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Shareholders of Palo Alto Networks (PANW) have seen solid returns into, and immediately after, the release of the company's fourth-quarter earnings report.

Despite the impressive results, I remain on the sidelines on valuation motives, and the use of excessive non-GAAP stock-based compensation.

Yet I acknowledge the potential of the firm and will refrain from taking a short position given the promising industry prospects, the limited float, and the possibility for a take-out by an established technology player.

I remain on the sidelines.

Fourth-Quarter Results

Palo Alto Networks generated fourth quarter revenues of $112.4 million, up 49% on the year before. Revenues came in ahead of consensus estimates of $108.9 million.

GAAP net losses more than tripled from $4.6 million to $15.8 million, as losses per share increased by four cents to $0.22 per share.

Non-GAAP earnings doubled to $0.06 compared to the year before, in line with consensus estimates.

Looking Into The Results

Revenue growth was driven by service revenues, which were up by 78.4% to $46.9 million. Product revenues were up by 32.4% to $65.5 million.

The increased scale boosted operating margins by 160 basis points to 73.1% of total revenues. Margin expansion was driven by a favorable product mix as well as cost reductions.

At the same time, operating expenses rose by 210 basis points to 79.2% of total revenues. This was entirely explained by a 320 basis point increase in sales & marketing efforts, which totaled 53.1% of total sales.

Upfront investments in this category, notably customer acquisition efforts, are recognized upfront. Therefore they do not keep pace with service revenues on sales which are recognized over the entire duration of the contract.

Operating losses increased from $4.2 million to $6.9 million. Net losses came in at $15.8 million on the back of an almost $9.0 million income tax provision.

And Looking Ahead

Palo Alto Networks sees first quarter revenues of $118 to $122 million, up 37 to 42% on the year before. Revenues are seen up 7% on a sequential basis at the midpoint of the guided range.

Non-GAAP earnings are expected to rise by a penny on a sequential basis to $0.07 per share. The outstanding share base is seen between 76 and 78 million shares.

Analysts were expecting Palo Alto Networks to guide for non-GAAP earnings of seven cents per share on revenues of $119 million.

Valuation

Palo Alto Networks ended the quarter with $419.6 million in cash, equivalents and short term investments. The company has no outstanding debt, for a solid cash position

Full year revenues for the fiscal year of 2013 came in at $396.1 million, up 55% on the year before. A $0.7 million profit in 2012 turned into a $29.2 million GAAP loss, although non-GAAP earnings rose slightly to $16.0 million.

Trading around $48 per share, the market values Palo Alto at $3.4 billion, or its operating assets at $3.0 billion. This values operating assets at 7.6 times annual revenues and some 200 times non-GAAP earnings.

Palo Alto Networks does not pay a dividend at the moment.

Some Historical perspective

Back in July of 2012, shares of Palo Alto Networks were offered to the general public at $42 per share. Shares have risen to highs of $72 in September of last year, and have fallen back to lows of $40 in July of this year. After witnessing a modest upwards trend in recent weeks, shares are exchanging hands at $48 per share.

Between the fiscal year of 2009 and 2013, revenues have grown from merely $13 million to $396 million, while net losses have remained under control.

Investment Thesis

Palo Alto continues to report stellar revenue growth, while GAAP losses widened to $15.8 million. This is partially driven by large tax provisions, but also by $14.2 million in stock-based compensation.

With a headcount of 1,147 workers at the end of the quarter, this translates into $12k in quarterly share based compensation for the average employee. I am skeptic about excluding these costs in the true cost of operations, as apparently the company needs to pay this to retain and attract workers. While this does not result in actual cash outflows, it does cause real dilution to its shareholders.

Network security becomes increasingly more important given the relative importance of data for organizations, the consequences of misuse of this information, and the fact that more applications are being accessed from the cloud. Palo Alto competes with the big guys in this area including Cisco Systems (CSCO), Juniper Networks (JNPR) and Check Point Software (CHKP).

The company remains committed to outgrow the competition and gain market share in an already fast growing industry. As a testimony to this success, Palo Alto added over a 1,000 new customers for the quarter, bringing the total count to 13,500.

This boosted deferred revenue to $249.2 million, which was up 84% on the year before. Besides adding new customers, intensifying relationships with existing customers is another source of growth. Its top 25 customers have purchased a total of 15 times the value of their initial purchase amount on a lifetime basis.

The hybrid revenue model is working, as recent billings boost service and maintenance revenues going forwards. With high retention rates of over 85%, these sources of revenue are really attractive and "guarantee" revenues going forwards.

This is especially nice if the company continues to announce major customer wins. The strong service revenue demonstrates the power of the hybrid model. Typical maintenance and service revenue packages run at 35% of list prices per year.

Palo Alto remains upbeat, driven by the success of WildFire, the detection and prevention offering. Some 2,000 customers have signed up for this offering, including 630 premium subscriptions.

Back at the start of June of this year I last took a look at the company's prospects. I concluded that the revenue slowdown and margin pressure in the third quarter does not bode well for the immediate future amidst US budget costs and the still struggling European economies. Yet the reported 49% revenue growth in the fourth quarter is hardly below the third quarter growth rate of 54% and comes in ahead of the guided 43%.

I was a bit bearish at the time given the weakness in revenue growth and pressure on GAAP margins. Yet I concluded to not initiate a short position as well, recognizing that the company has grown from nothing to a $400 million business in 5 years. Add to that a solid balance sheet and there is no reason to panic over these modest losses.

I remain on the sidelines with a slightly bearish stance. While I think the current valuation is way too high given the current valuation multiples, 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 with ambitions to establish a solid base in a promising long term growth industry.

Source: Palo Alto Networks: Solid Quarter, Solid Outlook