Investors have abandoned many cloud-services stocks in the wake of the pandemic on fears that demand gains will collapse as the world returns to more normal working patterns. But the cloud-security niche is showing no signs of such a growth hangover.
Palo Alto Networks (PANW 1.24%) recently announced strong sales trends through its fiscal fourth quarter that ended in late July. Management also projected another year of more than 20% annual sales gains ahead.
Yes, investors shouldn't read too much into short-term operating trends. But Palo Alto Networks' success implies bigger earnings gains ahead as the company prepares to reach $7 billion in annual sales.
Let's take a closer look.
The growing industry
Investors were happy to hear management raise its fiscal year outlook back in May, but it turns out that the business wasn't done producing pleasant surprises. Revenue in fiscal Q4 jumped 27% to $1.6 billion, beating Palo Alto Networks' upgraded forecast.
For the year, the company gained market share in a spending niche that is becoming more important to a growing number of large businesses. "Our integrated three-platform strategy," CEO Nikesh Arora said in a press release, "continues to drive large deal momentum."
Executives added context about that momentum in a shareholder presentation that stressed how the company has expanded its selling footprint into more categories around network and cloud security since 2018. This transformation has accelerated sales growth, but it also created more predictable cash and earnings streams thanks to the software-as-a-service (SAAS) selling model.
Finally profitable
One big knock against the stock has always been the company's persistent net losses. For the year that ended in late July, this red ink landed at $367 million compared to $500 million in the prior year.
But that disappointing track record could be over. Palo Alto Networks reached profitability for the first time in four years this quarter, with GAAP earnings touching $3 million. Yes, that equates to a tiny net margin on $1.6 billion of revenue. But it could be the start of a steady march toward impressive profitability. Software industry leader Microsoft enjoys operating profit margins over 40%, after all.
Palo Alto Networks doesn't enjoy anything approaching Microsoft's huge and diverse portfolio. Yet there's room for it to become much more profitable over time.
Looking ahead
Investors shouldn't get too excited about Palo Alto Network's short-term earnings outlook. The company is only predicting barely breaking even this year. But two metrics imply much higher profits ahead. The first is sales growth, which could reach 25% in the new fiscal year to mark just a modest slowdown from the prior year's 29% spike.
The second is cash flow, with Palo Alto Networks on track to convert over 33% of sales into free cash flow this year, after adjustments. It is conceivable that operating profit margin will move toward that rate over time, assuming the company continues winning share in steadily growing niches around cloud and network security.
But investors interested in this space shouldn't wait around and simply watch this stock from the sidelines until those gains occur. The tilt into profitability this past quarter, while modest, marks a good time to consider buying Palto Alto Networks if you've been on the fence about this tech stock.
