Please ensure Javascript is enabled for purposes of website accessibility

Is Palo Alto Networks Stock a Buy?

By Leo Sun – Jul 15, 2020 at 12:30PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The cybersecurity company will likely overcome its near-term headwinds and generate more long-term gains for patient investors.

Palo Alto Networks (PANW 0.26%) has been a volatile stock since its public debut eight years ago, but investors who held on tight are now sitting on a near six-bagger gain from its IPO. But does this cybersecurity stock still have room to run in this unpredictable market? Let's take a fresh look at the bull and bear cases to find out.

Understanding Palo Alto's business

Palo Alto's core product is its Next-Generation Firewall, which is deployed via physical appliances and virtual services. After locking in customers, it deploys a "land and expand" strategy to sell add-on services like Prisma, its cloud security suite; and Cortex, its AI-powered threat detection platform.

Security software running on a tablet.

Image source: Getty Images.

Palo Alto serves more than 70,000 customers in more than 150 countries, including some of the largest Fortune 100 and Global 2000 companies. Gartner has named it a "Magic Quadrant" leader in network firewalls for eight consecutive years, and that "best in breed" reputation widens its moat against its rivals.

Palo Alto's revenue rose 29% in fiscal 2018, 28% in 2019, and 17% in the first nine months of 2020. It expects its revenue to rise 16% to 17% for the full year. But it still isn't profitable under generally accepted accounting principles (GAAP), mainly due to its heavy use of stock-based compensation to supplement its cash salaries.

Palo Alto's GAAP net losses narrowed year over year in 2018 and 2019, but widened significantly in the first nine months of 2020. It attributed those wider losses to its acquisitions of Internet of Things (IoT) security company Zingbox, machine identity firm Aporeto, and software-defined networking company CloudGenix over the past year. Higher real estate and legal costs, along with the COVID-19 crisis, exacerbated the pressure.

But on a non-GAAP basis, which excludes most of those one-time and variable expenses, Palo Alto remained firmly profitable. However, its non-GAAP EPS still declined 14% in the first nine months of 2020, and it expects that figure to dip 12% for the full year.

Looking further ahead, analysts expect Palo Alto's revenue and non-GAAP earnings to rise 17% and 21%, respectively, in fiscal 2021. However, Palo Alto's forward P/E of 42 suggests a lot of that potential growth is already priced into the stock.

The bulls vs. the bears

The bulls believe Palo Alto's growth will remain consistent, and its margins will improve as it transitions from lower-margin appliances to higher-margin cloud services. Those services will also lock in customers with stable subscriptions.

An IT professional checks a tablet.

Image source: Getty Images.

However, the bears claim that transition will throttle its revenue growth. For example, FireEye's (MNDT) revenue growth decelerated significantly after it transitioned from appliances to cloud-based services.

The bears will also claim Palo Alto lacks a viable path toward GAAP profitability, it's still too dependent on stock-based compensation (20.5% of its revenue in the first nine months of 2020), and its growing dependence on acquisitions suggests its core firewall business is running out of room to grow.

Competition from other perimeter security companies -- including FireEye, Cisco, and Check Point -- could also limit Palo Alto's pricing power in the competitive market. Palo Alto's founder Nir Zuk previously worked at Check Point, which is firmly profitable on a GAAP basis and spends a lot less money on stock-based compensation.

Nonetheless, the bulls will note Palo Alto's deferred revenue -- a key indicator of forward demand -- still rose 28% annually in the third quarter, and claim its recent acquisitions merely strengthen the Next-Generation Firewall's ecosystem instead of acting as crutches for its revenue growth.

Should investors believe the bulls or the bears?

Back in early 2018, I declared Palo Alto's stock still had plenty of room to run. The stock has risen about 30% since then, but I'm still bullish on its long-term prospects. Palo Alto might generate lackluster growth over the next few quarters as it digests its latest acquisitions, balances its older appliance and newer cloud businesses, and struggles with softer enterprise spending through the COVID-19 crisis. But over the long term, Palo Alto will likely profit from the growing demand for "best in breed" security services to counter the rising frequency of hacks and data breaches worldwide.

Leo Sun owns shares of Cisco Systems. The Motley Fool owns shares of and recommends Check Point Software Technologies and Palo Alto Networks. The Motley Fool recommends Gartner. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.