Five Reasons to Buy This Stock and Two to Avoid It

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

Palo Alto Networks (NYSE: PANW) delivered its latest sparkling set of numbers and confirmed its status as the up and coming force in a competitive IT security market. None of this is in much doubt, but as investors we are not buying the story or the company. We are buying the price of the company. So is the stock worth buying now?

Five Reasons to Love This Company

Total revenue grew 70%, but that is only part of the story. There were plenty of other plus points in these results. I’m going to highlight five of them.

Firstly, the mix of product and service revenues suggests that strong revenue growth and cash flow will follow in the future. PANW grew product revenues by over 60% in the quarter, and its current mix of product/services revenues is 64%/36%. Compare this with Check Point Software’s (NASDAQ: CHKP) 41%/59% numbers for products & licenses/software & subscription. Software and services tend to generate higher profitability and cash flow, but they are led by product revenue. In summary, PANW will clearly convert much more revenue into cash flow in the future because of its current strength in product revenues.

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Second, billings grew at 81% and much faster than revenues. This implies that growth is accelerating for PANW, although it is somewhat puzzling why PANW was a bit conservative with guidance given these numbers.

Thirdly, the company stated that its top 25 customers' follow on purchases averaged 11.4x the initial purchase, a figure up from 9.9x in the last quarter. Trust me, if this was the year 2000 we would be seeing half the investment analyst community scribbling down notes arguing that the value of the company just went up (11.4/9.9)=15%!  It’s probably not prudent to assume this--and a business is so much more than its 25 best customers--but it does demonstrate that PANW is able to increase revenues from existing clients.

Fourthly, PANW continues to replace incumbents. As usual it discussed some contract wins over Check Point, Cisco Systems (NASDAQ: CSCO) and Juniper Networks (NYSE: JNPR). It’s natural to expect such a fast growing company to be winning market share, but recall that all three of these companies have advantages. Cisco and Juniper are able to bundle their security solutions with networking equipment, and Check Point’s model is a classic razor/razorblade. In other words it wants its hardware installed in order to sell add-on software blades. Therefore it is not a great sign if its firewall solutions are being displaced.

Finally, PANW has a lot less European exposure (currently 25% less than Check Point or Cisco).

What Does All This Mean?

Essentially PANW’s pitch is that its disruptive technology enables it not to suffer extensive pricing competition. I’m not sure if this will always be the case, but there does appear to be some evidence to support this from a brief look at the market’s dynamics. Going back to Cisco's last results, its security revenues fell to minimal growth, and its main strength was in the data center. This suggests that Cisco is bundling security solutions in with other data center products.

Meanwhile, Check Point’s product revenue growth is negative, and it seems to be arguing that its new product range was encouraging customers to trade down, i.e. retain the same functionality at a reduced cost.

While Juniper, Cisco and Check Point are floundering, the other major winner in the sector is Fortinet (NASDAQ: FTNT). As I discussed at the time, Fortinet saw a substantive increase in larger sized deals in the quarter. This implies that its solutions are now being adopted by larger corporations and not just from its traditional SMB market. Fortinet is seen as one of the best ‘bang for buck’ providers whereas Check Point might be viewed as more sophisticated and expensive.  Again, I see its strength as a consequence of companies looking to secure their IT function, but at the right price.

Putting all these things together indicates a cautious but critical spending environment for IT security, and the fact that PANW is generating such strong growth with a premium product is a testimony to its quality. Perhaps it really does have a disruptive technology?

So Can I Buy the Stock?

As a GARP investor my answer is no. The company is performing very well and, as discussed above, its operational metrics (and therefore fundamental valuations) will get better in the future. The problem is that we are talking about a company on a forward PE ratio of 278 for this year and 133x next year’s earnings. That is not cheap by any measure.

Furthermore, a lot can happen in the time it takes for PANW to grow into its evaluation. Check Point could easily start marketing itself more aggressively or cut prices to get product revenues going (at the moment it seems content to ‘cash cow’ it), and Cisco or even IBM could, say, buy Fortinet at a much more reasonable price and generate immediate synergies with it.  

In conclusion, PANW is firing on all cylinders, but I think this stock is for growth investors only and, if you are so inclined (and there is nothing wrong with it), you better be prepared for substantive downside if anything goes wrong.


SaintGermain has a position in IBM. The Motley Fool recommends Check Point Software Technologies and Cisco Systems. The Motley Fool owns shares of 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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