Is Palo Alto Networks Stock a Buy Now?

Palo Alto Networks' (PANW -1.22%) stock surged 8% on May 24 after it posted its latest earnings report. For the third quarter of fiscal 2023, which ended on April 30, the cybersecurity company's revenue rose 24% year over year to $1.72 billion and matched analysts' expectations. Its adjusted net income surged 86% to $359 million, or $1.10 per share, and cleared the consensus forecast by $0.17.

On the basis of generally accepted accounting principles (GAAP), Palo Alto Networks generated a net profit of $108 million, compared to its net loss of $73 million a year earlier. That marked its fourth consecutive quarter of GAAP profitability.

Image source: Getty Images.

Those growth rates are impressive, but Palo Alto's stock has already rallied nearly 30% over the past 12 months and trades less than 3% below its all-time high. Is it too late to invest in this cybersecurity leader?

Another quarter of stable growth with expanding margins

Palo Alto splits its business into three ecosystems: Strata, which houses its on-site firewalls and network security appliances; Cortex, which handles its threat-detection tools powered by artificial intelligence (AI); and Prisma, which hosts its cloud-based security services.

Most of Palo Alto's recent growth has been driven by Cortex and Prisma, which it collectively refers to as its next-gen security (NGS) services. Its annual recurring revenue (ARR) from those NGS services rose 60% year over year to $2.6 billion -- or 40% of its total revenue over the past 12 months -- at the end of the third quarter.

As the following table illustrates, the expansion of Palo Alto's NGS services offset Strata's softer sales and enabled it to generate double-digit revenue and billings growth over the past year. Its margins also expanded as it generated more revenue from its higher-margin software (as opposed to its lower-margin hardware), reduced its supply chain costs, slowed down its hiring, and streamlined its customer support division.

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

For the fourth quarter, Palo Alto expects its revenue to rise 25% to 27% year over year, its billings to increase 17% to 19%, and for its adjusted EPS to grow 58% to 63% (after factoring in its three-for-one stock split last September).

For the full year, it expects its revenue to rise 25% to 26%, its billings to increase 23% to 24%, and for its adjusted EPS to grow 69% to 70%. All of its estimates for the fourth quarter and full year either met or exceeded analysts' expectations.

Palo Alto's stable revenue growth and expanding operating margins are also shoring up its free cash flow (FCF). It expects its adjusted FCF margin to rise to 37.5% to 38.5% in fiscal 2023, compared to 33.3% in fiscal 2022 and 32.6% in fiscal 2021.

It's landing and expanding to offset the macro headwinds

During the conference call, CEO Nikesh Arora admitted that the "overall macro trends of cautious spending, deal scrutiny, and cost and value consciousness" continue to curb enterprise spending on big cybersecurity upgrades. However, Arora also insisted his company was still "staying ahead" of those challenges with "rigorous execution."

That execution can be seen in its land-and-expand strategy with Prisma -- in which it locks in customers with a few modules to sell additional modules. It currently offers 10 cloud-based modules on Prisma, and its number of customers that were using at least two of its modules rose 37% year over year in the third quarter. Its number of customers that were using four or more modules nearly doubled.

That expansion could help Palo Alto weather the near-term macro headwinds, squeeze out more revenue per customer, and widen its moat against cloud-native challengers like CrowdStrike (CRWD -3.90%) and Zscaler (ZS -2.17%).

Is it too late to buy Palo Alto Networks?

Palo Alto Networks' stock had a great run over the past year, but it still doesn't seem terribly expensive at 40 times forward earnings. CrowdStrike and Zscaler, which are growing slightly faster than Palo Alto, both trade at about 57 times forward earnings. Unlike Palo Alto, CrowdStrike and Zscaler are both still unprofitable by GAAP measures.

Therefore, I don't think it's too late to buy Palo Alto's stock at these levels. It's a best-in-breed cybersecurity company that offers robust growth, expanding margins, and stable profits. Its diverse mix of older and newer services also arguably makes it a more balanced investment than CrowdStrike, Zscaler, and its other higher-growth peers.