Palo Alto Networks (NYSE:PANW) is a major player in the fast-growing network security market. It has enjoyed strong sales growth since its founding in 2005, yet has only managed a single year of profitability in that time.
Below, we'll look at the important trends that characterize this software specialist's business.
Sales growth has collapsed recently, falling to a 25% rate last quarter from the 50% or better pace that Palo Alto managed in each of the last two fiscal years. Part of that decline can be attributed to general sluggishness in the industry. Rival FireEye (NASDAQ:FEYE), for example, has seen its expansion pace fall even more dramatically.
But industry issues have been compounded by strategic stumbles. Palo Alto executives said they were surprised that the company failed to close a few big deals in its fiscal second quarter. "We were disappointed that we came in below top-line expectations due to some execution challenges," CEO Mark McLaughlin explained in late February. The company is reorganizing its salesforce structure in hopes of improving its go-to-market strength.
Palo Alto Networks is shifting deeper into a hybrid software-as-a-service model that management believes offers the best shot at producing sustainable profits. There's good evidence to support that idea, given that non-GAAP operating margin has roughly doubled to 20% of sales in the three years ended in fiscal 2016.
The company's gross profit margin is ultimately dependent on its software and hardware engineers, who must continuously develop improvements in its next-gen security platform so that average contract prices steadily rise. The metric dipped last quarter, but its long-term trend is steady at around 73% of sales -- compared to 63% for FireEye.
The company lost $226 million last year, and in fact has only generated positive earnings in one fiscal year since its inception over a decade ago. Its sales and market costs are the biggest single drag on profits, accounting for over 50% of revenue over the past nine months. Like FireEye, Palo Alto Networks will need to bring that ratio down over the next few years. Its priority today is sales growth, though, and so it makes sense that management would aggressively fund its global marketing and contract-servicing infrastructure.
The stock is up a dramatic 170% over the past five years. However, shareholders have had to endure significant volatility along the way. In just the last year, for example, the stock has been up as much as 25% and down by as much as 15%. Investors aren't likely to see a change in these swings until it becomes clear that Palo Alto Networks' sales growth trends have stabilized and are putting the company squarely on track to generate consistent profits.
Deferred revenue is a window into Palo Alto Networks' future growth, since it represents contracted but not yet billed sales. The metric is expanding, but its pace slipped in concert with revenue gains over the past few quarters. Billings make up an important portion of deferred revenue, and they slowed to a 12% increase last quarter from 22% in the prior quarter.
That decline is the main reason why management has predicted another quarter of decelerating sales growth ahead. Executives hope the changes they're making with the sales force reorganization will help put things back on track. The first clue to that potential rebound will likely come in the form of a robust improvement in Palo Alto Networks' billings metric.