In addition to competing in the growing data security space, Fortinet (NASDAQ:FTNT) and Palo Alto Networks (NYSE:PANW) have something else in common: Both are reeling in the wake of quarterly earnings reports that offered disappointing expectations for the balance of the year. Fortinet, and to an even greater extent Palo Alto, are both victims of their own success.
Until last quarter's "mere" 48% jump in revenue to $345.8 million, Palo Alto had been on a tear in which it reported 50% sales improvements or better each quarter for nearly two years. Fortinet's revenue run didn't quite match Palo Alto's, but last quarter's 30% increase to $311.4 million kept its own streak of four quarterly top-line gains of 30% or better intact. So, which is the better buy?
The case for Fortinet
Founder and CEO Ken Xie summed up Fortinet's Q2 saying, "We are pleased with our billings and revenue over-performance, and ability to meet our expense and profitability targets while still investing for growth." Billings for the quarter climbed 26% year over year to $373.8 million, and deferred revenue inched up to $904 million, compared to $837.2 million in Q2 2015.
However, questions remain about how the $230.9 million in operating expenses last quarter -- 38% higher than the year-ago period -- and its whopping 45% higher sales and marketing spending "meet" Xie's expense-management targets.
That said, Fortinet is in a growth phase, and that requires spending in key areas including research and development, and getting its products in front of prospective customers, so its $0.01 a share loss in Q2 wasn't surprising. In fact, on a non-GAAP basis (excluding one-time items), Fortinet's net income of $0.14 per share last quarter was up from $0.11 per share a year ago, and in line with consensus analyst estimates.
In addition to growing its top line, Fortinet's end-to-end product platform -- or, as Xie calls it, an integrated "Security Fabric" -- means it's well-positioned to capture share in the skyrocketing cloud and Internet of Things markets as IT departments shift to enterprise-wide solutions. Offering a platform that covers all a customer's data security needs, whether housed in the cloud, on-site, or a hybrid solution, is what Fortinet does best.
The case for Palo Alto Networks
If Fortinet's stock has taken a bit of a beating since the company announced Q2 earnings on July 28 -- it's down about 6% -- Palo Alto shares have been clobbered over a longer period. Since it shared its fiscal 2016 third-quarter earnings results on May 26, Palo Alto's shares have suffered through a more than 13% decline as of Aug. 1. But those tough couple of months has made the stock an even better value.
Similar to Fortinet, one of Palo Alto's strengths is its "Next Generation Security Platform," an enterprise solution that as of last quarter boasts over 31,000 customers. Another feather in Palo Alto's cap is its emphasis on subscription sales, which in turn drive more stable recurring revenue.
Palo Alto's services revenue climbed 63% to $183.7 million last quarter and now handily accounts for the majority of total sales. That's a strong signal that its focus on subscription deals is working, and it may help Palo Alto conquer its own spending concerns in the quarters and years ahead. Last quarter, Palo Alto's operating expenses climbed 50% and now sit at $309.5 million.
The bigger concern, and one that Palo Alto needs to address considering its slowing revenue growth -- it forecast a 36% to 37% improvement this quarter -- is the rise in its overhead cost, of which a mind-boggling $112.7 million consists of share-based compensation. How much and how long those costs continue to soar warrants monitoring.
So, which is the better buy? While questions remain about both Fortinet and Palo Alto, the latter's top-line improvements, albeit slower than in the past, will continue to widen its lead over Fortinet. Fortinet's $40 consensus price target is a shadow of the $185 a share upside analysts expect for Palo Alto, and this time the analysts got it right.