Palo Alto Networks: A Bargain or a Bust?

By Markets Fool.com

Even before the surprising Brexit vote sent the world's markets into a tailspin, Palo Alto Networks' stock was reeling. After announcing earnings on May 26, Palo Alto revealed it had finally broken its nearly two-year-long string of reporting quarterly revenue growth of 50% or more. As a result Palo Alto stock has nosedived 18%.

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The "mere" 48% jump in sales, to $345.8 million, in fiscal 2016's third quarter wasn't the only thing that disappointed investors. Palo Alto's guidance of $386 million to $390 million in the current quarter -- equal to year-over-year revenue growth of 36% to 37% -- fueled the bearish fire.

As Palo Alto's stock price inches closer to its 52-week low of $111.09 a share, some value investors might consider it a bargain.

Image source: Getty.

First, the good news

It's unrealistic to assume Palo Alto could continue its impressive run of revenue growth indefinitely. As any business matures, even one some pundits expect to generate over $1 trillion in sales from 2017 to 2021, the slowing of top-line growth is inevitable. So it could be argued that Palo Alto's 48% sales gain in Q3, and even its expectations of a 36% to 37% revenue jump in the current quarter, is still commendable.

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Relative to its peers -- namely Fortinet and Check Point Software Technologies -- Palo Alto's sales will continue to lead the pack. Fortinet also has a nice string of revenue growth intact, having reported 30% or more for three straight quarters. Check Point CEO Gil Shwed's methodical approach to its business has translated to justa 9% sales improvement the first quarter in 2016.

One of the reasons Palo Alto compares so favorably to its competitors is its security platform solution: It was ahead of both Fortinet and Check Point in delivering an all-in-one platform rather than offering a piecemeal approach to data security sales. Palo Alto is also focused on further developing its recurring revenue streams via its subscription services, and it's working.

According to Palo Alto CFO Steffan Tomlinson, last quarter's 48% revenue gain was largely due to "increased investments in our Next-Generation Security Platform, with particular strength in our subscription services." Service results actually surpassed new product sales last quarter -- a testament to Palo Alto's emphasis on generating a solid foundation of long-term, recurring revenue.

Now, for the bad news

Not surprisingly, when a stock generates investor interest based almost entirely on continuing its phenomenal top-line growth, as was the case with Palo Alto, it gets hit especially hard when the inevitable slowing kicks in. To put that into perspective, Palo Alto's stock is down 32% year to date, while Fortinet is flat and Check Point is down all of 5%. And that's not likely to change any time soon.

Palo Alto's security platform solution and focus on subscription sales aren't unique any longer, as both Fortinet and Check Point have unveiled their own enterprise-wide data security solutions, which has increased service revenue. Fortinet CEO Ken Xie cited "customer adoption of broad, integrated platforms" as a key driver of last quarter's solid results, and Check Point's Shwed pointed to strong "subscription revenue growth" behind its solid, albeit not spectacular, Q1 sales.

But growing competition in end-to-end data security solutions and competitors' efforts to increase their own recurring revenue streams are only blips on the radar as far as Palo Alto's troubles are concerned. The overriding problem is out-of-control spending that has left Palo Alto in the red for years, and will continue to do so in the foreseeable future.

Spending -- both cost of revenue and operating expenses -- jumped a whopping 50% last quarter, to $404.4 million. And that's not even the worst part. Nearly half of all that overhead, $202 million to be precise, went to Palo Alto's sales and marketing efforts. These were not one-time investments for product development or infrastructure, but ongoing costs associated with selling its products, and there's no end in sight.

When investors add it all up, Palo Alto's stock sell-off was a matter of when, not if. And even at these depressed levels, Palo Alto still has too many areas of concern to warrant a look.

The article Palo Alto Networks: A Bargain or a Bust? originally appeared on Fool.com.

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.