It's been a rough two months for Palo Alto Networks (NYSE:PANW) shareholders following a disappointing forecast of $386 million to $390 million in sales for its current quarter, equal to "just" 36% to 37% revenue growth. The guidance was given in late May, at the same time the company reported quarterly earnings that saw the end of a nearly two-year string of reporting top-line gains of 50%. (The $345.8 million in the quarter equaled a 48% increase.) Palo Alto shares sank to as low as $116.76 in the wake of the quarterly report and by July 27 were still down more than 11% from their pre-earnings price.
But investors' negativity was brushed aside by most of the 36 analysts following Palo Alto. The pundits still have an average price target of $185 a share, and other than a couple of downgrades to "hold" following Q3, its stock retains a strong buy rating. Are analysts right to keep singing the praises of Palo Alto Networks?
First, the good news
Palo Alto didn't keep its impressive run of 50% or more quarterly sales growth intact in Q3, nor will it this quarter, its fiscal fourth quarter. However, it's safe to say most established companies -- though Palo Alto is undeniably still in a growth phase, it has been around for 11 years -- and their shareholders would be ecstatic with a 48% bump in revenue.
Palo Alto bulls also point out that even this quarter's "disappointing" expectation of 37% year-over-year sales improvement isn't nearly as bad as investors' initial bearish reaction indicates. One of Palo Alto's primary competitors, Fortinet (NASDAQ:FTNT), has had a banner year, climbing 19% in value year to date thanks to four straight quarters of revenue growth of 30% or more.
Meanwhile, Palo Alto's exceptional results relative to its peers have translated to a 25% decline in share price in 2016. Why the difference? Palo Alto is a victim of its own success after its run of impressive sales, which analysts have clearly set aside as near-term investor sentiment rather than a long-term concern.
There's also the small matter of Palo Alto nearly doubling non-GAAP (excluding one-time items) per-share earnings to $0.42 in Q3, up from $0.23 in the year-ago period, not to mention its 44% increase in deferred revenue, which now sits at $610.4 million compared to $423.9 million nine months earlier, suggesting a strong pipeline of business going forward.
Now, the not-so-good news
Have investors overreacted? Possibly, but the reality is that Palo Alto was able to get away with sky-high spending that has kept it unprofitable since going public because of those revenue gains. Now that sales are trending downward, Palo Alto needs to begin delivering on the bottom line before it can warrant investor confidence.
Share-based compensation expense skyrocketed 76% in Q3 to $112.7 million, accounting for more than half of Palo Alto's stunning $202 million in sales and marketing expense last quarter, which was up 54% compared to 2015. It's one thing for a growth-oriented company to increase spending on items such as research and development (R&D) -- which it did by 53% last quarter -- or infrastructure. Those are legitimate, one-time expenses to fuel growth. But there's nothing "one-time" about continually boosting spending on sales and marketing: Those are ongoing costs.
When Palo Alto reports fiscal 2016 Q4 and annual earnings on Aug. 30, investors considering Palo Alto as an investment would be wise to zero in on both share-based compensation and total operating expenses, which also jumped last quarter to the tune of 50%.
Some analysts point to Palo Alto's impressive 95% increase in free cash flow (FCF) in Q3 as an indicator that even though it's far from profitable, it is a cash-generating machine. There's just one small problem: Palo Alto includes share-based compensation and increases in deferred revenue in its FCF calculation, which some would argue skew the results.
Adding both compensation expense and the $140.4 million increase in deferred sales included in FCF results -- though Palo Alto has yet to pocket the revenue -- is a legitimate accounting practice, but it warrants consideration before jumping on the FCF bandwagon.
Market sentiment is a reality, and with so many analysts onboard the Palo Alto train, don't be surprised to see its recent slow-but-steady stock appreciation continue. However, when Palo Alto reports Q4 earnings on Aug. 30, if the realities of slowing revenue gains, increased spending, and no profitability in sight hit home -- again -- sentiment might change.
Tim Brugger has no position in any stocks mentioned. 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.