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Is Palo Alto Networks Inc Finally Turning Things Around?

By Harsh Chauhan – May 21, 2017 at 11:38AM

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After suffering a double-digit plunge in February, the stock has begun to bounce back -- is the rally sustainable?

Palo Alto Networks (PANW -1.74%) stock has rallied about 5% in May (as of this writing), thanks to fellow cybersecurity specialist FireEye's robust first-quarter results. It appears that FireEye's impressive full-year guidance helped to trigger a rally for Palo Alto before major cybersecurity attacks across the world lifted shares for the entire industry. All of this activity must come as a sigh of relief for Palo Alto investors after the stock sank over 20% in a single day following disappointing second-quarter results and weak guidance.

But is this newly found momentum sustainable, or will investors get a harsh reality check when the company reports its third-quarter results on May 31?

Palo Alto Networks logo.

Image source: Palo Alto Networks. 

The problem in Palo Alto

Palo Alto Networks has encountered short-term execution issues that led to weak guidance for the third quarter (which ended in April). As it turns out, the company has struggled on account of an obsolete sales model that involved dividing its target markets into smaller segments and territories.

Evidently, this model of dividing territories and spending marketing dollars no longer works. The company has been busy racking up more customers without paying attention to the key accounts that could substantially impact revenue, lowering the productivity of its sales and marketing exercises.

Despite the recent rally, investors need to be cautious when evaluating the stock.

Can Palo Alto deliver?

Palo Alto's third-quarter results should meet analyst expectations, as Wall Street has dialed back their estimates to reflect the company's weak guidance. But the forward guidance will be critical, though management has assured investors that efforts to improve the business model are already underway.

For instance, the company is recalibrating its sales model to focus more on those accounts that better align with its long-term goals. The turnaround efforts are expected to continue throughout the current fiscal year, so results could improve as the year progresses, but the company believes that the entire effect of its transition will not be reflected until fiscal 2018.

Investors shouldn't bank on a turnaround just yet, but instead, wait for Palo Alto's upcoming quarterly results before making a call. Ultimately, long-term investors shouldn't lose faith in the company's story even if its results and guidance don't pass muster, as it is rapidly adding customers in a high-growth industry.

Looking past the short-term headwinds

Palo Alto's network and endpoint security markets will grow at almost 8% a year through 2020, according to IDC. This could boost revenue by 37% to $2.16 billion compared to current levels, assuming the company can defend its 9% market share.

But an increase in Palo Alto's market share shouldn't surprise anyone, as the company is still taking business away from rivals. As it turns out, the cybersecurity specialist added 2,000 new customers in the second quarter by displacing competitors like Cisco, McAfee, and Check Point. For instance, Palo Alto has replaced Cisco at a North American healthcare provider's data center project.

More importantly, Palo Alto seems to be adding the right customers, as the lifetime value of its top 25 clients was up 46% in the last-reported quarter thanks to a booming subscription business. In fact, subscriptions and support now account for 60% of the company's total revenue, leading to a bump in its deferred revenue and margins.

What's great about Palo Alto's subscription business is that it is driving terrific growth in the company's long-term deferred revenue. The metric jumped 73% last quarter on a year-over-year basis, while overall deferred revenue (including the short term) increased 61%. This indicates that Palo Alto is trying to add sustainable revenue streams that'll boost the top line in the long run, so investors shouldn't focus too much on the near-term results.

Harsh Chauhan has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Check Point Software Technologies. The Motley Fool recommends Cisco Systems, FireEye, and Palo Alto Networks. The Motley Fool has a disclosure policy.

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