On Tuesday, cybersecurity-provider Palo Alto Networks (NYSE:PANW) posted another blowout quarter — and PANW stock soared as a result. As of this writing, Palo Alto Networks stock is up 8.4% on trading Wednesday, reaching a new all-time high in the process.
To be certain, there’s a lot to like when it comes to Palo Alto Networks stock. The fiscal Q2 earnings report was the latest in a series of strong releases. (By my count, PANW has beaten consensus expectations for sales and earnings for eight consecutive quarters.)
Growth isn’t likely to end any time soon as the shift to cloud computing benefits Palo Alto in two major ways.
First, it allows PANW to move its own products into subscription models, boosting revenue and (eventually) margins. Second, increased use elsewhere adds to security demands and to the need for Palo Alto’s products, whether hardware like firewalls or software subscriptions.
The combination of strong earnings and an attractive story unsurprisingly has moved Palo Alto Networks stock higher. But there are some risks to which investors need to pay attention, particularly amid the enthusiasm that greeted Tuesday’s earnings report.
PANW Stock Soars After Earnings
It’s no surprise PANW stock moved higher after earnings. In a note, analyst firm Wedbush called it a “monster beat and raise special” — and that’s an apt description.
Revenue of $711 million rose 30% year-over-year — a growth rate more than 5 points better than analysts projected. As Wedbush pointed out, product revenue growth of 33% was a full 11 points ahead of the Street. The combination seems to confirm the bullish argument that Palo Alto is well-positioned in both hardware and software.
On the bottom line, the news looks strong as well. Adjusted EPS of $1.51 crushed consensus estimates by $0.29, and rose 44% year-over-year. There’s no tax help in that figure, either (the adjusted tax rate was 22% in each quarter, per the respective conference calls), which shows the company’s ability to expand margins even while investing behind the business.
Looking forward, guidance for the fiscal third quarter, too, was above expectations. Revenue guidance of $697-$707 million compares favorably to average Street estimates at the low end of that range. EPS of $1.23-$1.25 is in-line with consensus of $1.24, but also includes expenses from the acquisition of Demisto, announced last week. That impact aside, PANW likely is ahead of expectations on the bottom line as well.
From a headline standpoint, certainly, Wedbush’s description seems fitting. That firm raised its price target on Palo Alto Networks stock to $300 from a previous $265. And it seems likely other analysts will follow.
The Case for Palo Alto Networks Stock
Q2 earnings don’t necessarily change the case for Palo Alto Networks stock. Rather, they seem simply to confirm the existing case. PANW now seems to have all the aspects of a classic growth stock bull case.
Its industry is growing — and should continue to grow for years to come. It’s simply self-evident that security threats are rising, and will continue to do so.
Palo Alto Networks appears to be taking share in that growing market as well. FireEye (NASDAQ:FEYE), still in the midst of a turnaround (and still dealing with some weakness in hardware), grew revenue just 6% in its December quarter, and gave disappointing guidance for Q1. Palo Alto is significantly outgrowing Check Point Software Technologies (NASDAQ:CHKP) as well. Only Fortinet (NASDAQ:FTNT), who grew revenue 22% in its Q4, seems to be keeping pace.
Two tuck-in acquisitions seem to be performing well, with the Demisto deal adding to machine learning capabilities and Wedbush seeing “serious dividends” from the purchase of RedLock last year. Palo Alto even announced a $1 billion stock buyback in conjunction with the Q2 release.
It’s a story that seems close to flawless. But that’s not quite the case.
The Risks
There are three risks investors need to keep an eye on with PANW stock at the all-time highs.
The first is the health of the industry as a whole. It was only about two years ago that hardware as struggling. PANW stock lost half its value and FEYE plunged to all-time lows. That side of the business has rallied, but pressure could return amid the shift to cloud.
Even the cloud side of the business has some risks. We’ve seen with chipmaker Nvidia (NASDAQ:NVDA) that aggressive cloud growth may be pulling sales forward. Palo Alto’s exposure is not nearly the same (it should generate much more recurring revenue than Nvidia, for instance), but there is a sense in some areas of the market that cloud growth is going to last forever. That’s not going to be the case.
The second risk is the market as a whole. Growth stocks, as I pointed out recently, are back to their highs. That comes just three months after investors were dumping those same stocks as fast as they could. That includes PANW, which dipped by one-third between early September and late November. Particularly with new highs intact, PANW could be a candidate for profit-taking if volatility returns to tech and/or the broader markets.
Valuation and Share-Based Comp
The biggest risk, however, looks to be valuation. Palo Alto Networks stock doesn’t look that expensive. At the moment, it trades at about 40x fiscal 2020 consensus EPS estimates. The multiple is even lower – perhaps closer to 30x — backing out net cash, and assuming that those estimates will be raised in the coming days. Against 44% EPS growth, a 32x or 34x forward multiple might seem downright cheap.
But the fact is that PANW isn’t that profitable. Nearly all — again, nearly all — of its adjusted EPS comes from the fact that the company excludes share-based compensation from its non-GAAP numbers. Per figures from the Q2 release, at least $2.20 of the $2.67 in adjusted EPS generated in the first half of this year came from share-based compensation. (It’s not clear exactly how PANW adjusted the figure for taxes.)
YTD, Palo Alto Networks’ share-based comp has totaled over 20% of its revenue. The giveaways of PANW stock are so extreme that shareholders opposed compensation last year, after incoming CEO Nikesh Arora made $125 million for 39 days’ worth of work.
The issuance of PANW stock is a real cost. It should come down over time: Twitter (NYSE:TWTR) had the same problem, and has made some progress in recent years. But in terms of earnings backing out share-based comp, PANW’s multiple actually is well over 100x. And even excluding net cash, it trades at something like 8x revenue.
Those are both enormous multiples considering a good chunk of Palo Alto sales still come from hardware. And the share-based comp figure seems like exactly the thing investors ignore when the news is good — and focus on when trouble arises. Right now, investors are fine with that dilution. But it only takes one quarter — or one jolt to the market — for that to change.
As of this writing, Vince Martin has no positions in any securities mentioned.
