In previous articles, I listed numerous other tech stocks that I'd "hate" to buy. But since there's never a shortage of weak stocks to avoid, it's time to add two more names to that list -- Palo Alto Networks (PANW -1.21%) and IBM (IBM 1.56%).
Palo Alto Networks
On the surface, next-gen firewall provider Palo Alto Networks looks like a solid growth stock. Revenue rose 41% annually to $400.8 million last quarter, topping estimates by $11.1 million, and 49% for the full year. However, that growth represented a slowdown from 55% growth in 2015 and 51% growth in 2014.
That "slowdown" seems tame, but it also makes it harder to justify Palo Alto's price-to-sales ratio of 10. By comparison, its next-gen firewall rival Check Point and threat prevention firm FireEye -- which both have lower revenue growth rates -- both trade at 9 times sales. All three companies trade at a premium to the software industry's average P/S of 5.
The core problem with Palo Alto is that its expenses -- particularly stock-based compensation (SBC) expenses for high-paid sales and R&D jobs -- are outpacing its revenue growth. SBC expenses soared 75% last year and consumed 30% of its revenues, causing its GAAP net loss to widen from $165 million to $226 million. The additional shares it's issuing to cover SBC also boosted its share count by 25% over the past three years, diluting existing shares and inflating its multiples. Unless Palo Alto gets its costs under control, it could face cash flow problems in the near future -- so investors should avoid this stock until the company demonstrates better financial discipline.
I previously highlighted IBM as a decent income play with a solid forward yield of 3.5%, a sustainable payout ratio of 44%, and a low P/E of 13 -- which is much lower than the industry average of 21 for IT services companies. However, I personally wouldn't want to buy Big Blue for two reasons -- its turnaround plan is painfully slow, and rising interest rates could cause income investors to dump IBM as a dividend play while throttling is ability to use debt-funded buybacks.
IBM has posted 18 consecutive quarters of year-over-year revenue declines due to sluggish enterprise spending, competition, and currency headwinds throttling the growth of its IT services, software, and hardware businesses. The company's long-term turnaround plan is to divest weaker businesses while nurturing the growth of its five "strategic imperatives" -- cloud, analytics, mobile, security, and social platforms.
Revenue from those businesses, which accounted for 40% of IBM's revenue over the past 12 months, rose 16% annually last quarter. But that growth didn't bring Big Blue's sales growth back into positive territory, and its overall revenue fell 0.4%. Analysts expect IBM's revenue and earnings to respectively decline 2% and 10% this year. Therefore, I'd avoid IBM until it can prove that its strategic imperatives growth can offset its top line declines in other businesses.
But both stocks could eventually be worth buying...
Although I believe that Palo Alto and IBM aren't compelling buys today, investors should still keep an eye out for signs of improvement. For Palo Alto, this means that GAAP losses must narrow alongside non-GAAP income growth. It also must prove, through acquisitions or new services, that its "best in breed" reputation in next-gen firewalls can withstand fierce competition.
Meanwhile, IBM must prove that its inorganic growth strategy is actually fueling the growth of its strategic imperatives businesses. If IBM gets too aggressive with its purchases, it could "deworsify" those businesses instead of streamlining them for stronger growth. It also must introduce meaningful ways to counter cloud infrastructure leaders that are arguably leaving Big Blue behind in the cloud market. If Palo Alto and IBM can accomplish all those things, I'll reevaluate their stocks as potential buys.