Palo Alto Networks (PANW 0.91%) has been one of the best leaders in the cybersecurity sector, with the stock having been up about 116% in the past year alone.
That is until Wednesday, Feb. 21, when the stock plunged over 28% in a single day following its second quarter earnings.
Investors were spooked when Palo Alto lowered its prior guidance for the year. In its defense, management said the lower guide was due to a deliberate aggressive pricing strategy aimed at winning market share.
But should investors really buy the dip, and take on the risk of this new strategy working out?
Taking down expectations
In the earnings release, Palo Alto management took its full-year revenue guidance down to $7.95 billion to $8 billion from prior guidance of $8.15 billion to $8.2 billion. Moreover, management also took down full-year billings guidance to $10.1 billion to $10.2 billion, from a prior range of $10.7 billion to $10.8 billion .
Needless to say, with a stock trading around 60 times earnings heading into the print, the guide-down was bound to get a nasty reaction. Hence why Palo Alto plunged 28.4% on Wednesday following the earnings release.
Management explains
The revenue and billings shortfall was explained by management as a deliberate strategy, in which Palo Alto plans to essentially give away a lot of products for free, temporarily, in order to allow customers to consolidate around Palo Alto as a complete "platform."
The thinking, according to CEO Nikesh Arora, is that a lot of Palo Alto's customers have different vendors for different products, whether it's for intrusion protection (IPS), SD-WAN network protection, firewalls, zero trust, or endpoint protection. While Palo Alto has been taking share and delivering strong results prior to this quarter, Arora explained that sometimes it's difficult to transition a customer to adopt more of its services and displace an incumbent vendor on a certain product, due to customer fears over execution risk.
What Palo Alto is now doing is saying to customers it will provide this service for free while the customer is still under contract with another vendor, until the existing contract runs out. The thinking is that because Palo Alto has one of the stronger portfolios of cyber products in the space, and since corporations are looking to mitigate their corporate costs, Palo Alto may use this strategy to help customers adopt its "bundle" and therefore simplify their vendors while saving money.
It's actually a pretty smart-sounding strategy, but there are several risks for investors to consider, too.
Image source: Getty Images.
Why now?
To be sure, the move is spurring concerns over a lack of demand and perhaps price wars in the cybersecurity sector, which might not be good for Palo Alto, at least in the near-to-medium term.
Moreover, when management was explaining the reasons behind the strategy shift, it was a bit obtuse. On the one hand, it maintained that demand for cybersecurity was "strong," yet also said customers had shown "spending fatigue." When challenged on the seeming contradiction, Arora went on:
... they're feeling like my budget for cybersecurity keeps going up in double-digits every year because I'm trying to protect against every new threat vector. Yet, you see the number of breaches continues to rise. So our customer are sitting down and saying, if I spend more money, can you show me how I get a lower total cost of ownership across my enterprise? How do I spend less on the services that I have to deploy? And how do I get better ROI? So I think it's more about optimizing their current cybersecurity budgets as opposed to there being no demand. Demand continues to be very strong.
Clearly, customers are getting angry about how much they are having to spend on cybersecurity. And while that means the need is high, it also means there could be a short-term price war and pressure on cyber stock margins.
Another concern is that another quasi-peer in Cloudflare (NET 1.44%) just reported excellent numbers, which seems to go against Palo Alto's narrative. While Cloudflare isn't a direct competitor in many cases to Palo Alto, as its core products deal with network performance, it does have a lot of security offerings such as Zero Trust, DDoS protection, application firewalls and network security.
So, it's a little bit tough to square why Palo Alto feels it has to take this bold step while a company like Cloudflare is doing so well.
But the move could pay off... eventually
While price wars are unpleasant to wage, the eventual winners could come out stronger on the other side. But that only happens if less-strong players eventually go away or merge to consolidate to fewer competitors. That process could take time, and come with more pain across the entire sector.
If Palo Alto's announcement is any indication, it could be rough going for both Palo Alto as well as its competitors in the space for a while. Given that the company makes minimal GAAP profits and still trades above 10 times this year's sales guidance even after the drop, the stock could tread water for quite a while until the new strategy's success or failure is verified by investors.
