Palo Alto Networks Remains a Buy, Cisco Should Listen

Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Growth investors can be very “finicky” - which is a kind way to say “entirely confused.”  It seems no matter how much growth a company produces, it is never enough to satisfy investors. This is regardless of how absurd the expectations might have been.

Watching shares of Palo Alto Networks (NYSE: PANW) get destroyed following the company’s stellar earnings report was not entirely a surprise. After all, the stock has had a considerable run following its IPO earlier this year. Rather, it was the reasons given for the selloff that was mindboggling. And astute investors would be wise to take these shares out of weak hands. The more I think about it, so should Cisco.

The Quarter that was

For the period ending October, the company grew revenues 50% year-over-year to $85.9 million. This compares to revenues of $57.1 million for fiscal Q1 2012. Remarkably 50% year-over-year and 14% sequential growth is not enough to keep some investors happy. But it’s not just about revenues.

The company is also expanding its customer base, which now stands at over 10,000 after adding 1000 new customers during the quarter. From a fundamental standpoint, Palo Alto ended the period with cash and equivalents of $342 million – an increase of $20 million. Better still, the company has no debt. It’s hard to see what’s not to like.

It would seem Palo Alto is suffering from investor’s expectations that were too high to begin with. Granted, profitability was a disappointment as non-GAAP net income of $2.9 million during the quarter was considerably lower than the $5.6 million the company earned a year ago. 

On the other hand, investors have to appreciate that this is a young company with (only) two full quarters under its belt as a public issue. That it is able to grow revenues by 50% means that Palo Alto is stealing market share from the likes of Cisco (NASDAQ: CSCO), Check Point Software (NASDAQ: CHKP) and Fortinet (NASDAQ: FTNT)

For instance, in Fortinet’s most recent quarter, the company reported net income of $17.2 million, or $0.10 per share on revenues of $136.3 million. Revenues rose 17% year over year, but it arrive (only) in line with consensus estimates.

As a consequence, Fortinet’s margins took a hit. Gross margins shed 100 basis points year over year, while the company also saw its operating income decline by 1.5%.  Check Point Software didn’t necessarily outperform either. For its third quarter, Check Point earned $152.4 million, or $0.73 per share on revenues of $332.4 million.

Not only did revenue arrive below estimates of $333 million, but overall, Fortinet's numbers were pretty unimpressive. Investors punished the stock after management failed to inspire any confidence that Q4 would be much better. So at least on a relative basis it seems Palo Alto’s performance measures up pretty well.

Moving Forward

Investors have to realize that 50% revenue growth does not arrive cheaply. Although net income was down, it is because Palo Alto has been investing in its technology as it strives to set itself apart from the rest of the group. That Palo Alto is able to grow customers in high quantities in such a short period of existence proves that its capital investments are working.

What’s more, as a sign of confidence, the company guided for Q2 much higher than the street had been modeling. Management expects earnings per share (excluding items) to arrive at $0.04 on revenues coming in the high range of $94 million. Not only would this represent a 66% jump, but it also exceeds estimates of $90.8 million.

In the meantime, it certainly seems plausible that any "growing pains" pains that Palo Alto experiences will only be temporary - as in, the company might not be independent for too long. As I noted above, Cisco remains at the top of my list of potential suitors,  as I've also discussed in this recent article. Cisco cannot afford to sit idle and ignore Palo Alto's impressive growth rate.

What's more, with Palo Alto's combination of disruptive technology and addressable market, the company might one day grow and become a formidable threat to Cisco - if not through organic growth, but worse yet, as an entity of a Cisco rival. In that regard, Hewlett-Packard or Dell comes to mind.

Also, it seems with Cisco's recent transactions, including the purchase of three cloud-based companies last month, Cisco would be wise to address the future of cloud security by scooping up Palo Alto. And it's not as if Cisco couldn't finance this deal if it wanted to.

Bottom Line

With management asserting such levels of confidence, it's tough to expect investors to remain conservative in their expectations - I'm willing to concede that much. But we can't lose sight of the fact that this is still a very young company that will at some point experience some growing pains. 

It seems however that Palo Alto biggest hurdle is its own success. On the other hand, that is a problem that most companies would love to have. Investors want more growth, but the company needs is time to make its capital investments work. In the meantime, it would also help if investors had more realistic expectations. With the recent dip, I would be adding shares on weakness in anticipation of a better than expected Q2.

rsaintvilus has no positions in the stocks mentioned above. The Motley Fool owns shares of Check Point Software Technologies. Motley Fool newsletter services recommend Check Point Software Technologies. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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