How Risky Is Palo Alto Networks Inc.?

By Markets Fool.com

If the question of how much risk investing in Palo Alto Networks (NYSE: PANW) poses is asked of the 35 analysts who follow its stock, the vast majority would likely say not much. Of course, all stocks come with some measure of risk, but with a consensus "buy" rating and price target of $180.23 a share -- one analyst has gone so far as to estimate a whopping $215 -- pundits like what they see.

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That said, as with any stock that relies heavily on continuing to post top-line growth to fuel investors' good tidings, it doesn't take much to knock the Palo Altos of the world off their lofty perch. But how likely is Palo Alto to stumble in the coming quarters? The answer to that question will determine Palo Alto's level of risk.

Image source: Palo Alto Networks.

Risk, what risk?

Until this year, Palo Alto's revenue growth was off the charts. For nearly two straight years, Palo Alto posted revenue gains of over 50%. Fortinet (NASDAQ: FTNT), one of Palo Alto's data security peers, has a nice quarterly sales jump of its own, boosting revenue 30% or more for the past year. But even that can't touch Palo Alto.

The top-line revenue improvements slowed last quarter -- Palo Alto's fiscal 2016 Q4 but a 41% year-over-year gain to $400.8 million is nothing to be ashamed of, and helps explain analysts' bullish sentiment. Sales had climbed 48% in Q3 to $345.8 million. But Palo Alto's good news doesn't begin and end with revenue growth.

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Palo Alto added some 3,000 new customers last quarter, and now boasts "approximately 34,000." The swelling client base is largely due to Palo Alto's next-gen security platform -- an end-to-end solution rather than a piecemeal approach -- and it's driving increases in recurring revenue. Palo Alto now generates more service sales, and the ongoing revenue that comes with it, than products. A positive trend that shows no signs of slowing anytime soon.

Oh, that risk

The reason for Palo Alto's current valuation -- it actually has a larger market capitalization than consistently profitable Check Point Software (NASDAQ: CHKP)-- is its history of soaring revenue gains, which far and away poses its biggest risk should it stumble. And investors may get a taste of that risk this November when fiscal 2017 Q1 earnings are announced.

Forget the 50% plus revenue gains of the past, or even the company's more recent 40% plus improvements: Palo Alto's guidance for this quarter is $396 million to $402 million, equal to a 33% to 35% increase compared to a year ago. As if its forecast for this quarter weren't eye-opening enough given its historical gains, it's indicative of a trend, and not a good one.

The risk -- and it's a very real one -- is if Palo Alto doesn't positively surprise Wall Street and posts "just" 35% sales growth, investors may start running for the hills. Worse still would be if Palo Alto's guidance for fiscal Q2 continues the quarterly revenue slide it's in the midst of.

Unlike Check Point that can at least point to ongoing per-share earnings improvements quarter in and quarter out, just as it did again in Q2 by posting an 8% pop to $0.95, Palo Alto's bullish followers rely on swelling sales to justify its ongoing lack of profitability. When sky-high revenue growth disappears, what will Palo Alto bulls lean on then?

Investors are also less likely to be tolerant of Palo Alto's inevitable slowing top-line growth if it continues to spend like there's no tomorrow. The risk lies in CEO Mark McLaughlin's unwillingness to alter Palo Alto's open checkbook policy, and when the sales are no longer through the roof, shareholders will get antsy and rightfully so.

Cost of revenue climbed 38% last quarter to nearly $102 million, and operating expenses soared to $344.5, up 41% year over year. By comparison, Check Point's operating expenses inched up 5% in Q2, as did its cost of revenue.

So, how risky is Palo Alto? It's teetering on the edge of slowing sales and skyrocketing expenses, and it doesn't get much riskier than that.

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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 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.