How to take a silk purse and make it look like a sow's ear
OK - maybe not a sow's ear. Even after today's haircut, no one is going to mistake Palo Alto's (NYSE:PANW) valuation for the bargain at which train wrecks can most often be had and certainly the share price is quite a bit more than the cost of a sow's ear. But come on, does someone think that PANW actually missed its expectations or that its sales people are being left to go barefoot and starving in the streets?
It has been a tough few weeks for hyper growth in the IT space. Just yesterday, to go along with unpleasantness at Palo Alto, Splunk (NASDAQ:SPLK) had its own set of concerns that have driven its shares down 8%. The other day, Pure Storage (NYSE:PSTG) fell 15% because of weaker-than-hoped guidance. Investors in these names are increasingly concerned about their valuations and their prospects in markets that some managements say are encountering macro headwinds.
For the record, Palo Alto reported that its revenues grew 48% year on year, above expectations. It reported a third successive quarter of 61-62% bookings growth and it reported that cash flow from operations and free cash flow both grew 95% in the quarter, year over year. The GAAP net loss per share in the quarter grew from $.56 to $.80 while the non-GAAP net income per share grew from $.23 to $.42.
Guidance was merely in line with prior expectations, a fatal issue for short-term share price movement of a company valued as this has been. Guidance now calls for revenues of $386 million to $390 million, which is 43-45% growth, with EPS of $.48-.50. Prior consensus expectations for both metrics were at the high end of the new range. Management does not forecast bookings or cash flow although as is the case for many companies with SaaS models, it is those metrics that are far more important to many including this writer as an indication of the fundamental health of the business.
I was surprised to see that one of the downgrades today from a professional analyst at DB was predicated on his expectation that the growth in product shipments for this company would fall from 33% to the mid 20% growth range next quarter. Perhaps it will - I really do not know. The comparison is against the relatively best quarter that the company ever printed during which total revenues grew by 59% and total bookings grew by 69%. And even Jim Cramer in his Smart Money program got it wrong. Analysis 101 - for a company like this, look at total bookings growth and not at the slowest part of it. Analysis 102 - if the legacy products are concentrated in the physical products that this company ships, and the highest growth products are concentrated in those sold on a subscription model, then it would be pretty surprising if the percentage growth of physical products didn't decline while the percentage growth of the products being sold under subscription didn't accelerate. Analysis 103 - it is more or less impossible to run a hyper-growth story in a company with a macho sales culture (politically correct or not, most IT sales cultures remain red-blooded American macho even when women and foreign nationals occupy management roles) and not brag about competitive displacements. If you really have them, of course you are going to flaunt them. I was frankly surprised not that the CEO, Mark McLauglin mentioned them, but that they had so many.
Many analysts were concerned that PANW's management said on the call that the business had reached a scale where it was now seasonal. Other observers were troubled by CEO Mark McLaughlin's repeated comments both about seasonality and about potentially negative macro influences. Most IT companies do have seasonality of some kind. The year-end, seemingly whenever it occurs is strong, the first quarter of a new fiscal year is often weaker, followed by very strong results in the succeeding quarter. That is pretty much what management at PANW has forecast and it would only have been surprising if they had not.
As to macro-headwinds - well, the company just experienced them with its 24% growth in Asia/Pac. If there is to be a significant macro slowdown, I will personally guarantee one and all that the revenues of IT companies in all sectors will be less than would otherwise have been the case. Security, web, big data and analytics will all feel the impact of a recession. IT solutions are the capital goods of this era, their revenues declined significantly both during the recession in 2001-2003 and in the great recession of 2008-2009 and they will really decline again if things start to materially decelerate in the broad economy.
Some observers, including this one, are not happy with the magnitude and growth of stock-based comp. Stock-based comp was $113 million in the quarter or 33% of revenues compared to $64 million or 27% of sales in the year earlier period. The fact that Palo Alto is located in Silicon Valley is no new thing. The fact that there is strong competition for talent in the Bay Area is no new thing. No one is faulting this company for doing what it needs to do in order to hire new employees. What observers, including this writer object to, is the use of the stock-based comp expense as a piggy bank to enhance headline EPS. No matter how well accepted it is amongst tech companies, tech investors certainly do not have the same sanguine view of the practice. The concept on its face is both silly and pernicious. Stock-based comp is a real expense and it should be used by investors in evaluating companies. And so far as it goes, it is a real expense and the management of this company, as well as others, should use the real costs including stock-based comp expense in evaluating their spending priorities. As I mention below, I like to use both operating cash flow and free cash flow as the best indicators of profitability, but that certainly does not mean that I think this company can go on without addressing its out-of-control stock-based compensation expense.
Some analysts were concerned that the long-awaited operating leverage except on the G&A line has yet to be seen in terms of GAAP results. PANW's shares were hardly cheap before a quarter and guidance that many perceived as "not good enough." Using the share price indicated this morning, EV/S is now 7.4X. The EV/S on the consensus revenues forecast for fiscal 2017 (ends 7/31/17) is 5.5X. These metrics are high to be sure, but certainly comparable to EV/S ratios of many other hyper-growth companies.
The P/E based on the currently indicated share price is 77.7X. Even looking a year ahead, the P/E on the consensus expectations for fiscal 2017 earnings is 49X. Of course these are non-GAAP earnings. This company is a long way from GAAP profitability. The combination of high valuation and some modestly cautionary language during the call regarding headwinds from economic macro weakness is bad enough. Couple that with comments regarding seasonality and a revenue model that is at best not understood by all (sadly including men who really ought to know better and seem not to understand the difference between product sales and subscription revenues) is a formulation for a witches' brew that is inflicting severe pain on the shares today.
There have been two opinion downgrades and several price target reductions I have seen so far this morning and it would not particularly surprise me if there are others. It is what to expect after a quarter that was displeasing to some and left room for observers to spin negative theories. But at this point, I believe that those theories are inaccurate. I will spend the rest of this article talking about a more nuanced view of what is actually happening at PANW and whether investors should look to use this pullback and perhaps further pullbacks in the next couple of days as an entry point in the shares. Just for those readers who might otherwise expire with suspense, I believe that buying PANW's shares over the next couple of weeks will produce positive alpha for investors.
So what really happened and why
Let's start out by pointing out the less controversial components of the facts as they now exist. One thing that is evident is that PANW continues to grow significantly faster on a percentage basis than any of its smaller or larger rivals, which is not what you might expect to see in a market like this. I recently wrote about how this company was poised to shortly overtake Check Point (NASDAQ:CHKP) as the largest company in cybersecurity at least on the basis of reported revenues. In the most recently published Gartner Magic Quadrant report for Enterprise Networks firewalls, Palo Alto and Check Point are essentially tied. Fortinet (NASDAQ:FTNT) and Cisco (NASDAQ:CSCO) are called challengers and 13 other companies are in the dreaded niche box. There are no prizes to be had for guessing if there are any of these vendors, some large like Cisco and Hewlett Packard Enterprise (NYSE:HPE) and most small like Sophos and WatchGuard which are growing at rates anywhere within hailing distance of 60%, which I would use as a proxy for the real growth rate of PANW.
There is no compelling reason for me to try to put all of PANW's products under a comparative microscope. Whatever else is true it is that this company is growing significantly faster than its competitors and is developing new offerings at a rate that should protect its market share gains into the future. The company's latest two offerings Aperture and Traps are both performing strongly for this company and both of them represent opportunities that are new worlds to conquer for this company. Just by the way, both Aperture and Traps are sold using subscription pricing. The company will gain market share for the foreseeable future absent some kind of black swan event.
I doubt that anyone is going to talk about competitive pressures as a problem for this company. There appears to be some myth that heretofore the network security business was not competitive. If almost all companies in the space spend half or more of their revenues on sales and marketing, the idea that competition is some new thing, politely said, is misguided.
Management talked about some very high-profile competitive displacements and was as forthright as well in its commentary about its competitive positioning as it was regarding incipient seasonality and the influence of macro-events on its results both current and in the future. If managements seem transparent in terms of showing areas that might be considered problems, I have to regard their credibility as significantly higher than management teams that wish to deny the obvious.
In one of its recent evaluations, Gartner suggested that this company's endpoint security offering which it calls Traps might not have the same incredible success of the company's core enterprise firewall offerings. Management presented figures and articulated that Traps was achieving the kind of growth it had forecast. Endpoint security is a newer market for PANW and it is an opportunity for the company to sustain its growth rate.
The overall cybersecurity market is immense by any standards. Aggregate revenues for cybersecurity were about $75 billion last year and are forecast to reach $170 billion by 2020. That's a CAGR of 10%, which is hardly shabby in this era of constrained IT budgets. Based on the overall mix of revenues and the growth in bookings compared to revenues, it would be difficult to maintain that PANW is not growing at something more than 3X the aggregate growth of its competitors. If the market size is $75 billion and PANW has revenues that have not yet started to approach $2 billion, the conclusion that I would draw is that there is plenty of headroom for this company to grow in greenfield bids and in competitive wins.
It was true that the quarter exhibited some signs that PANW's business is influenced by macro trends. The Asia/Pac region had much slower growth than the other geos and grew by just 24%. This was attributed to some deals, particularly in Australia, that were inhibited by the concerns of the customers about their ability to spend money on cybersecurity when their own businesses were turning down. The quarter did evince that PANW has vulnerabilities in the macro sphere. It may or may not, depending on the point of view, expect that its growth rate would be impacted by the law of large numbers. But the quarter also illustrated that at a different level than headlines, the company's growth is not slowing either materially or unexpectedly, but that its growth is now being reported in different buckets than heretofore.
So what about those different buckets? If you are going to understand the issues at Palo Alto - or indeed the lack of real issues, the company's hybrid revenue model has to be explored and understood. It is really the hybrid model that has led to the results we have seen and it is a major influence on guidance as well. Palo Alto does have a bit more complicated model than some companies - but the model is not particularly new. I might have thought that in a company like this - investors and observers would take a look at bookings growth and at cash flow as a better indication of business health when compared to reported or guided revenues and reported or guided non-GAAP and GAAP earnings.
Palo Alto is not quite a software company and it does not have a purely SaaS revenue model. And therein lie some problems that investors and observers have to face in trying to value this company. The company sells physical appliances and is likely to continue to sell physical appliances for the foreseeable future. Many users are going to want to buy their firewall appliances because they know they are going to be around more or less indefinitely. Palo Alto also offers virtualized next-generation firewalls. And it offers several of its solutions including AutoFocus, GlobalProtect, Threat Prevention, Aperture, Traps and the very successful Wildfire solution. Some of the subscription solutions are bought with appliances and some are sold on their own.
At the moment, the company offers eight solutions on a subscription basis with various kinds of available terms. Some of the subscriptions that are offered are not attached to hardware and these are the fastest growing part of the subscription offerings. Not terribly surprisingly, the revenue contribution from the company's SaaS offerings is growing far faster than are any of the other revenue components. Product revenues, again not terribly surprisingly, are still the largest component of the revenue mix. And they are seeing a growth slowdown and that will continue. Product revenues were $162 million last quarter and that was up 33%.
But the future for this company is in its subscription revenues. I do not mean that from a product standpoint - but from a financial standpoint. Subscription revenues grew by 69% last quarter and reached $93 million. The performance of maintenance revenues wasn't shabby either as that category grew to $91 million, up 57% year on year.
This kind of transition in which hardware or on-premise revenue growth declines and subscription revenue growth ramps is hardly unique to PANW and many readers and most analysts will have seen it before. If a company is dealing with a finite level of demand, and if subscription revenues are rising more rapidly than bookings, then the math says that product revenue growth has to slow. And so it has. Personally, I think that the transition is good for shareholders. Recurring revenues are now 53% of the total. The stickiness of PANW's software is going to be incredible. The only way it is leaving a customer premise would be if the enterprise shut down or if the user wants to upgrade at some additional payment to some later incarnation of technology.
One thing that happens is that when a company starts to offer subscriptions, deferred revenue starts to increase. Actually the dollar growth in deferred revenues just about doubled over the past nine months during which it reached $355 million. Deferred revenue on the balance sheet has now grown to $1.1 billion, which is double the deferred revenue balance a year ago. The company, to this point, has not discussed whether or how much non-booked deferred revenues may have come to exist.
My contention is that only by looking at the constituents of Palo Alto's revenues can an investor derive some accurate evidence of the company's momentum or lack thereof. Overall, revenues coming from the sale of physical products are decelerating and likely will continue to decelerate. But the percentage growth declines in the realm of physical products growth for this company does not mean that its growth as a whole is decelerating or that it is still growing its market share. Indeed, why should it not continue to gain market share. The company has essentially entered new parts of the security space with both Aperture and Traps. Those are hot products for PANW and they are sold on a subscription basis. That is where the fastest growth is, but it is obscured to a degree because those products have subscription pricing.
There's no objective evidence to the effect that Palo Alto is approaching senescence or even middle age. The subscription growth rate will slow down in the near future because it is impossible mathematically for it to keep growing at 69% as the balance of deferred revenues continues to build up. But the bookings growth rate can sustain more quarters of 60% growth, and I think Q4 will prove to achieve that level unless there's a marked acceleration in global headwinds.
To sum up this section, all that I think is happening is that this company is in the midst of a transition from mainly selling physical hardware to now selling lots of subscriptions. It is, perhaps, more difficult to meld those two revenue buckets together in order to get an accurate picture of growth. But, overall, while this company has seen impacts from macro conditions and will continue to do so, its market share gains are continuing unabated and its overall positioning or the growth rate of the cybersecurity market has not deteriorated.
Well, you always have to get to that. The question at the start and at the end depends on valuation. No matter if the PANW outlook is quite a bit better than it may seem - the question is can you achieve positive alpha by buying the shares over the next few weeks. I have mentioned that the valuation of these shares in the first section of this article remains at elevated levels even in the wake of today's share price decline.
The one other metric that I think is worth considering is that of the free cash flow yield. Based on current trends, it appears that this company will achieve operating cash flow of $650 million this fiscal year. That would suggest that calendar 2016 cash flow would be about $800 million. I think that capex for the calendar year is likely to be $100 million. So that yields a free cash flow of $700 million this calendar year. At current prices, the company has a market cap of $11.4 billion, and the net amount of cash and equivalents on the balance sheet was reported at $1.3 billion. So that yields an enterprise value of $10.1 billion. The free cash flow yield on enterprise value is about 7%, one of the higher yields available among hyper-growth enterprise IT companies.
If cash flow is more important to you as an investor than either GAAP or non-GAAP EPS, the valuation of PANW is far more compelling than you might otherwise believe. The only way to objectively measure and value the results of companies that are making the transition from selling physical products to selling multi-year subscriptions is to look at the free cash flow yield. The other standard valuation metrics will yield inaccurate conclusions over the long term, in my opinion.
Palo Alto reported the results of its third fiscal period that ended on April 30, 2016. While revenue was a significant beat and bookings and cash flow were strong compared to prior expectations, the EPS beat was smaller as a percentage than it had been in the past. And management talked about a back-end loaded quarter as evinced by DSO of 70 days.
Management guidance, which was not greater than previous consensus estimates, was quite disappointing to many investors. In addition, cautionary comments from Mark McLaughlin, the company CEO, and Stefan Tomlinson, the company CFO, regarding macro headwinds and seasonality further spooked investors. The shares are still highly valued, but the share price compression of about 13% on the day and more than 27% year to date.
Even after the share price compression, the valuation metrics are quite elevated except significantly when it comes to the free cash flow yield that is 7%. The high free cash flow yield is a function of the company's hybrid revenue model, which apparently confuses some and leads others to make unsupportable statements. A company such as this, that is transitioning much of its revenue stream from the sale of physical products to the sale of subscriptions is, to an extent, replacing one source of revenue that is recognized immediately with another source of revenue that is recognized over several years. This impacts not only reported revenue growth, but also impacts profits as well as many expenses, including sales commissions, are recognized on deal signing and not when revenue is recorded. Much of the negativity surrounding this name is because some observers think that the forecast for product revenue growth of 33% marks a real growth slowdown for the company. Those observers are totally ignoring the hyper growth in subscription revenues, which grew 69% last quarter, and are likely to achieve a similar performance this quarter based on inferences that can be drawn from management comments during the conference call.
The company is continuing to significantly gain share in the cybersecurity space. It seems to be having significant success with its two major new products; Traps and Aperture seem to be opening new markets for the company which are greenfield opportunities.
Investors are ignoring the strong bookings and the hyper growth in cash flow generation to focus on growth constraints that have far more to do with the business model transition than they do with any actual slowdown in the company's business. Usually, in the wake of these share price disasters, the bloodletting is not over in a single day. I do think the new valuation and the overall misunderstanding of the causes of the apparent revenue growth slowdown afford investors a decent entry point in the name, but I would wait a few days before starting to establish a position. It is a lot easier for me to recommend the shares today than it was before the earnings release and concomitant valuation compression.
Disclosure: I/we 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.