2 Simple Reasons to Buy Palo Alto Networks

Palo Alto Networks (NYSE: PANW) is showing no signs of stopping. The cybersecurity specialist's fourth-quarter results, released on Sept. 6, crushed Wall Street estimates thanks to a rapidly increasing customer base that accelerated its top- and bottom-line growth. In fact, the company has strung together a series of impressive quarterly reports over the past year that have helped the stock rally more than 60%.

But don't fret about having missed the Palo Alto gravy train. Here are two simple reasons Palo Alto is capable of delivering more upside.

Going after a bigger pie

Palo Alto had 54,000 customers at the end of the latest quarter, up from 42,500 at the end of the prior-year period. But the impressive thing to note is that Palo Alto has been boosting its customer count at an accelerated rate.

The chart above is a clear indicator that Palo Alto's strategy of attacking the various niches within the cybersecurity space by way of acquisitions is paying off. The company has spent a total of $400 million this year to bolster its presence in the cloud security and the endpoint protection markets.

Palo Alto believes that its addressable market will be worth $24 billion by 2020 as compared to $19 billion last year, so the company is doing the right thing by covering as much ground as possible. And it's working.

It controlled just 1.9% of the cybersecurity market at the end of fiscal 2012, but a series of four acquisitions over the next five years helped it boost that by 7.3 percentage points to 9.2% at the end of the 2017 fiscal year. The latest market share numbers aren't in yet, but it seems safe to say, based on its accelerated customer growth, that the company has gained.

Assuming that Palo Alto manages to boost its market share over the next couple of years to around 13%, its annual revenue could exceed $3 billion if the addressable market grows as per the company's estimates. By comparison, Palo Alto pulled in $2.2 billion in revenue in the recently concluded fiscal year, indicating that its top-line growth should remain healthy going forward even if its market share grows conservatively.

Aiming for profitability

The impressive thing about Palo Alto is that its top-line growth is filtering down to the bottom line. The company's GAAP net loss fell 31% last fiscal year to $148 million, thanks mainly to the growth of its high-margin subscription business.

Palo Alto's subscription business shot up 33% in fiscal 2018 to $1.4 billion, and it now supplies nearly 62% of the total revenue. By comparison, subscription revenue accounted for just over 59% of the total revenue in the preceding fiscal year, with the rest coming from product sales. Palo Alto's gross margin from the subscription business stands at more than 73%, while that from product sales is relatively lower at 69%.

Given that Palo Alto's subscription business still has a lot of room to grow, it is in a solid position to cut the loss once again this year. What's more, the company's customer acquisition costs are coming down as customers are spending more money on its products and subscriptions. This is evident from the 45% annual increase in the lifetime value of Palo Alto's top 25 customer.

Lifetime value denotes the money made by a company from a particular customer after subtracting acquisition and service costs. So the increase in this number is a clear indicator that Palo Alto is winning more business from its existing customers, leading to a drop in marketing expenses. More specifically, Palo Alto spent 48% of its revenue on selling and marketing costs last year, down from 52% in the prior year.

Now that the company can provide new services after its latest acquisitions, it should be able to improve cross-sales to its existing customers and further reduce the marketing outlay. As a result, Palo Alto's margin profile should get better.

This is exactly what analysts are forecasting, as they expect the company's earnings to increase at a compound annual growth rate of nearly 30% over the next five years.

Still a good buy

Palo Alto has a lot going for it. Its revenue growth is terrific, as the customer base is swelling rapidly and clients are spending more money on its services. The high-margin subscription business now forms a bigger part of total revenue, and it has room to grow. This makes Palo Alto a good bet at the moment, as it trades at nearly 48 times forward earnings, which is much lower than the industry average price-to-earnings (P/E) ratio of 114.

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