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3 Reasons Palo Alto Networks Inc Stock Could Rise

By Tim Brugger – Sep 1, 2016 at 3:25PM

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After its repeat earnings performance from the prior quarter, the upstart data security company can get things turned around.

The last two days are a microcosm of the concerns surrounding Palo Alto Networks (PANW -0.86%) stock -- at least for investors without a cast iron stomach. From the middle of this month to Monday, Aug. 30's closing price of $143.50, Palo Alto shares had jumped 10% ahead of its fiscal 2016 Q4 and annual earnings news. Following its relatively sound quarter, Palo Alto stock opened the following day plummeting about 13%.

Like last quarter, the problem is relatively strong revenue growth coupled with less-than-ideal guidance for fiscal 2017 Q1. So, what can Palo Alto do to break free of the ongoing rollercoaster ride -- its 52-week trading range is $111.09 to as high as $194.73 -- it has subjected its shareholders to the past year? If CEO Mark McLaughlin and team can deliver in a few key areas, Palo Alto will finally become the stock so many pundits and investors believe it can be.

Image source: Getty.

Seeing the forest for the trees

Palo Alto delivered a 41% jump in sales last quarter to $400.8 million, beating guidance of 36% to 37% improvement to a mid-point of $388 million. In fiscal Q1, Palo Alto expects a 33% to 35% jump in revenue to about $399 million. Playing the "guidance game" -- in which CEOs sacrifice short-term stock price hits based on forecasts it is fairly confident it will beat -- is nothing new, and this quarter has much the same feel to it.

Is McLaughlin toying with forecasts to garner short-term gains after an earnings "beat"? Only he knows, but it's consistent with Palo Alto's management approach: sacrifice long-term profitability -- or even a shift in that direction -- for top-line growth. Its history of sky-high revenue gains are why so many analysts have a love affair with Palo Alto, including a consensus $185 average price target and a "strong buy" recommendation.

It's time to take a more structured, long-term view toward profitability and managed growth, rather than a "growth at all costs" mentality, even if that means Palo Alto takes it on the chin in the interim. In fact, one of Palo Alto's primary competitors is a case in point.

Tighten the purse strings

Check Point Software (CHKP -0.61%) CEO Gil Shwed's disciplined approach to spending and management has translated to "just" single-digit revenue gains for over a year, including 7% in Q2. Check Point's slow-but-steady approach isn't going to deliver "wow" revenue growth each quarter. But it does increase profits and offers a lot less volatility.

Check Point stock is down 6% this year; Palo Alto's is down 25%. And Check Point's 52-week trading range of $71.64 to $89.98 is nothing compared to Palo Alto's more than $80 one-year price spread. Palo Alto's spending soared again last quarter, though to its credit, not quite as much as its revenue grew. Total cost of revenue and operating expenses combined increased 40% to $446.2 million in Q4, compared to its 41% sales gain.

Streamline sales

One of Palo Alto's expenses in particular offers a world of opportunity to minimize overhead and, in turn, boost bottom-line results. The amount Palo Alto shells out each quarter for sales and marketing expenses to drive revenue, along with its share-based compensation, are exceedingly high. A full 66% of Palo Alto's $344.5 million in operating expenses -- equal to $228.1 million -- went to the sales and marketing teams. That translates to Palo Alto spending 59% of its entire quarterly revenue to get its message, and sales folks, out in the streets.

With that kind of expenditure, Palo Alto should be generating at least 40% plus revenue each quarter. By comparison, Check Point's sales-related expenses were $107.6 million, equal to 48% of operational costs and about a quarter of its $422.75 million in sales in Q2.

Palo Alto Networks can sell its services; it added nearly 3,000 or so clients sequentially last quarter. But managing those and other costs requires a long-term view with an eye toward profitably. When Palo Alto starts showing signs of progress in these key areas, rather than a focus on its quarterly revenue "wow" factor, shareholders will reap the rewards.

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. 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.

Stocks Mentioned

Palo Alto Networks Stock Quote
Palo Alto Networks
$163.28 (-0.86%) $-1.42
Check Point Software Technologies Stock Quote
Check Point Software Technologies
$130.72 (-0.61%) $0.80

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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