Is Palo Alto Networks, Inc. a Buy?

Shares of Palo Alto Networks (NYSE: PANW) have surged nearly 60% over the past 12 months, fueled by four straight quarters of big earnings beats. That crushed the 25% return of the ETFMG Prime Cyber Security ETF (NYSEMKT: HACK), a commonly used benchmark of the cybersecurity market.

But after that big run, is it too late to invest in this next-gen firewall provider? Let's examine the bull and bear cases to find out.

What the bulls believe

Palo Alto serves more than 48,000 customers in more than 150 countries -- including over 85% and 63% of the Fortune 100 and Global 2000 companies, respectively. Gartner has named it an enterprise firewall market leader for the past six years.

That best-in-breed reputation indicates that Palo Alto is well poised to profit from surging demand for cybersecurity solutions worldwide. Its revenue rose 28% in 2017, outpacing the rest of the industry, and analysts expect 26% growth this year.

Although Palo Alto is best known for its next-gen firewall, it also upsells new products -- like its hybrid cloud software-as-a-service (SaaS) platform -- that boost its overall revenue per customer. This "land-and-expand" model widens Palo Alto's moat against bigger rivals like Cisco (NASDAQ: CSCO), which bundles cybersecurity solutions with its networking hardware and software.

Palo Alto is also profitable on a non-GAAP basis. Its non-GAAP earnings climbed 43% last year, and Wall Street anticipates another 43% growth this year. Based on that estimate, its forward P/E of 49 still looks surprisingly reasonable. It finished last quarter with $915 million in cash and equivalents, which is a comfortable cash cushion for launching new products or acquiring smaller companies.

What the bears believe

The bears will point out that Palo Alto is actually deeply unprofitable on a GAAP basis, due to high stock-based compensation (SBC) expenses. Here's how much money Palo Alto actually lost over the past four quarters, with SBC expenses factored back in.

Metric

Q3 2017

Q4 2017

Q1 2018

Q2 2018

GAAP net loss

($60.9 million)

($38.2 million)

($64.0 million)

($34.9 million)

SBC expenses

$120.6 million

$120.9 million

$128.9 million

$136.3 million

In other words, Palo Alto spent 25% of its revenue on SBC expenses last quarter. If it had simply cut that figure in half, it would have reported a GAAP profit.

Palo Alto spends so much money on SBC expenses because it's based in Silicon Valley, which has a cutthroat job market and high living costs. Palo Alto doesn't have enough cash to pay competitive salaries, so it pads its salaries with big stock bonuses. That's a classic strategy for younger tech companies, but Palo Alto was founded 13 years ago.

Comparable cybersecurity companies based in lower-paying markets don't have this problem. Israeli firewall provider Check Point Software (NASDAQ: CHKP), which is profitable by both non-GAAP and GAAP measures, spent just 5% of its revenue on SBC expenses last year.

If we accept the fact that Palo Alto is unprofitable, the stock looks pricey at nine times sales -- which is higher than the industry average of seven for application software makers. Meanwhile, competitors like Cisco -- which can undercut Palo Alto to gain market share -- remain a threat to long-term growth.

So is it time to buy Palo Alto?

I think Palo Alto's best days are still ahead of it. Its best-in-breed reputation in firewalls, the expansion of its firewall into a cloud-based security platform, and the surging number of data breaches worldwide should all bolster its top-line growth for the foreseeable future.

Those strengths outweigh its weaknesses, and indicate that Palo Alto could still have a lot more room to run.

10 stocks we like better than Palo Alto NetworksWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Palo Alto Networks wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of March 5, 2018

Leo Sun 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 Cisco Systems, Gartner, and Palo Alto Networks. The Motley Fool has a disclosure policy.