How Risky Is Palo Alto Networks Inc.?

By Tim Brugger Markets Fool.com

Shareholders of Palo Alto Networks (NYSE: PANW) are being rewarded in 2017. As of Jan. 26, Palo Alto stock is up 17% this month, which isn't surprising. Relatively short run-ups, as well as significant Palo Alto share price declines, is par for the course.

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The reaction to last quarter's earnings explains Palo Alto's recent history. After a disappointing quarter, its share price nosedived 15% overnight. The concern is what's behind the wild share price swings and if there will be progress made when Palo Alto reports fiscal 2017 second-quarter results on Feb. 23? If not, Palo Alto will remain one of the riskier stocks in the data security sector.

Image source: Palo Alto Networks Security.

Great expectations

In some respects, Palo Alto is a victim of its own apparent success. Until 2016's third quarter, Palo Alto had reported a nearly two-year run of revenue growth of 50% or more. Both analysts and investors alike seemed more than willing to overlook Palo Alto's mounting losses because of its stellar top-line improvements.

In fact, many analysts are still in Palo Alto's corner. It has a buy rating and consensus price target of $172.5, or another 18% upside. One estimate goes so far as to suggest Palo Alto stock will hit $209 a share.

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The problem is that like Palo Alto's peers, including Check Point Software (NASDAQ: CHKP), the pace of growth is slowing. Last quarter, Palo Alto reported a 34% jump in sales to $398.1 million. The aforementioned 15% drop in value was the result. Any guesses what will happen if Palo Alto simply meets its forecasted 27% to 29% revenue improvement this quarter to $426 million to 432 million? Exactly.

... lead to problems

With sales slowing, fairly dramatically in Palo Alto's case, prospective investors would be wise to monitor Palo Alto's spending. Slowing revenue growth hasn't slowed Palo Alto's soaring overhead, and that's becoming harder to overlook with each passing quarter. The inevitable consequence of slowing top-line gains with rampant spending is increasing losses.

Combined, Palo Alto's cost of revenue and operating expenses totaled $448 million last quarter, or 113% of revenue. That compares with $329.2 million in total costs a year ago, equal to 111% of sales. A stunning $220.3 million last quarter, 38% more than a year ago, was spent on sales and marketing alone. Palo Alto's open checkbook policy is continuing even as growth is easing, which is why its level of risk is rising right along with overhead.

For some perspective, Check Point Software's totalcosts were $245.3 million in its fourth quarter, a hair over 50% of its $486.7 million in revenue. The result was a 21% increase in earnings per share to $1.31, and $1.46 excluding one-time costs, also good for a 21% improvement. Check Point's bottom line came from just a 6% in total revenue. As for sales-related expenses, Check Point spent $116.8 million in the fourth quarter, or 24% of revenue.

Palo Alto's net loss last quarter of $0.69 a share was 47% worse than a year ago. Bulls may point out that non-GAAP (excluding one-time items) per-share earnings were improved. True. However, the reason for that was the adding back in of the whopping $1.28 per share Palo Alto paid out in stock-based compensation, up from $0.86 a year ago. Some investors don't see a problem with tweaking non-GAAP earnings per share by adding back in share-based comp while others do.

How risky is Palo Alto?

Considering sales easing is expected to continue, the amount of risk Palo Alto shareholders assume is directly related to its spending, which in turn is destroying its bottom line. The upcoming quarter will speak volumes about Palo Alto's future. But don't be surprised to see more of the same from Palo Alto, essentially buying revenue -- through excessive spending -- appears to be ingrained.

Until Palo Alto is able to either kick-start its revenue growth -- not a likely scenario given market conditions -- or streamline its operations to invigorate earnings, it will remain the riskiest stock in its peer group.

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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. The Motley Fool has a disclosure policy.