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Why I Will Never Buy Palo Alto Networks Stock

By Tim Brugger - Updated Oct 29, 2017 at 2:23PM

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The cybersecurity provider's revenue growth may look attractive, but some of its other numbers raise huge red flags.

Granted, "never" is a very long time, but Palo Alto Networks (PANW 0.29%) is so far away from meeting, let alone exceeding, the criteria of a fundamentals-focused investor such as myself I can't imagine plunking down the $147 a share or so it's trading for today, let alone the $165.69 a share high it reached over the past 52 weeks.

Palo Alto bulls will likely point to its 20%-plus revenue gains in the last couple of quarters and its nearly two-year string of 50%-plus improvements not long ago as positives. Its market capitalization of $13.6 billion, and the growth potential that represents in the fast-growing data security market, could also be viewed as bullish.

Despite what some investors and pundits view as upsides, for me, the case against buying Palo Alto stock boils down to one glaring reason.

Digital image of a translucent globe with a key floating inside.

Image source: Getty Images.

First, the (sort of) good news

Palo Alto's fiscal fourth-quarter revenue jumped 27% year over year to $509.1 million, beating analysts' expectations as well as the company's guidance. Of course, beating your own forecast is fairly common since CEOs tend to under-promise so they can subsequently over-deliver, but still, Palo Alto's total revenue was a positive.

For the year, Palo Alto's $1.8 billion in sales was good for a 28% increase, and deferred revenue climbed 43%, also to $1.8 billion. Deferred sales are a good indication that Palo Alto's better-late-than-never push to boost its recurring revenue via subscriptions is getting results.

Another positive note was, as per CEO Mark McLaughlin, that Palo Alto inked "the highest number of new customer additions" in its history last quarter. Unfortunately, the fact that Palo Alto's revenue gains are so dependent on it making new sales is also one of its fundamental weaknesses, particularly compared to rivals such as Check Point Software Technologies (CHKP 0.25%). More on that shortly.

Guidance for the current quarter of revenue in the $482 million to $492 million range would equate to growth of 21% to 24%, which by most standards would reflect a nice start to Palo Alto's fiscal year -- except for a few matters that still need to be addressed.

What's not to love about Palo Alto? Quite a lot, actually

A glance at Palo Alto's statement of operations speaks volumes as to why I'd never buy its stock. Despite a 27% rise in revenue, its earnings  sank 20% to a loss of $0.42 a share compared to last year's $0.35 a share. The culprit? Continued spending that's bordering on out of control.

To his credit, McLaughlin has promised to curb expenses, particularly on the sales and marketing fronts. To say "it's about time" for that would be an extreme understatement, considering Palo Alto's costs have been sky high for years.

Last quarter's $245.4 million in sales-related costs equaled an astounding 48% of total revenue, and believe it or not, that too was an improvement compared to quarters gone by.

For some perspective, Check Point -- which is well along its way to its objective of building a foundation of sustainable,  recurring revenue -- generated $458.57 million in sales last quarter. Check Point's top-line growth of 8% was nowhere near Palo Alto's, but the $114.68 million it spent on sales and marketing equaled just 25% of total sales -- nearly half Palo Alto's 48% -- which is why its EPS climbed 18% to $1.12 a share.

I understand the bullishness surrounding Palo Alto; many investors like seeing revenue growth. But investors like myself are not impressed until growth trickles down to the bottom line. Unfortunately, Palo Alto is a long, long way from making that happen.

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Stocks Mentioned

Check Point Software Technologies Ltd. Stock Quote
Check Point Software Technologies Ltd.
CHKP
$121.52 (0.25%) $0.30
Palo Alto Networks, Inc. Stock Quote
Palo Alto Networks, Inc.
PANW
$493.22 (0.29%) $1.42

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