Palo Alto Networks (PANW 1.37%) sounds confident about delivering impressive long-term growth, but the cybersecurity specialist is finding it difficult to manage near-term expectations. Its stock plunged 12% on the day following its fiscal first-quarter results after guidance failed to pass muster yet again.
The script is similar to Palo Alto's recent earnings reports in which the company has low-balled its guidance thanks to acquisition-related costs. As it turns out, Palo Alto has bought eight companies in the past two years. Investors are probably concerned about whether the cybersecurity expert has taken too much on its plate, and whether it is finding it difficult to stitch together the different acquisitions into a cohesive unit.
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Has Palo Alto Networks gone overboard with its acquisitions?
Acquisitions are a key part of Palo Alto Networks' strategy to stay on top of the competitive cybersecurity industry. The near-term consequences of this strategy take a toll on the company's profitability as it works to integrate them into its business. That's the reason why Palo Alto's fiscal 2020 earnings prediction of $5 to $5.10 per share was significantly below the Wall Street target of $6.25 per share.
A similar story will unfold in the current (second) quarter, as the company projects earnings between $1.11 and $1.13 per share, missing the consensus estimate of $1.30 per share by a wide margin. Annual top-line growth is expected to remain relatively solid in the range of 18% to 19% at $843 million, according to the midpoint of the company's guidance. This is slightly below the $845 million in revenue Wall Street was looking for.
The weaker-than-anticipated bottom-line performance can be attributed to Palo Alto's $150 million acquisition of Aporeto, which it hopes will boost its presence in the cloud security market. This makes it clear that Palo Alto is willing to forego near-term profitability for long-term gains. But more importantly, Palo Alto's acquisitions have allowed it to increase cross-selling opportunities.
When Palo Alto buys a new company, it not only gets access to a new market opportunity, it also gets its hands on a new capability that it could sell to its existing customer base. Similarly, Palo Alto can sell its existing products to the new customers that a newly acquired company brings into its fold.
As a result, Palo Alto has to spend less effort on going out to acquire new customers, leading to lower spending on marketing expenses along with a nice bump in revenue. This is clearly evident from the reduction in Palo Alto's expenses as a percentage of revenue over the past two years, which has led to improved bottom-line performance.
PANW SG&A Expense (% of Annual Revenues) data by YCharts.
Don't lose sight of the bigger picture
By now it is clear that Palo Alto's acquisition-driven growth strategy is working in its favor, so the company continues to pursue it. The purchase of Aporeto is expected to further strengthen Palo Alto's cloud security platform with the addition of the microsegmentation feature.
Microsegmentation allows data center operators and cloud companies to secure individual workloads through the creation of secure zones. Aporeto specializes in this application through its machine identity-based technology.
The addition of Aporeto to Palo Alto's suite of features should boost the attractiveness of the cybersecurity specialist's cloud security platform. That's because the demand for microsegmentation solutions is expected to clock a compound annual growth rate of 21% through 2025, according to a third-party estimate. As a result, companies looking to secure microsegmented workloads could flock to Palo Alto Networks.
So, the long-term gains that the Aporeto acquisition could deliver should be greater than the near-term pain that it will cause.
In the end, investors shouldn't forget that cybersecurity spending is predicted to grow 9.2% a year through 2022, according to IDC, hitting nearly $134 billion at the end of the forecast period. Palo Alto is doing the right thing by trying to cover a wide range of cybersecurity niches through its acquisitions, as doing so will aid its long-term growth.
More importantly, the company has already announced how this strategy could lead to a substantial improvement in its margins and cash flow over the next three years. And finally, the valuation makes Palo Alto stock attractive right now.
The company's price-to-sales ratio has dropped below 7 thanks to the post-earnings carnage, which is lower than the five-year average of nearly 10. The forward price-to-earnings ratio of 43 is also lower than the five-year average multiple of 67. As such, savvy investors looking for an attractive cybersecurity stock for the long run should consider Palo Alto given its valuation and bright prospects.
