock price nosedive, its forecast for the current quarter will be downright depressing. On the high end of McLaughlin's forecast, Palo Alto expects 37% revenue growth to end its fiscal year, or $390 million.
On a more positive note, Palo Alto's services unit grew a whopping 63%, to $183.7 million, in Q3, and now represents 53% of total sales. Service sales, and the recurring revenue they generate, are a critical initiative for Palo Alto, and they took a step in the right direction last quarter.
Now for the bad news
As noted before, Palo Alto has been on a spending spree for years to drive its stellar 50%-plus revenue jumps. But with growth beginning to slow -- Q3's results and this quarter's guidance are proof of that -- minimizing costs has become a necessity, not a nicety. The problem is, McLaughlin and team can't seem to keep their checkbooks in their pockets.
A comparison with Palo Alto's peer and primary competitor, Check Point Software (NASDAQ:CHKP), demonstrates why the former's stock is down 26% year to date, and the latter's is up 3%. Palo Alto's total operating expenses of $309.5 million equaled 90% of sales. Check Point, on the other hand, spent 50% of last quarter's $404.3 million in revenue on its operating expenses.
As for cost of revenue, Palo Alto spent $94.9 million to drive its product and services sales, more than twice Check Point Software's $45 million last quarter. Is it any wonder Check Point is profitable, on both a GAAP (including one-time items) and non-GAAP basis? And Check Point's profits continue to climb, too, rising 10% last quarter.
Considering Palo Alto's slowing revenue growth and increased spending, it could be years before shareholders are in the black. Unfortunately, it gets worse because of the nature of Palo Alto's skyrocketing expenses. Check Point's sales and marketing costs equaled 23% of revenue in fiscal Q1, whereas Palo Alto's $202 million ate up a head-shaking 58% of its total sales last quarter.
When investors add it all up, the answer is fairly straightforward: Slowing top-line growth was inevitable, but continuing to spend indiscriminately is not. Until McLaughlin reins in overheads, even improvement in services unit sales and the recurring revenue that comes with it won't be enough to placate shareholders. Nor should it be.