Palo Alto Networks (NYSE:PANW) was once a great growth stock. The pioneer of next-gen firewalls went public at $42 in 2012 and hit nearly $200 in 2015, but eventually stumbled back to the $130s.
The stock rose just 6% this year, compared to the S&P 500's 8% growth and a 12% gain for the PureFunds ISE Cybersecurity ETF (NYSEMKT:HACK), which holds a basket of the top players in the industry. The optimists might believe that Palo Alto can regain its mojo, but these five red flags indicate that it's smarter to sell the stock than to buy it.
1. Decelerating sales growth
Palo Alto's year-over-year sales growth has decelerated for seven straight quarters. Its revenue rose 49% to $1.4 billion in 2016, but analysts anticipate just 26% growth this year and 22% growth next year.
Much of that slowdown is due to its maturing business. Palo Alto already serves 39,500 customers worldwide -- including 86 of the Fortune 100 and about 1,200 of the Global 2000 -- so a slowdown isn't surprising. But Palo Alto also blamed some of the slowdown on inefficient sales and marketing teams, which it reorganized during the third quarter.
Nonetheless, it might be wise to ignore Palo Alto until its growth either stabilizes or rises again. After all, its industry peer FireEye's (NASDAQ:FEYE) revenue growth dropped from the high double-digits to the low single-digits within a single year.
2. Non-existent profits
Palo Alto's revenue slowdown could be forgivable if it were profitable. But it's only profitable on a non-GAAP basis, which excludes the hefty stock-based compensation (SBC) expenses that gobbled up 28% of its revenues last quarter. By that metric, its net income rose 35% to $57.1 million.
But on a GAAP basis, which includes the SBC charges and other expenses, Palo Alto's net loss narrowed only slightly from $64.1 million to $60.9 million during the quarter. Considering that its top line growth is decelerating and its core market is getting saturated, it's hard to see how Palo Alto can ever achieve profitability.
3. Lofty valuations
Since Palo Alto isn't profitable, investors usually look at its price-to-sales ratio to gauge how "expensive" the stock is. Palo Alto currently trades at 7.2 times sales, which is higher than the industry average of 5.6 for application software makers. FireEye trades at just 3.4 times sales.
Palo Alto's P/S ratio isn't that historically expensive, since it traded at nearly 19 times sales at the peak of is heyday in 2015. But it still doesn't seem like a safe stock to own with the market hovering near historic highs with frothy valuations.
I believe that a safer pick would be Check Point Software (NASDAQ:CHKP), the former employer of Palo Alto founder Nir Zuk. Check Point is profitable by both non-GAAP and GAAP measures, and it trades at just 26 times earnings compared to the industry average P/E of 103.
4. Enemies at the gates
Palo Alto is the "best in breed" player in next-gen firewalls, but bigger tech companies like Cisco (NASDAQ:CSCO) and Microsoft (NASDAQ:MSFT) are gaining ground. Cisco bought companies like ThreatGRID and SourceFire to counter smaller companies like Palo Alto, and it now offers a wide range of next-gen firewalls.
Microsoft's new Windows Defender ATP (Advanced Threat Protection) system for Windows 10 pulls data from over a billion Windows devices worldwide into a cloud-based security graph to counter perimeter threats. Microsoft also pledged to invest over $1 billion annually in cybersecurity R&D earlier this year.
This is troubling for Palo Alto, because Cisco and Microsoft can respectively bundle their security solutions with their market-leading networking products and operating systems. To stay competitive, Palo Alto might need to slash prices or pile on new features -- which would cause its bottom line to sink deeper into the red.
5. The insiders are bearish
Lastly, Palo Alto's insiders don't seem confident in the company's growth prospects. Over the past three months, insiders sold nearly 67,000 shares without buying a single share on the open market. Over the past 12 months, they dumped over 699,000 shares while only purchasing about 213,000 shares.
Insiders have plenty of reasons to sell their stock, but those ratios strongly suggest that it isn't the best time to buy Palo Alto.
The key takeaways
With cyberattacks on the rise, investors should have some exposure to the cybersecurity industry, which could grow from $122.5 billion to $202.4 billion between 2016 and 2021, according to research firm Markets and Markets.
But they also should be choosy with those stocks, since many cybersecurity companies -- like Palo Alto -- have decelerating sales growth, non-existent profits, and lofty valuations. For now, investors should skip Palo Alto and stick with companies like Check Point, which are profitable and trade at more reasonable valuations.