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3 Things Palo Alto Networks Inc Needs to Do to Win Back Investors

By Tim Brugger – May 20, 2016 at 4:24PM

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The data security provider is growing by leaps and bounds, but shareholder’s rollercoaster ride won’t end until a few areas improve.

Like many growth stocks, Palo Alto Networks' (PANW 1.04%) value has bounced all over the place in the past year, as its 52-week trading range of $111.09 to $200.55 per share attests to. Price fluctuations are to be expected for hyper-growth stocks, since the slightest inkling of either good or bad news can send investors scrambling.

For the past month and half, give or take, Palo Alto has been in a downward spiral, losing about 16%. What does Palo Alto need to do to win back investors' confidence, not to mention perform at the level so many of its bullish analysts expect? There are a few steps Palo Alto can take that will go a long way toward turning its recent negative sentiment around.

Image source: Palo Alto Networks.

Keep on, keeping on

For an impressive seven straight quarters, Palo Alto has posted revenue gains of 50% or more, which is a string none of its immediate competitors -- including Fortinet (FTNT 1.73%) and Check Point Software Technologies (CHKP -3.55%) -- can touch.

Small-ish Fortinet, at least in comparison to Palo Alto and Check Point, has posted a few quarters of 30% or more of top-line growth, while Check Point's six straight quarters of 9% sales gains speaks to CEO Gil Shwed's slow-but-steady management approach. Clearly, Palo Alto's sales results drive its future success, and it will need more of the same to keep investors in its corner.

The upcoming quarter will say a lot about Palo Alto shareholders: Its guidance for the current fiscal 2016 Q3 is for "just" 43% to 45% year-over-year revenue improvement. That may not be good enough given Palo Alto's recent track record of 50% plus, but 45% top-line improvement -- if it comes to that -- needs to be the low-end watermark: Anything less, and the rollercoaster ride begins anew.

You spent how much?

To Palo Alto's credit, last quarter's $334.7 million in sales was evenly split between its product and services divisions. Services' $164.8 million stood out since it's a key component of CEO Mark McLaughlin's plans to balance high growth with recurring services revenue. Despite the positives, Palo Alto has a couple of concerns.

For one, Palo Alto spent over $55 million more in operating expenses and total revenue costs than it earned. That was 44% higher than the year-ago period. Palo Alto bulls may point out that its non-GAAP (excluding one-time items) earnings per share climbed over 50% in its fiscal 2016 Q2, which is true. But the thing is, non-GAAP results exclude, among other things, share-based compensation, which helps us segue to Palo Alto's biggest expense-related concern.

A whopping $106.9 million was paid out in share-based compensation last quarter, the majority of which went to its sales folks. That equates to nearly 30% of Palo Alto's total overhead, and you can bet Palo Alto's salespeople won't settle for less going forward. It would be one thing if all of that spending was in the development of new products or infrastructure, but that's not the case. And that's why compensation expenses warrant a place near the top of McLaughlin's to-do list.

Protecting its moat

One of Palo Alto's competitive advantages over Fortinet and Check Point is its enterprise security platform. Both Fortinet and Check Point offer piecemeal security solutions for its commercial and government customers, which explains why Palo Alto owns the largest share of the fast-growing enterprise market.

Maintaining its platform solution market leadership position will be critical in the months and years ahead for Palo Alto to meet the Street's high expectations, as evidenced by its consensus $190 price target. But it won't be easy, as both Fortinet and Check Point have developed their own data center and platform security solutions. Fending off Check Point with its $404 million in revenue last quarter may prove to be Palo Alto's biggest challenge. By comparison, Fortinet generated $284.6 million in Q1.

Palo Alto shareholders will be vulnerable to price fluctuations: That's the nature of the growth stock beast. However, continuing to drive impressive revenue results, getting a handle on expenses -- particularly ongoing costs -- and fending off competition will put Palo Alto back into investors' good graces.

Tim Brugger has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Check Point Software Technologies. The Motley Fool recommends Palo Alto Networks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Palo Alto Networks Stock Quote
Palo Alto Networks
PANW
$175.65 (1.04%) $1.81
Fortinet Stock Quote
Fortinet
FTNT
$53.59 (1.73%) $0.91
Check Point Software Technologies Stock Quote
Check Point Software Technologies
CHKP
$114.00 (-3.55%) $-4.19

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