Though its stock price is up 11% year to date, Palo Alto Networks (NYSE: PANW) is lagging well behind most of its peers, including FireEye (NASDAQ: FEYE) and Check Point Software (NASDAQ: CHKP), to name but a couple.
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At first glance, Palo Alto's relatively meek performance may seem odd given it's growing the top line considerably faster than FireEye, Check Point, and others. But Palo Alto's muted stock price growth is warranted.
When Palo Alto announces its fiscal 2018 first-quarter results Nov. 20, investors will likely note the same two reasons why its troubles will continue. And therein lies the problem for CEO Mark McLaughlin and team.
I'll get to that later
Palo Alto had been the darling of its peer group for years following multiple quarters of 50%-plus total revenue growth. In fact, Palo Alto's top line had been so impressive for so long, investors had no problem ignoring its ongoing lack of profits.
The argument for the Street's love affair is that Palo Alto is in all-out growth mode, and that requires spending. However, there are two problems with that argument that are manifesting themselves more and more each passing quarter. The first concern is that McLaughlin vowed to pare expenses, particularly sales and marketing costs, but it simply isn't happening.
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Last quarter's revenue of $509.1 million was a record and a28% jump year over year. So why, after a spike in share price following Palo Alto's earnings news has its stock retreated? Because McLaughlin not only hasn't cut overhead, it continues to soar.
Total operating expenses in Palo Alto's fiscal fourth quarter rose 27% compared to $397.9 million -- and it gets worse. McLaughlin's focus on sales and marketing costs is still blurry. Palo Alto spent a mind-boggling $245.4 million on sales expenses, up 19% from a year ago and equal to nearly half its total revenue.
For some perspective, new-ish FireEye CEO Kevin Mandia made much the same promise as McLaughlin when he took over in June 2016. Last quarter, FireEye shaved another 20% off its operating expenses, including 20% in sales overhead. FireEye's cost-cutting initiative has been on display every quarter since Mandia became CEO -- in other words, a promise kept.
Check Point offers another example of sound expense management. Last quarter's $106 million in sales-related spending was essentially flat year over year and equaled a mere 23% of its $454.6 million in revenue. A year ago, Check Point spent 24% of total revenue on its sales efforts. FireEye and Check Point have proven it can be done, but McLaughlin can't seem to manage it.
Now, for the double whammy
The second problem for Palo Alto is that sky-high revenue gains are a thing of the past. Even as its growth rate slows, Palo Alto continues to adhere to its open checkbook policy. Though Palo Alto's 27% jump in revenue sounds great, it wasn't enough to overcome the rise in operating expenses. The end result was last quarter's loss of $0.42 a share, 20% worse than a year ago.
Based on McLaughlin's midrange revenue guidance for the first quarter of $487 million, Palo Alto's growth rate will slow to 22.5%. Sure, McLaughlin is likely underselling Palo Alto's actual revenue for a quarterly "beat," the usual CEO-speak. But the declines in growth rate are an ongoing theme, as are Palo Alto's mounting losses. Worse still, investors can expect more of the same in the quarters ahead.
Check Point is an ideal example of an efficiently run organization with its priorities in order. The aforementioned $454.6 million in revenue Check Point reported was "just" a 6% bump year over year. However, Check Point's earnings per share (EPS) skyrocketed 18% to $1.16 a share. Call me old-fashioned, but I like consistently rising profits.
It's been over six years since McLaughlin joined Palo Alto as CEO, and it remains far from profitable. The culprit is obvious and has been for years, but nothing's changed. Essentially "buying" revenue by overspending on sales and marketing needs to end if Palo Alto shareholders want to see even the slightest of profits. And that's clearly not going to happen with McLaughlin in charge.
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Tim Brugger has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Check Point Software Technologies. The Motley Fool recommends FireEye and Palo Alto Networks. The Motley Fool has a disclosure policy.