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How Risky Is Palo Alto Networks Stock?

By Herve Blandin – May 26, 2020 at 12:30PM

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The cybersecurity specialist posted solid fiscal third-quarter results amidst the coronavirus pandemic, but its stock price is becoming elevated again as it recovered from the market sell-off in March.

Palo Alto Networks (PANW 2.45%) posted a strong fiscal third quarter, and management raised its full-year guidance amid the coronavirus uncertainties. Yet investors should remain prudent as the stock has become riskier: The cybersecurity specialist's results aren't as strong as they look like, and the stock price is back to high levels.

Shift to cloud computing

The cybersecurity specialist sells legacy hardware security devices -- firewalls and gateways -- that protect enterprises' on-premises data centers from external threats. But given the rise of cloud computing, Palo Alto has been enhancing its portfolio with cloud-based security solutions thanks to acquisitions and internal developments.

That transition materialized over the last several quarters, and the company was ready to address the surge in demand for cloud cybersecurity solutions to protect the computing environment of many employees that were requested to work from home to try to limit the spread of COVID-19.

Palo Alto's fiscal third-quarter results reflected the success of this transition. Total revenue grew by 20% to $869.4 million, mostly thanks to the cloud. Revenue from the company's product segment, which includes legacy offerings, increased by only 1% to $280.9 million. In contrast, revenue from Software-as-a-Service (SaaS) subscriptions increased by 37% to $354.3 million. 

In addition, the shift to cloud computing could accelerate as several enterprises recently announced their employees could choose to permanently work from home, which bodes well for Palo Alto's cloud-based cybersecurity business.

As a result, management raised its fiscal full-year guidance amid the coronavirus uncertainties with forecasted revenue in the range of $3.373 billion to $3.383 billion, which represents strong 16% to 17% revenue growth. It also forecasted a solid adjusted free cash flow margin of approximately 27% to 28%.

Man touching cloud with padlock icon on network connection.

Image source: Getty Images.

Acquisitions and share-based compensation blur the picture

However, you should keep in mind Palo Alto's strong revenue growth is partly due to acquisitions. Management didn't communicate its revenue contribution, but over the last 12 months, the company spent about $1.1 billion for the acquisitions listed in the table below.

Date Acquired Company Cost
June 13, 2019 PureSec $47 million
July 9, 2019 Twistlock $410 million
Sept. 20, 2019 Zingbox $75 million
Dec. 23, 2019 Aporeto $150 million
April 21, 2020 CloudGenix $420 million

Data Source: Palo Alto Networks.

Also, you should consider management's forecasted adjusted free cash flow margin of 27% to 28% with a grain of salt. That goal decreased from approximately 30% a couple of quarters ago, and it excludes litigation and headquarters costs. 

But more importantly, free cash flow doesn't take into account the significant costs of acquisitions over the last several quarters. And it excludes share-based compensation (SBC), which remains an important and recurring noncash expense for the company. During the last quarter, SBC reached $173.5 million, or 20% of revenue.

Thus, in contrast with a high expected adjusted free cash flow margin, Palo Alto actually operates at losses under generally accepted accounting principles (GAAP). During the first three quarters of its fiscal year, GAAP net losses amounted to $208.1 million.

High valuation again

Despite CEO Nikesh Arora's confidence for the next quarter, the company is not immune to a potentially prolonged recession. Thus, because of the coronavirus-induced uncertainties, management withdrew the three-year plan it communicated in September. Yet, after the market sell-off in March, the stock price recovered to its pre-crisis levels. 

PANW Chart

PANW data by YCharts

Taking into account the midpoint of full-year revenue guidance, the market values Palo Alto at an enterprise value-to-sales ratio of 6.5. And its market cap of $22.72 billion represents 24 times forecasted free cash flow, assuming a free cash flow margin of 27.5% in 2020.

Based on the company's strong double-digit revenue growth and solid free cash flow margin, that valuation seems reasonable. But it becomes much less attractive if you take into account revenue growth partly depends on acquisitions, and if you consider Palo Alto is not GAAP profitable (mostly because of SBC expenses).

Thus, from an operational perspective, risks are limited as the company's transition to a cloud-based security offering is materializing. However, investors should keep in mind the demanding valuation, back to pre-crisis levels, has become the main risk. Forecasted revenue growth and adjusted free cash flow margins show a rosy picture that doesn't reflect the significant costs that acquisitions and SBC represent for Palo Alto.

Herve Blandin has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Palo Alto Networks. The Motley Fool has a disclosure policy.

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Palo Alto Networks, Inc. Stock Quote
Palo Alto Networks, Inc.
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