About the only good news for Palo Alto Networks (NYSE:PANW) shareholders of late is that its stock price is slowly inching back up to its post-earnings level of $129.86. Of course, Palo Alto shares were sitting at $148.18 on May 26, before fiscal 2016 third-quarter earnings were announced, then nosedived over 12% the following day. With a 52-week high of $200.55 a share, value investors may think Palo Alto represents an opportunity.
There is no shortage of bullish Palo Alto analysts -- one even upped his target price to a whopping $215 a share last month, and he's not the only pundit in the company's corner. The 37 analysts who follow Palo Alto have an average target price of $185.43, good for a 46% jump from Wednesday's close. The question is, why?
Not only has Palo Alto's string of soaring quarterly revenue growth ended, but spending remains off the charts, and competition is heating up from the likes of Check Point Software (NASDAQ:CHKP) -- not to mention some of the industry's largest data security players.
What are analysts excited about?
It wasn't necessarily Palo Alto Networks' seven straight quarters of 50% or more revenue growth coming to an end in Q3 that sent its stock price reeling. Its guidance for the current quarter really stung. Palo Alto's top-line growth had been the primary driver of its once-soaring stock price. It sure wasn't profits fueling Palo Alto's fire, because the company's a long way from being in the black. Nor were Palo Alto pundits and investors citing its expense control efforts to warrant its sky-high valuation, because there aren't any.
Last quarter's 48% increase in sales to $345.8 million was a bit of an eye opener given Palo Alto's long string of 50% or better. But with an expected year-over-year revenue between $386 million and $390 million, equal to a 36% to 37% improvement over this quarter, Palo Alto's revenue trend is now heading in the wrong direction.
Palo Alto CEO Mark McLaughlin and CFO Steffan Tomlinson are quick to point out that free cash flow (FCF) is soaring, and they're right. In Q3, FCF rose an impressive -- at least at first glance -- 95% from the year-ago quarter, to $150.8 million from $77.4 million in fiscal 2015's third quarter. Sounds pretty good, right?
Actually, not so much
The only problem with Palo Alto execs and bulls pointing to FCF as a sign the company is hitting on all cylinders is that a large part of the aforementioned 95% "improvement" is due to skyrocketing share-based compensation, as well as deferred subscription revenue.
The $112.7 million Palo Alto paid out in share-based compensation this year was $48.6 million higher than the amount in 2015, and deferred revenue climbed $72.4 million, to $140.4 million. Though to Palo Alto's credit, soaring deferred revenue is a bullish sign in that it supports Tomlinson's assertion that "particular strength in our subscription services" last quarter helped drive results.
But soaring share-based compensation costs are nothing to brag about, not to mention they skew FCF because let's face it, they're not really cash generated as much as a being a non-cash expense that is added back into the FCF calculation mix. In fact, remove the staggering $48.6 million increase in comp expense and Palo Alto's FCF grew 32%. High-growth companies often show strong FCF for the same reasons, which is why slow but steady data security providers, including Check Point Software, will rarely compare favorably against the Palo Alto Networks of the world.
But that's primarily because Check Point's CEO, Gil Shwed, takes a more conservative approach to spending, as evidenced by last quarter's meager 2.5% increase in stock-based comp to $18.22 million, from $17.78 million a year ago. There's another significant difference between Palo Alto and Check Point for investors to consider: The latter is consistently profitable, including and excluding one-time items.
When all is said and done, Palo Alto's stock price of around $125 a share is about right. At least until the company gets spending under control, which in turn will help stop the bleeding on its bottom line. And that is particularly vital now that its stellar top-line growth has become a thing of the past.
Tim Brugger has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Check Point Software Technologies. The Motley Fool recommends Palo Alto Networks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.