Shares of Palo Alto Networks (PANW -1.71%) have surged nearly 60% over the past 12 months, fueled by four straight quarters of big earnings beats. That crushed the 25% return of the ETFMG Prime Cyber Security ETF (HACK -0.19%), a commonly used benchmark of the cybersecurity market.
But after that big run, is it too late to invest in this next-gen firewall provider? Let's examine the bull and bear cases to find out.
Image source: Getty Images.
What the bulls believe
Palo Alto serves more than 48,000 customers in more than 150 countries -- including over 85% and 63% of the Fortune 100 and Global 2000 companies, respectively. Gartner has named it an enterprise firewall market leader for the past six years.
That best-in-breed reputation indicates that Palo Alto is well poised to profit from surging demand for cybersecurity solutions worldwide. Its revenue rose 28% in 2017, outpacing the rest of the industry, and analysts expect 26% growth this year.
Although Palo Alto is best known for its next-gen firewall, it also upsells new products -- like its hybrid cloud software-as-a-service (SaaS) platform -- that boost its overall revenue per customer. This "land-and-expand" model widens Palo Alto's moat against bigger rivals like Cisco (CSCO -0.52%), which bundles cybersecurity solutions with its networking hardware and software.
Palo Alto is also profitable on a non-GAAP basis. Its non-GAAP earnings climbed 43% last year, and Wall Street anticipates another 43% growth this year. Based on that estimate, its forward P/E of 49 still looks surprisingly reasonable. It finished last quarter with $915 million in cash and equivalents, which is a comfortable cash cushion for launching new products or acquiring smaller companies.
What the bears believe
The bears will point out that Palo Alto is actually deeply unprofitable on a GAAP basis, due to high stock-based compensation (SBC) expenses. Here's how much money Palo Alto actually lost over the past four quarters, with SBC expenses factored back in.
|
Metric |
Q3 2017 |
Q4 2017 |
Q1 2018 |
Q2 2018 |
|---|---|---|---|---|
|
GAAP net loss |
($60.9 million) |
($38.2 million) |
($64.0 million) |
($34.9 million) |
|
SBC expenses |
$120.6 million |
$120.9 million |
$128.9 million |
$136.3 million |
Data source: Palo Alto Networks quarterly reports.
In other words, Palo Alto spent 25% of its revenue on SBC expenses last quarter. If it had simply cut that figure in half, it would have reported a GAAP profit.
Image source: Getty Images.
Palo Alto spends so much money on SBC expenses because it's based in Silicon Valley, which has a cutthroat job market and high living costs. Palo Alto doesn't have enough cash to pay competitive salaries, so it pads its salaries with big stock bonuses. That's a classic strategy for younger tech companies, but Palo Alto was founded 13 years ago.
Comparable cybersecurity companies based in lower-paying markets don't have this problem. Israeli firewall provider Check Point Software (CHKP -5.00%), which is profitable by both non-GAAP and GAAP measures, spent just 5% of its revenue on SBC expenses last year.
If we accept the fact that Palo Alto is unprofitable, the stock looks pricey at nine times sales -- which is higher than the industry average of seven for application software makers. Meanwhile, competitors like Cisco -- which can undercut Palo Alto to gain market share -- remain a threat to long-term growth.
So is it time to buy Palo Alto?
I think Palo Alto's best days are still ahead of it. Its best-in-breed reputation in firewalls, the expansion of its firewall into a cloud-based security platform, and the surging number of data breaches worldwide should all bolster its top-line growth for the foreseeable future.
Those strengths outweigh its weaknesses, and indicate that Palo Alto could still have a lot more room to run.
