3 Reasons Palo Alto Networks Inc. Stock Could Fall

By Markets Fool.com

Based on the bullish sentiment of industry analysts, it may seem unlikely to some that Palo Alto Networks (NYSE: PANW) stock could perform any worse than it already has in 2016. Down over 29% year to date, including another 4.4% on Aug. 10, it's becoming harder to justify pundits' consensus $185 price target and what amounts to a strong "buy" recommendation.

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After nearly two years of posting revenue growth of 50% or more, Palo Alto finally broke its impressive string last quarter by reporting a "mere" 48% jump in sales to $345.8 million. But what really sent Palo Alto shares nosediving from its pre-earnings price of $148.18 a share was its guidance for the current quarter. So, how could things get any worse for Palo Alto shareholders?

Image source: Palo Alto Networks.

Overpromise, underdeliver

The reason Palo Alto has underperformed most of its peers of late its stock has been battered in 2016 compared to a 6.5% improvement across the data security sector -- was its revenue guidance of 36% to 37% this quarter. Its long run of top-line improvements overshadowed its ongoing lack of profitability, but those days are long gone.

That makes this quarter's sales that much more critical. It's likely that CEO Mark McLaughlin's guidance of $386 million to $390 million for Palo Alto's fiscal Q4 was on the low end of actual expectations so it could post an earnings "beat" when it reports fourth-quarter and fiscal 2016 annual results on Aug. 30.

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However, if Palo Alto merely hits its 36% to 37% year-over-year revenue increase forecast or, worse, falls short by even the slightest of margins, shareholders will pay a steep price. Palo Alto's 52-week trading low of $111.09 would be in range if revenue doesn't perform up to expectations.

Come on down

The good news for Palo Alto is that the market for cybersecurity solutions is expected to skyrocket to over $202 billion in five years. The not-so-good news is that kind of revenue opportunity leads to increased competition, and not just from its existing peers including Check Point Software Technologiesand Fortinet.

Two tech heavyweights that immediately come to mind are Cisco (NASDAQ: CSCO) and IBM (NYSE: IBM). Cisco and IBM are each in the midst of significant business transitions that include shifting focus to the fast-growing cloud and Internet of Things (IoT) markets. Both up-and-coming markets entail gathering massive amounts of data for storage, analytics, and ultimately providing customers with actionable results.

A concern of most all cloud and IoT customers is data security, which is why both Cisco and IBM have made it a priority, and it's working. CEO Chuck Robbins attributed at least part of Cisco's 3% jump in revenue last quarter to the 17% increase in data security-related sales. IBM did Cisco one better by reporting an 18% year-over-year improvement in security revenue. Palo Alto's sandbox is getting bigger, and so are the players it's competing with.

Close the checkbook

The reason Palo Alto continues to lose more and more money each quarter is spending -- lots and lots of spending. Again, investors looked the other way when Palo Alto was growing quarterly sales by more than 50%, but now that those days are past its management of expenses, or lack thereof, will be the target of more intense scrutiny. Last quarter was a microcosm of Palo Alto's rising overhead.

Operating expenses soared 50% in fiscal 2016's Q3 to $309.5 million and Palo Alto's cost of revenue jumped 47% to $94.9 million. Even more disconcerting was that 57% -- a staggering $202 million -- of Palo Alto's $345.8 million in total sales went to pay for its sales and marketing efforts.

Palo Alto hasn't painted a pretty picture for investors of late, and if it's not able to deliver revenue results this quarter, fight off some big-time competitors, and control its pocketbook, shareholders may not have seen the worst of it yet.

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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 Cisco Systems and 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.