Palo Alto Networks (PANW -1.18%) gave investors a rude shock with its fiscal second-quarter results last month. The cybersecurity specialist failed to meet its own expectations and lowered its full-year outlook. That was enough for investors to press the sell button.
The cybersecurity stock gave up all the gains it had clocked in 2019 in one fell swoop, and it's currently trading close to its 52-week lows. Wall Street now seems concerned about Palo Alto's execution abilities, as its growth has slowed down remarkably even though the company has spent a ton of money on acquisitions in the past couple of years.
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What gives?
Palo Alto's fiscal second-quarter revenue was up just 15% annually to $816.7 million, which was well below the company's guidance of $843 million. For the first six months of fiscal 2020, the company's revenue increased just 16%. That's a far cry from the 27.5% top-line growth Palo Alto had in fiscal 2019.
What's more, Palo Alto now expects fiscal 2020 top-line growth of just 16% to 17%. That's something investors wouldn't have wanted to see after the company's aggressive spending on acquiring smaller players to bolster its standing in the cybersecurity industry.
Palo Alto management blamed weak revenue from product sales during the quarter as it is transitioning away from legacy products to next-generation cybersecurity offerings. CEO Nikesh Arora said on the earnings conference call that a change in incentive structure led the company's sales team to focus more on next-generation security offerings. As a result, the company's product revenue during the second quarter fell 9.2% from the year-ago quarter.
Palo Alto counts its Prisma and Cortex offerings as a part of next-generation security services. Through Prisma, the company offers cloud security services, protecting its customers' applications, data, and users in the cloud. This is a fast-growing area as the global cloud security market has been growing at an impressive annual rate of 23.5%, according to one estimate.
Cortex, on the other hand, is an artificial-intelligence-enabled platform that's meant to automate Palo Alto customers' response to security threats. Cortex and Prisma differ from Palo Alto's product-based business that focuses on providing traditional network security offerings such as firewalls and appliances. The demand for security appliances has been relatively slow as compared to cloud security and AI-based security applications.
IDC estimates that the worldwide revenue of the security appliance market was up 9.4% annually in the fourth quarter of 2019 to $4.8 billion. But shipments of appliances increased at a much faster rate of 21% over the prior-year period. The slower pace of revenue growth indicates the commoditized nature of the security appliance market, which explains why Palo Alto is now focusing on cybersecurity niches with a faster pace of growth.
Meanwhile, Palo Alto's subscription and support revenue increased an impressive 29.7% annually. But since Palo Alto's product revenue accounts for just over 30% of its top line, it was enough to offset the growth in the subscription business to a large extent.
Management says that it has rebalanced the sales team's focus so that the product side of the business is not neglected. But the change will take some time to come into effect, and Palo Alto's product revenue will likely return to growth only in the fourth quarter of the fiscal year. As a result, the company anticipates its product revenue to arrive below expectations this year.
But at the same time, there are quite a few silver linings that might encourage bargain hunters to take a closer look at Palo Alto stock.
Don't miss these positives
There's no doubt that Palo Alto Networks is going to have a painful time for the rest of the fiscal year as it focuses more on the deployment of its next-generation products. But the good news is that there were positive takeaways last quarter that indicate that its slowdown may be temporary.
For instance, Palo Alto forecasts that the billings for its next-gen security products could jump 79% to 82% this fiscal year to a range of $810 million to $820 million. For comparison, the company's total billings are expected to increase 17% to 18% annually in fiscal 2020 to $4.1 billion at the midpoint of its guidance range.
Palo Alto's next-generation products will account for nearly 20% of its billings this year, compared to 13% last year. As billings give us an idea of a company's future revenue growth, it can be concluded that Palo Alto's transition is moving in the right direction. The company's deferred revenue growth, which is another yardstick of future revenue performance, is also growing at a fast clip.
Palo Alto's deferred revenue shot up 27% in the second quarter to nearly $3.2 billion. This is a positive sign of things to come, as deferred revenue is the amount of money collected by a company in advance. It is recognized on the income statement at a later date when those services are actually rendered.
For a company like Palo Alto that's providing subscription-based services, this means its customers are entering into long-term contracts.
So investors should not rule out the possibility of Palo Alto making a nice comeback once its product-related business stabilizes, since the subscription-driven business is growing at a nice clip already. Additionally, the stock is attractively valued right now.
Palo Alto is currently trading at 40 times forward earnings, which is lower than its five-year average multiple of 56. Its price-to-sales ratio of 5.7 is also lower than its five-year average of 9.4. Savvy investors looking for a cybersecurity play should consider Palo Alto Networks stock, as it could step on the gas once the short-term pain is over.
