Buy Palo Alto Stock on Post-Earnings Weakness

Palo Alto Networks (NYSE:PANW) stock dropped sharply in late May after the cybersecurity giant reported third-quarter numbers that topped expectations, but provided mundane fourth-quarter guidance. The guidance implies that the company’s growth will slow going forward,  displeasing investors and causing PANW stock to drop more than 5%.

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This drop in PANW stock is an opportunity to buy a long-term winner on weakness.

Palo Alto Networks is the heartbeat of the cybersecurity market, and this hyper-growth market will remain red hot because cybersecurity is at the center of the rapidly expanding digital economy. As this economy continues to expand, and as more workloads and information move into the digital realm, corporations will spend more money on cybersecurity.  Palo Alto Networks will get a big chunk of that money because this company has established itself as having the best cybersecurity solutions.

As a result, Palo Alto Networks’ revenue should grow rapidly for the foreseeable future. Additionally, its gross margins are stable and high. Its operating-spending rates are dropping. Its profits are rushing higher. All of these dynamics should help the  company generate strong profit growth over the next several years.

This rapid profit growth will drive PANW stock higher in the long run. Consequently, its near-term weakness is a buying opportunity.

Don’t Pay Too Much Attention to the Weakness of Its Earnings Report

There are two major reasons why Palo Alto Networks stock dropped sharply in response to its third-quarter earnings report. Neither of them is a longer-running concern.

Palo Alto Network’s Q3 report surpassed analysts’ average expectations on both the top and bottom line. PANW provided in-line Q4 guide. Over the past several quarters,  Palo Alto Networks ‘ revenue and EPS have usually beat expectations, and the company has tended to raise its top-line and bottom-line guidance. Management didn’t continue the latter trend, disappointing the owners of PANW stock.

But just because management didn’t raise guidance to above-consensus levels doesn’t mean the company’s outlook is falling apart. Instead, it means management is rightfully exercising caution amid the trade war which has created an uncertain economic outlook. If the trade war clears up, Palo Alto’s fourth-quarter numbers will likely come in way ahead of expectations.

Second,  Palo Alto Networks’ growth is slowing. Specifically, since the first quarter of 2018, its revenue has consistently increased 27% YoY or higher. But its guidance calls for 21%-22% revenue growth this quarter, representing a sharp deceleration. Furthermore, in Q3, its revenue growth slowed to 28% from 31% in the prior quarter,.

But slowing growth should be expected at this point. Palo Alto Networks has been firing off 20%-plus growth rates for a long time, and after a while, the law of large numbers  says that its growth should slow. We are at that point today, so PANW’s growth slowdown shouldn’t worry the owners of PANW stock.

The company still has a ton of operational momentum, as it continues to win large contracts and launch new products. Moreover, Palo Alto stock is much less expensive than it was when its growth was higher (PANW now trades at 35 times its forward earnings, versus its five-year average forward multiple of nearly 80).

Overall, then, the company’s  in-line guidance and slowing growth trend aren’t deal breakers for PANW stock.

The Valuation of PANW  Stock Is Still Attractive

Palo Alto Networks remains the top dog in the non-cyclical-growth cybersecurity industry, which will continue to grow rapidly over the next several years as more and more information and workloads migrate to the digital world.

The cybersecurity market is expected to  grow at an annualized rate of  17% over the next several years. In that market, Palo Alto Networks is a leader whose share  has been rapidly expanding. Conservatively assuming Palo Alto Networks goes from expanding share to maintaining share, the company’s revenue should rise at a 17% annual clip over the next several years.

Meanwhile, it’s generating really high gross margins of about 76%. They are also stable at those high levels, and could move higher as it sells more subscriptions. However, its operating-spending rate, which is north of 50%, is also very high. but its growth has been knocking that opex rate down rapidly. This trend should continue, as 15%-plus revenue growth should be enough to continue to reduce its spending rates.

All in all, then, Palo Alto Network’s profits will probably increase in excess of 20% over the next several years. I think its 2025 EPS will come in around $15. Based on a forward price-earnings multiple of 25, which is average for high-growth companies, that equates to a 2024 price target for PANW stock of $375. Discounted back by 10% per year, that implies a reasonable 2019 price target of over $230.

This recent selloff has brought PANW stock down to $200. Consequently, Palo Alto stock should rise meaningfully over the next several months, making PANW stock  look compelling.

The Bottom Line on PANW Stock

Palo Alto Network’s third-quarter report wasn’t great. But it was good enough to warrant buying PANW stock at $200.

Over the next several years, cybersecurity tailwinds will propel meaningful revenue growth by Palo Alto Networks, while healthy margin expansion will turn its substantial revenue growth into significant profit growth. That profit growth will ultimately drive PANW stock to levels far above $200.

As of this writing, Luke Lango was long PANW. 

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