Various studies forecast the global cybersecurity market will grow annually by more than 10% over the next several years, and Palo Alto Networks (NYSE:PANW) is poised to profit from this tailwind. With the development of cloud computing, the cybersecurity vendor has been expanding its portfolio beyond its traditional firewalls to capture the cloud security market's expected 21.2% annual growth by 2022.

As a result, management forecasts a strong 20% annual revenue growth over the next three years and it aims at improving the company's long-term non-GAAP (adjusted) operating margin to a solid 25%.

But with its stock price climbing back to its historical high, is Palo Alto a buy?

Legacy vs. cloud cybersecurity

For more than a decade, Palo Alto has been selling next-generation firewalls that secure corporate networks thanks to granular rules based on users and applications. Today, this technology remains relevant and it is still generating non-negligible revenue for the company. During the last quarter, Palo Alto's product segment, which mostly includes sales from next-generation firewalls, represented 30% of its total revenue.

But cloud computing changed the way networks are used and secured. With mobile users accessing on-premises and cloud resources like applications and data from anywhere, protecting corporate's physical networks from outside is not enough anymore. Users need a trusted network environment wherever they operate.

That's why high-growth cloud-based cybersecurity companies such as CrowdStrike and Zscaler emerged. They propose native cloud security solutions such as cloud-based endpoint protection and remote secure access to address this new paradigm. In contrast, legacy vendors such as Symantec and Check Point Software Technologies have been struggling to adapt their legacy portfolios.

Thus, Palo Alto accelerated its transformation with acquisitions to complement its legacy portfolio with cloud-based security solutions. The company recently acquired Aporeto to strengthen its cloud security platform Prisma Cloud.

Man touching cloud with padlock icon on network connection.

Image source: Getty Images.

Palo Alto's race for growth

With its trailing-12-month revenue of $3.02 billion, Palo Alto remains one of the largest actors in the segmented cybersecurity market. The company's strategy consists of increasing its scale to propose a comprehensive security portfolio for customers to benefit from more consistent and simpler solutions instead of dealing with multiple vendors. Also, with scale, Palo Alto aims at spreading its sales and marketing as well as its research and development efforts over a larger revenue base.

And, partly thanks to several acquisitions over the last several quarters, the company kept generating strong growth despite its multi-billion revenue base. During the last fiscal quarter, revenue increased to $771.9 million, up 18% year over year. And management showed confidence with its three-year plan that forecasts 20% annual revenue growth.

Not a buy despite strong growth and impressive free cash flow

The company's expected full-year adjusted free cash flow margin of 29% seems impressive in the context of high revenue growth. Looking forward, management's three-year plan forecasts $4 billion of free cash flow over the next three years and a long-term free cash flow margin above 30%.

Thus, the trailing-12-month price-to-sales ratio of 7.86 for this growth stock with high forecasted long-term free cash flow and non-GAAP operating margins looks cheap.

However, these non-GAAP metrics exclude significant costs such as share-based compensation (SBC). As an illustration, SBC, which is a real cost to shareholders in terms of dilution, represented 19.6% of the company's revenue during the last quarter. Also, Palo Alto's revenue growth partly comes from acquisitions that are not accounted for in adjusted free cash flow and non-GAAP metrics. And Palo Alto spent more than $1 billion, mainly in cash, to acquire several competitors over the last 12 months.

As a result, the company has been posting GAAP losses -- $59.6 million during last quarter and $81.9 million in fiscal 2019 -- because of its high sales and marketing expenses. With scale, these costs are declining as a percentage of revenue, but they still represented 47.4% of sales during the last quarter.

Thus, investing in Palo Alto is a bet on the company to gain scale while increasing its GAAP operating margin in a significant way. But improving margins will require lower sales and marketing expenses as a percentage of revenue, which could have a negative impact on revenue growth. In addition, many emerging cloud-based security vendors have been exceeding Palo Alto's revenue growth, which indicates Palo Alto has been losing market share to them. During their last respective quarters, CrowdStrike and Zscaler grew their revenue by 88% and 48%, respectively. 

With this context, Palo Alto's market capitalization of $23.71 billion while GAAP profits have yet to materialize doesn't seem to offer any margin of safety. The uncertainties around the company's growth and profits over the long term in such a competitive environment remain significant; prudent investors should stay on the sidelines.