During its fiscal first-quarter earnings call, Palo Alto Networks(NYSE:PANW) management confirmed the company was on track to deliver according to its three-year plan it outlined a few months ago. Executives expect revenue will grow 20% annually while generating $4 billion in adjusted free cash flow during this time frame, which is impressive. But these long-term goals aren't representative of the cybersecurity specialist's performance.

Mixed fiscal first-quarter earnings

Despite the weakness in Palo Alto's product segment, which includes its appliances such as firewalls, the company's fiscal first-quarter revenue of $771.9 million, up 17.7% year over year, came in slightly above guidance. Non-GAAP (adjusted) EPS of $1.05 also beat expectations.

The better-than-expected results were due to the strong growth of Palo Alto's subscription and support segment, which includes its cloud-based solutions. Management indicated the underwhelming performance of the product segment was related to the incentives for its sales force and partners to prioritize solutions such as Cortex and Prisma instead of appliances. Since executives indicated this issue was solved, investors should pay attention to product revenue growth over the next few quarters to confirm this underperformance was temporary.

Guidance for the next quarter doesn't look that strong, though. Palo Alto expects revenue to increase by 18% to 19% and total billings -- a leading indicator of revenue -- to grow by 16% to 17%. Given the company's important scale compared to many smaller competitors in the segmented cybersecurity market, this double-digit growth remains solid. But these forecasts are below the expected full-year revenue growth of 19% to 20%, which indicates the company will have to deliver a stronger performance over the second half of its fiscal year.

Besides, management highlighted Palo Alto was still on track to grow revenue by 20% annually until 2022. This three-year plan also includes a cumulative adjusted free cash flow forecast of $4 billion. Also, operating and free cash flow margins are expected to exceed 22% and 30%, respectively..

Man touching cloud with padlock icon on network connection.

Image source: Getty Images.

Palo Alto's three-year plan is not representative of the company's performance

With its three-year plan, Palo Alto is poised to generate at least $5 billion in revenue and $1.5 billion in annual adjusted free cash flow beyond 2022. The current market valuation at 14.2 times this estimated adjusted free cash flow looks attractive given the company's revenue growth and high margins. But these selected metrics exclude some significant costs.

First, non-GAAP operating income and adjusted free cash flow ignore share-based compensation (SBC), which is a non-cash expense and a real cost to shareholders. Taking into account GAAP operating income, which includes SBC and some other smaller expenses, Palo Alto's operating margin suddenly becomes less impressive. During its fiscal first quarter, the company's non-GAAP operating margin was 15.8% compared to a negative GAAP operating margin of 6.7%. 

Second, Palo Alto's three-year plan doesn't take into account the costs of acquisitions. In addition to its research and development efforts, Palo Alto has been acquiring companies to enhance its portfolio and generate revenue growth. Investors should keep in mind the costs of these acquisitions are not accounted for in the company's non-GAAP operating income and adjusted free cash flow. And with acquisitions -- listed in the table below -- that amounted to more than $1 billion over the past 12 months, this extra expense is significant.

Date Acquired Company Cost Payment
March 28, 2019 Demisto $560 million Cash and stock
June 13, 2019 PureSec $47 million Cash
Sept. 7, 2019 Twistlock $410 million Cash
Sept. 20, 2019 Zingbox $75 million Cash

Data source: Palo Alto Networks.

The list of acquisitions will most likely expand since Palo Alto recently said that it intended to acquire Aporeto, a cloud-based cybersecurity company, for $150 million in cash.

Looking forward

With GAAP losses of $59.6 million during its latest quarter, Palo Alto's market capitalization above $21 billion looks much less attractive than a valuation based on its significant adjusted free cash flow that excludes many important expenses.

Thus, investors shouldn't value this cybersecurity stock based on the non-GAAP metrics management has outlined in its three-year plan. Instead, they should look at GAAP earnings that take into account Palo Alto's high SBC. Also, investors should keep in mind that the company's strong double-digit revenue growth is helped by many acquisitions.