Next-gen firewall vendor Palo Alto Networks (NYSE:PANW) shed nearly 30% of its value over the past year due to ongoing concerns about its slowing sales growth, widening losses, and rising competition. But as Palo Alto hovers near its 52-week low, investors might be tempted to start a position in this high-growth stock. However, I believe that the stock could still fall further for five main reasons.
1. Its high valuation
Palo Alto currently trades at 8 times trailing sales. That's a high P/S ratio compared to many of its cybersecurity peers -- Fortinet (NASDAQ:FTNT) trades at 4 times sales, FireEye (NASDAQ:FEYE) trades at 3 times sales, and Symantec has a P/S ratio of 4.
With the market hovering near all-time highs and big investors rotating out of the tech sector toward energy and financials, tech stocks with high valuations and zero GAAP profits or dividends (like Palo Alto) could be highly exposed to big sell-offs.
2. Slowing sales growth
Palo Alto posted 34% year-over-year sales growth last quarter, but that represented its slowest growth rate since its 2012 IPO. Analysts expect the company to post 31% sales growth this year, compared to 49% growth last year. That slowdown has been attributed to slower enterprise spending, competition in the perimeter security space, and a market shift from on-site appliances to automated solutions and subscription-based software and services.
3. The rise of bundled platforms
To stay competitive in that market, Palo Alto launched its Next-Generation Security Platform to bundle together natively integrated technologies, automated protection solutions, and threat intelligence sharing solutions on a scalable platform for businesses.
However, rivals like Fortinet and FireEye are also expanding with similar bundled plays. Fortinet offers an integrated security platform which bundles additional security services with its firewall, and FireEye recently unveiled Helix, which bundles its threat prevention services together under a single user interface. Cisco (NASDAQ:CSCO) also bundles next-gen firewalls and other security tools with its networking hardware and software -- making it tough for stand-alone players like Palo Alto and FireEye to stay competitive.
4. Widening GAAP losses
Palo Alto's bottom line growth initially looks solid -- its non-GAAP net income rose 66% annually to $51.2 million last quarter. But on a GAAP basis, its net loss widened from $39.9 million to $61.8 million. That disparity was mainly caused by its stock-based compensation (SBC) expenses, which rose 55% annually last quarter and gobbled up 29% of its revenues.
High SBC expenses are common in the competitive Silicon Valley job market, but that puts Palo Alto at a clear disadvantage against non-Silicon Valley rivals like Israeli firewall vendor Check Point Software (NASDAQ:CHKP) -- which spent a mere 5% of its revenue on SBC expenses last quarter. But if Palo Alto cuts jobs and SBC expenses, as FireEye is currently doing, it could eventually be outgunned by its rivals' better-funded R&D and sales teams.
5. Insiders still hate the stock
If Palo Alto shares were considered undervalued, we should see lots of insider buying. However, insiders actually sold nearly 900,000 shares over the past six months without buying a single share on the open market. Many major executives, including CEO Mark McLaughlin, sold large positions when the stock hit the $140s earlier this year.
Insiders have plenty of reasons to sell their shares, but those sales seemingly contradict the two-year $500 million buyback plan the company announced in late August. But as I noted in a previous article, that buyback plan is likely aimed at offsetting the share dilution from its big stock bonuses instead of tightening up its earnings per share.
The key takeaway
Palo Alto Networks might look like a great growth stock, but its sales growth is slowing down and analysts' rosy projections for 32% annual earnings growth over the next five years are based on its non-GAAP earnings.
Palo Alto is still a "best in breed" player in the crowded cybersecurity market, but its stock could keep falling if it doesn't counter its competitors in the security platform market and get its costs under control. Therefore, I'd suggest that investors interested in the cybersecurity market take a closer look at conservative plays like Cisco or profitable niche players like CyberArk instead.