Palo Alto Networks - Industry Tailwinds, Settlement And Customer Growth Drive Current Momentum

| About: Palo Alto (PANW)


Investors are relieved after solid results and a settlement with Juniper Networks.

The company has benefited from tailwinds on the back of high-profile cyber security threats.

Yet I remain cautious after shares nearly doubled over the past six months.

Investors in Palo Alto Networks (NYSE:PANW) were relieved by the company's third quarter results released on Wednesday after the close. The fact that the company agreed to settle its litigation issues is applauded as well by investors.

After the strong momentum amidst a favorable external environment and strong customer growth, I find shares a bit expensive.

Third Quarter Headlines

Palo Alto Networks reported third quarter revenues of $150.7 million, which implies a 49% gain year-over-year.

The company posted a $139.1 million GAAP loss versus a much more modest $7.3 million loss last year. As discussed later, this loss was largely due to settlement charges which total $175 million before-tax in total.

Based on popular non-GAAP earnings metrics, the company was profitable and posted a $8.7 million profit. Non-GAAP earnings of $0.11 per share came in four cents ahead of last year's results.

Looking Into The Numbers

Topline growth was overall impressive. Product revenues were up by 38.4% to $84.1 million. The company managed to boost gross margins of the unit by 180 basis points to 75.7% of sales.

The real strong growth came from service revenues which rose by 64.4% to $66.6 million. Gross margins of this business are slightly lower at 71.0% and improved just very modestly compared to last year.

Other costs were on the increase as well with R&D, sales and marketing as well as general and administrative costs growth all outpacing topline revenue growth. As a result, operating losses came in at $24.6 million after even excluding settlement costs. This was up sharply from a $6.5 million loss reported last year.

Just like many other technology names, Palo Alto pays a huge portion of salaries and compensation in stock-based compensation which does not impact non-GAAP earnings. These expenses more than doubled to $27.9 million for he quarter.

According to the company ¨fast facts¨ Palo Alto Networks employs about 1,375 workers at the moment. This would imply an average compensation in stock of about $20,000 for the quarter, or $80,000 per annum.

Settlement With Juniper (NYSE:JNPR)

The market was relieved that the company has finally reached a settlement with Juniper Networks. Both parties have agreed to license their patents for the rest of their life till expiration. The companies furthermore agreed not to sue each other for patent infringements in the coming 8 years.

As part of the deal, both companies have agreed that Palo Alto will pay Juniper $175 million in awards. This is split up in a $75 million cash payments, $70 million worth of common stock and $30 million worth of warrants on common stock. Shares of Juniper rose about a percent on the back of this news, as the awards of $175 million are equivalent to roughly 1.5% of its market valuation at $12 billion.

Valuing The Business

Trading around $75 per share in after-hours trading, Palo Alto's equity is valued at $5.6 billion. The company holds $368 million in cash, equivalents and short term investments and has no debt outstanding, valuing operating assets at little over $5.2 billion.

Revenues for the first nine months of the year came in at $420 million, putting the company on track for annual sales of $560 million to $570 million. Of course, profitability remains a whole other issue. At current levels, operating assets are valued around 9 times annual revenues.

Strong Tailwinds

The world's increased awareness of cyber security, as manifested by recent attacks on Target (NYSE:TGT) and eBay (NASDAQ:EBAY), have been big tailwinds for the company. Palo Alto of course sells network security solutions through its firewall-based solution.

The company furthermore completed the $200 million acquisition of Israel-based Cyvera, thereby adding endpoint protection capabilities to Palo Alto's offerings. Another promising development is the strengthening of the partnership with WMware (NYSE:VMW), having announced a new re-seller agreement for security deployments within software-defined data centers.

On top of these high-profile developments the company's operations run at a strong pace after the company reported having more than 17,000 global customers at the moment.

Implications For Investors

Palo Alto made some big steps recently, including the acquisition of Cyvera, the settlement with Juniper, as well showing strong operational growth.

High profile cyber attacks have added to the momentum as well with shares nearly doubling from levels around $40 as recent as November of last year.

Billings which came in at 129% of reported revenues only added to the backlog, but this is needed to sustain the spectacular growth. Total deferred revenues were up by 68% to $368 million.

I must say that I am very cautious after the strong momentum, with shares having doubled over the past six months. While growth is very impressive, the valuation at 9 times revenues is steep as the company is actually reporting increased operating losses at the moment. That being said, the market valuation is manageable for a big tech giant looking for increased presence in the cyber security space.

I remain on the sidelines for now.

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.