Is Palo Alto Networks Stock a Buy Now?

Shares of Palo Alto Networks (PANW -2.42%) surged more than 12% on Feb. 22 after the company posted its latest quarterly report. For the second quarter of fiscal 2023, which ended on Jan. 31, the cybersecurity company's revenue rose 26% year over year to $1.66 billion and beat analysts' expectations by $10 million.

Its adjusted net income jumped 79% year over year to $332 million, or $1.05 per share, and topped the consensus forecast by $0.27.

On the basis of generally accepted accounting principles (GAAP), Palo Alto generated a net profit of $84 million, compared wth a net loss of $94 million a year earlier. It's been GAAP profitable on a cumulative basis over the past four quarters.

Image source: Getty Images.

For the third quarter, Palo Alto expects its revenue to rise 22% to 24% year over year as its adjusted earnings per share (EPS) -- after factoring in its 3-for-1 stock split last September -- climbs 51% to 58%.

For the full year, it expects its revenue to increase 22% to 23% as its adjusted EPS grows 58% to 60%. Those growth rates are impressive, but does the stock still have room to run after rallying about 35% so far this year?

A well-balanced cybersecurity company

Palo Alto serves more than 80,000 enterprise customers worldwide. It splits its business into three main ecosystems: Strata, which revolves around its original next-gen firewall and on-site network security services; Prisma, which specializes in cloud-native services; and Cortex, which provides threat detection powered by artificial intelligence (AI).

Strata is the company's slower-growing core business; Prisma and Cortex -- which it expanded through investments and acquisitions -- are driving most of its growth while widening its moat against cloud-native companies like CrowdStrike (CRWD 1.33%) and AI-driven newcomers like SentinelOne (S 1.19%). It collectively refers to Prisma and Cortex as its next-gen security (NGS) platforms.

Palo Alto's scale and diversification enabled it to generate consistent growth. Between fiscal 2017 and fiscal 2022 (which ended last July), its annual revenue had a compound annual growth rate (CAGR) of 26%, billings registered a CAGR of 27%, and its adjusted net income had a CAGR of 27% -- even as the inorganic expansion of its higher-growth businesses reduced its adjusted operating margin from 20.1% to 19%.

Top-line growth has remained consistent over the past year, and its operating margins expanded as it stepped back from making big acquisitions. As a result, its adjusted EPS growth accelerated, and it finally achieved stable profitability on a GAAP basis. It expects its adjusted operating margin to expand to 21.5% or 22% in fiscal 2023. 

Data source: Palo Alto Networks. YOY = year over year.

Palo Alto's NGS services should drive most of that growth. Its annual recurring revenues (ARR) from its NGS services rose 63% year over year to $2.3 billion in the second quarter and accounted for 37% of its trailing-12-month (TTM) revenue. That's up from 36% of its TTM revenue in the first quarter and 35% in the fourth quarter of 2022.

The ongoing expansion of those NGS businesses should ensure that Palo Alto doesn't mature into a slower-growth cybersecurity company like Check Point Software (CHKP -1.65%) -- which competes against Strata in the next-gen firewall market -- anytime soon. It should also silence the bears who believe that younger cloud and AI-oriented challengers like CrowdStrike and SentinelOne will disrupt Palo Alto's business.

A recession-resistant growth play

Cybersecurity companies are well insulated from economic downturns because enterprise customers won't lower their digital defenses just to save a few dollars. But the macroeconomic headwinds can still cause companies to rein in their spending on new deals. Yet those challenges aren't affecting Palo Alto.

In the second quarter, the number of deals it closed that were worth over $1 million rose nearly 20% year over year. Its deals worth more than $5 million increased 84%, while those over $10 million surged 140%.

During the conference call, CEO Nikesh Arora said that while Palo Alto expected to see more-cautious spending over the next few quarters, it wasn't anticipating any big shocks to its core business. Arora also believes that companies will continue to adopt next-gen firewalls and other cloud-based cybersecurity services as they optimize their spending.

Is it the right time to buy Palo Alto?

At $190, Palo Alto trades at about 48 times this year's adjusted earnings and 8 times this year's sales. Those valuations aren't cheap, but they're reasonable relative to most of its cybersecurity peers.

CrowdStrike, which is growing faster, trades at 54 times its forward adjusted earnings and 12 times this year's sales -- but it's far from profitable on a GAAP basis. SentinelOne, which is growing even faster than CrowdStrike but unprofitable by both GAAP and non-GAAP measures, trades at 11 times this year's sales. Therefore, I believe Palo Alto is still worth buying at these levels -- and it could go much higher over the long term.