This Just In: Palo Alto Networks Stock Upgraded

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Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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2017 has been a bit of a nail-biter for investors in Palo Alto Networks (NYSE: PANW) stock. Entering the year at $135 a share in January, the network firewall specialist was hit almost immediately by news of a sales miss in February. That fiscal Q2 result shook investor confidence, and sent Palo Alto's stock price down 25% in a week.

It wasn't long before Palo Alto got back up on the horse, though. By fiscal Q3 (which for Palo Alto came in May), the company was back to its old ways, beating analyst estimates on both the top and bottom lines. Palo Alto repeated the feat with August's fiscal Q4 report. In each case, Palo Alto stock leapt in response to the good news, rising 17% after the Q3 report, then another 14% after Q4 -- recovering all its losses from earlier in the year, and returning the stock to positive territory along the way.

And now, one analyst thinks Palo Networks is ready to rise even more.

Morgan Stanley upgrades

This morning, investment megabanker Morgan Stanley announced it is upgrading Palo Alto Networks stock to overweight and assigning the shares a $185 price target. This new price target is 23% higher than the old, and implies a profit potential of as much as 27% for investors who buy in today.

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But why did Morgan Stanley wait to today to upgrade today -- after Palo Alto Networks had already recovered all its losses from earlier in the year?

Cheaper is better, but cheap is still good

Perhaps Morgan Stanley was just being cautious -- waiting a couple of quarters to be sure the coast really is clear. What's more, even after all its gains earlier this year, Palo Alto Networks stock still looks cheap.

As Morgan Stanley explains in a note covered on StreetInsider.com (requires subscription) today, "A ramping renewal base enables attached subscription billings growth to sustain 20%+ through FY20." This growth rate -- a rate that Palo Alto has exceeded in each of the past quarters, mind you -- is "on sale" given Palo Alto Networks' low stock price relative to its high rate of free cash flow (FCF) generation.

According to data from S&P Global Market Intelligence, Palo Alto Networks threw off $705 million in positive cash profits over the past 12 months. The stock's market capitalization of $13.5 billion, minus net cash on the balance sheet of $850 million, yields an enterprise value of about $12.6 billion. Thus, Palo Alto's enterprise value-to-FCF ratio is just 17.9 -- very cheap indeed if Palo Alto Networks can maintain 20% or better annual growth rates.

How do we know this growth is coming?

The first indication that Morgan Stanley is right about Palo Alto Networks being able to maintain "20%+" growth is ... because it already has. Over the past three quarters (including Q2, in which the company missed expectations), Palo Alto Networks achieved sales growth of 26% (Q2), 25% (Q3), and then 27% growth.

And going forward, Morgan Stanley argues that Palo Alto's "sales execution issues" are now behind the stock. With a "ramping renewal base" and more than "60% of the sales force now fully productive," Morgan Stanley expects sales growth to continue apace "despite a maturing attach opportunity" in the years ahead.

The upshot for investors

Morgan Stanley is right.

Palo Alto's stumble in Q2 wasn't really much of a stumble, given that the stock underperformed expectations by growing 26%. The fact that Palo Alto proceeded to post similar growth over the succeeding quarters suggests that this growth rate is in fact sustainable.

Even with its stock up 40% off its lows, given Palo Alto's strong free cash flow, still modest enterprise value, and rapid and sustainable growth rate, I think Palo Alto Networks shares remain a good bargain for investors today.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool recommends Palo Alto Networks. The Motley Fool has a disclosure policy.