Seeking Alpha
Long/short equity, special situations, value
Profile| Send Message|
( followers)

Shares of Palo Alto Networks (NYSE:PANW) have made a move towards the downside after the network security platform company reported its third quarter results on Thursday after the close. Despite a boost in sales and marketing efforts, revenue growth rates continue to decline. Given this development and the negative impact to the bottom line I remain on the sidelines with a slightly bearish stance.

Third Quarter Results

Palo Alto Networks generated third quarter revenues of $101.3 million, up 54% on the year before. Revenues were up "merely" 5.0% from second quarter revenues of $96.5 million and fell short on consensus estimates of $103.4 million.

The company added over a 1,000 new customers in the past quarter alone, bringing its total customer base towards 12,500. Deferred revenues grew by a solid 88% to $219.3 million, and were up 17% on the quarter before. Billings for the quarter were quiet strong, increasing by 57% on the year to $132.4 million, for a book-to-bill ratio of 1.31

Non-GAAP earnings fell from $4.7 million last year to $4.5 million. As a result, non-GAAP earnings fell by a penny to $0.06 per share, beating consensus estimates by a penny.

Net losses came in at $7.3 million, or $0.10 per share. This compares to second quarter losses of $0.04 per share and earnings of $0.00 per share last year.

CEO Mark McLaughlin commented on the results and the developments over the past quarter, "In our fiscal third quarter, we continued to gain market share, rapidly acquire new customers and extend our penetration within existing customers."

A Closer Look At The Results

Third quarter revenue growth was driven by a continued growth in service revenues which came in at $40.5 million, up 82.6% on the year. Product revenues were up by 39.7% to $60.8 million.

Gross margins expanded by 110 basis points to 72.7%, as service revenues which grew relatively faster carry higher margins. At the same time operating expenses continued to climb. Sales and marketing expenses rose by 5.1 percent point to an incredible 51.1% of total revenues. Research & Development expenses came in pretty flat at 15.8% of revenues while selling, general & administrative expenses rose by 2.3 percent point to 12.1% of revenues.

All in all, operating losses came in at $6.5 million compared to a break-even level last year. The reason is simple, growth in expenses outpaced revenue growth.

A Poor Guidance

Besides the poor revenue numbers for the third quarter, investors and analysts were also disappointed with the outlook for the final quarter of Palo Alto's fiscal year. The company expects to report adjusted earnings of $0.06 per share on revenues of $106 to $110 million for the fourth quarter.

At the midpoint of the guidance, revenues are expected to increase by 6.6% sequentially, and by 43% on the year. The guidance fell short on consensus estimates of adjusted earnings of $0.07 per share on revenues of $114 million.

Valuation

Palo Alto Networks ended its third quarter with $361.7 million in cash, equivalents and short term investments. The firm operates without the assumption of debt, for a solid net cash position.

Revenues for the first 9 months of its fiscal year came in at $283.7 million, up 58.1% on the year before, driven by a 94% increase in service revenues.

The company reported a net loss of $13.4 million compared to a profit of $5.3 million a year ago. At this rate the company could report annual revenues of $390 million, on which it is expected to report a modest net loss of around $15-$20 million.

Factoring in a 10% decline in Friday's trading session, the valuation of Palo Alto has fallen to $3.4 billion. Excluding the net cash position, operating assets are valued at around $3.0 billion. This values the firm at 7.7 times its fiscal 2013 expected annual revenues and about 200 times non-GAAP earnings.

Palo Alto does not pay a dividend at the moment.

Some Historical Perspective

Like many of its peers, Palo Alto has only recently got its public listing, back in July of 2012. Shares were offered to the public at $42 per share, after the company was looking to sell its shares initially in a $38-$40 price range. Shares did manage to gain some ground towards $70 in September, but have traded in a $50-$60 trading range from November onwards, currently exchanging hands around $48 per share.

Between 2009 and 2012, the company has witnessed phenomenally quick growth. Revenues rose from $13.3 million in 2009 to $255.1 million over the past year. The company turned a $19 million loss in 2009 into a very modest profit of $0.7 million over the past year.

Investment Thesis

The public offering and the year following have been a disappointment for investors, with shares trading merely 16% above the offering price range.

The rapid growth slowdown is attributed by Palo Alto Networks itself to US budget costs and continued European worries. Investors are not entirely "buying" these explanations given the fact that other competitors have not seen such steep declines in revenue growth rates and governmental revenues account for a minority of total revenues.

Investors are worried about the continued slowdown in revenues on the year. The fourth quarter outlook calls for a 43% increase in revenues on the year, down from 54% in the past quarter. In comparison, at the second quarter, revenues were still up 70% on the year.

Obviously it becomes more difficult to grow at high rates as the company continues to expand, but competitors are stepping up as well, including Checkpoint Systems (CKP) and Cisco Systems (CSCO).

In particular, investors are worried about the continued slowdown in product revenue growth, despite the fact that demand for online security continues to grow. A bit conflicting is the continued grow in the backlog, as book-to-bill ratios continue to be very healthy. Yet it does not appear to be the case that Palo Alto has a conversion problem of translating bookings into revenues. Rather, the company sees some genuine weakness in growth for its services.

Overall I think the slowdown in revenue growth is quite severe. This is especially the case considering that profits have come under pressure recently and the company spends an incredible 51 cent on each dollar of revenues being generated on sales and marketing expenses.

I remain on the sidelines with a bearish stance. While I think the current valuation is way too high given the reasons mentioned above, I remain hesitant to short. Palo Alto Networks has a modest market capitalization, and one cannot rule out an offer from an established technology company in order to establish a solid base in a promising long term growth industry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Palo Alto Networks - Revenue Slowdown And Margin Pressure Does Not Bode Well For The Future