3 Things Palo Alto Networks Inc Must Do to Regain Investor Confidence

By Markets Fool.com

It's been a rough couple of weeks for Palo Alto Networks shareholders. Since announcing so-so fiscal third-quarter 2016 earnings on May 26, Palo Alto stock has plummeted over 11%. On the surface, the problems Palo Alto is facing are fairly straightforward: After nearly two years of reporting quarterly revenue gains of over 50%, last quarter's "mere" 48% improvement over the year-ago period was viewed as a precursor of slowing top-line growth.

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CEO Mark McLaughlin's guidance for the current quarter of just $386 million to $390 million -- a 36% to 37% revenue gain -- confirmed investors' worst fears: Palo Alto is entering a new phase of its business. Gone are the days of those heady quarterly sales improvements of 50% or better.

That said, the Palo Alto ship isn't necessarily sinking. It's just adrift, and there are several steps McLaughlin and team can take to get it back on course. And for Palo Alto shareholders, getting things moving in the right direction can't come soon enough.

Image source: Palo Alto Networks.

Tighten the belt

The reason for investors' angst after Palo Alto reported a 48% jump in sales last quarter to $345.8 million, and shared guidance of 37% growth in the current quarter is that, historically, its stellar top-line gains overshadowed quarterly earnings-per-share (EPS) losses. But with its inevitable slowing of sales growth, suddenly those ongoing losses loom larger with each passing day. The overriding reason Palo Alto -- along with its peer Fortinet -- is in the red is spending.

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Last quarter was indicative of Palo Alto's, and Fortinet's, woes. Palo Alto's cost of revenue climbed nearly 50% in fiscal Q3 to $94.9 million, and its total operating expenses rose to a whopping $309.5 million, up from $206.5 million last year. Palo Alto's spending spree even puts Fortinet's to shame, and it lost money again last quarter, too.

Fortinet's cost of revenue was up 22% in its fiscal Q1 to $77.75 million, and its total operating expenses rose 43% to $212.5 million. Just as with Fortinet, what makes Palo Alto's increasing overhead tough to swallow is the majority of it goes to ongoing sales and marketing costs. An astounding $202 million -- equal to 58% of Palo Alto's total revenue in Q3 -- was spent to sell and market its services. Fortinet's $147.4 million in sales and marketing expense was "only" 52% of revenue. That's unacceptable, particularly combined with Palo Alto's slowing sales growth.

Keep it coming

On a brighter note, Palo Alto delivered big-time in Q3 on its initiative to boost recurring services unit revenue. Palo Alto CFO Steffan Tomlinson cited "particular strength in our subscription services" as a key driver behind its 48% jump in sales last quarter. Services revenue popped 54%, to $183.7 million, and now accounts for the majority of Palo Alto's total sales.

Not only does improved recurring revenue build a long-term, sustainable source of growth, but it does so without incurring the same level of expenses as generating new sales. As the aforementioned sky-high costs associated with finding new customers attest, anything Palo Alto can do to keep the revenue coming while paring overhead will be a welcome change -- and recurring services sales will do just that.

Time is of the essence

Can McLaughlin and team successfully manage Palo Alto's changing business dynamics? Addressing key areas, including expenses and services unit revenue, will give investors the answers to those questions. However, even with improvements where it counts in the coming months and quarters, patience is needed -- both for Palo Alto's executive team and its investors.

Make no mistake, Palo Alto is entering the next phase of its business life cycle. Gone are the days of hypergrowth overshadowing its unattractive bottom line. But the significant changes that Palo Alto needs to institute aren't going to happen overnight. The best Palo Alto investors can hope for is that with each passing quarter it demonstrates even slight improvements where it counts.

If positive steps are made, Palo Alto offers long-term upside, particularly at its current depressed share price levels. If not, investors can expect the roller-coaster ride to continue.

The article 3 Things Palo Alto Networks Inc Must Do to Regain Investor Confidence originally appeared on Fool.com.

Tim Brugger has no position in any stocks mentioned. 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.