Better Buy: Palo Alto Networks Inc or Check Point Software?

By Markets Fool.com

Palo Alto Networks (NYSE: PANW) and Check Point Software (NASDAQ: CHKP) are two of the largest firewall vendors in the world. The number of personal records exposed in data breaches worldwide doubled to 178 million last year, according tothe Identity Theft Resource Center, indicating that business should be booming for both companies.

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Yet shares of Palo Alto and Check Point have declined 18% and 4% respectively since the beginning of the year due to concerns about slower enterprise spending and competition from bigger rivals. Will either stock bounce back in the near future? Let's examine their core businesses, growth, and valuations to decide.

Image source: Getty Images.

What do Palo Alto and Check Point do?

Palo Alto and Check Point both provide firewalls and other security solutions to a wide variety of customers. Palo Alto, which serves over34,000 customers worldwide, mainly larger businesses -- including 85 of the Fortune 100 and half of the Global 2000. Check Point serves small and medium-sized businesses (SMBs) and individual consumers. Its customer base includes over 100,000 businesses and millions of users worldwide.

Palo Alto was founded in 2005 in the heart of Silicon Valley, while Check Point was founded in Ramat Gan, Israel, in 1993. Most of Palo Alto's workforce is still located in Silicon Valley, while Check Point's operations are spread across Israel, Sweden, Australia, Canada, and the United States. Both companies face the threat of larger competitors, like Cisco, undercutting each companies products with cheaper, bundled security solutions.

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How fast are Palo Alto and Check Point growing?

Palo Alto's revenue rose 41% annually to $400.8 million last quarter, but that represented a slowdown from 48% growth in the previous quarter and 59% growth in the prior year quarter. Total billings (reported plus deferred revenue) rose 45%, a slowdown from 61% growth in the previous quarter and 69% growth a year ago.

Palo Alto expects its third quarter revenue to rise 33%-35%, marking its slowest growth rate since its IPO four years ago. The company's full-year revenue is expected to rise 33% this year, down from 55% growth in2015. Those numbers weren't terrible, but that slowdown made its P/S ratio of 9 look a bit pricey.

Check Point's revenue rose just 7% to $423 million last quarter, compared to 8% growth in the previous quarter and 9% growth a year ago. Deferred revenues rose 14%, compared to 14% growth in the previous quarter and 18% growth in the prior year quarter. Analysts expect its revenues to rise just 5% this quarter and6% for the full year, compared to 9% growth last year. Those numbers don't look great, especially in comparison to Check Point's P/S ratio of 8.

How profitable are Palo Alto and Check Point?

However, Check Point -- which is profitable by both non-GAAP and GAAP measures -- has kept much better control over its expenses than Palo Alto. Its non-GAAP EPS rose 10% annually to $1.09 last quarter, while its GAAP EPS rose 8% to $0.95. Palo Alto's non-GAAP EPS rose 79% to $0.50 per share, but its GAAP net loss widened from $0.55 per share a year ago to $0.61.

That disparity can mainly be attributed to the difference between the companies' salaries and stock-based compensation (SBC) expenses. Since Palo Alto Networks is based in Silicon Valley, it pays its employees much more than Check Point, which has a more globally diversified workforce.

According to Paysa.com, Palo Alto employees receive average annual salaries of$193,000, while Check Point employees receive average salaries of$143,000. Last quarter, Palo Alto's SBC expenses surged 64% annually and consumed 28% of its revenues. Check Point's rose just 17% and claimed a mere 5% of its revenues. Therefore, Check Point easily wins any direct comparisons against Palo Alto in terms of operating margins and GAAP profitability.

Source:YCharts

But in terms of non-GAAP profits, which are used in analyst forecasts, Palo Alto's outlook is stronger. Analysts expect Palo Alto's non-GAAP earnings to improve 42% annually over the next five years, which gives it a 5-year price/earnings to growth (PEG) ratio of 1.2.

Check Point's earnings are expected to rise 10% annually over the next five years, which gives it a higher PEG ratio of 1.7. This means that Palo Alto is still cheaper than Check Point relative to its non-GAAP earnings growth potential.

The verdict: Palo Alto is a slightly better buy

Based on its sales, non-GAAP earnings growth, and valuations, Palo Alto is a more promising investment than Check Point. But as I mentioned in previous articles, Palo Alto's upside will remain limited if it can't reduce itsSBC expenses or buy additional companies to maintain its long-term sales growth.

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Leo Sun owns shares of Cisco Systems. 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.