Palo Alto: Some Concerns Despite Excellent Q1 2019 Results

Summary

• Palo Alto reported fiscal Q1 2019 earnings above expectations.
• The stock doesn't move despite the encouraging results and guidance.
• Share-based compensation, marketing expenses, and Amazon are sources of concern.
• The market still prices the company for growth above the market rate.

Palo Alto (NASDAQ:PANW) reported fiscal Q1 2019 earnings. Both top line and bottom line exceeded expectations. And the company announced an optimistic guidance for the next quarter.

But the stock price is insensitive to these positive developments despite the important drop over the last few months. The valuation is now in line with some competitors. The market takes the elevated share-based compensation (SBC) and the high marketing expenses into account.

In any case, with an enterprise value to sales (EV/S) ratio above 6, the market still prices the company for revenue growth above the market rate.

Image source: Tumisu via Pixabay

Earnings above expectations

Management had communicated the following guidance for fiscal Q1 2019 (source: Q4 2018 press release):

• Total revenue in the range of $625 to $635 million, representing year-over-year growth between 25 percent and 27 percent on an ASC 606 basis.
• Diluted non-GAAP net income per share in the range of $1.04 to $1.06 using 98 to 100 million shares on an ASC 606 basis.

And the Q1 2019 results exceeded the guidance by a wide margin. Revenue grew 31% YoY to reach $656 million. Consistent with the revenue growth, billing and deferred revenue grew by 27% and 34%, respectively. The growth is also consistent across all segments and all geographies.

Diluted non-GAAP net income per share amounted to $1.17 compared with $0.75 last year.

As expected, the company is still growing faster than its main competitors. Two weeks ago, Cisco (CSCO) announced its security segment revenue grew by 11% YoY. Check Point (CHKP) and Fortinet (FTNT) earlier reported a revenue growth of 4% and 21%.

In a security market that is expected to grow by about 10% over the next few years, Palo Alto is still growing its market share.

Beyond the excellent results, the company released an optimistic guidance for fiscal Q2 2019 (Source: Q1 2019 press release):

• Total revenue in the range of $675 to $685 million, representing year-over-year growth between 24 percent and 26 percent on an ASC 606 basis.
• Diluted non-GAAP net income per share in the range of $1.20 to $1.22 using 99 to 101 million shares on an ASC 606 basis.

The stock price is still underperforming

The chart below shows the stock underperformed its main competitors since Nikesh Arora took over as CEO on June 1, 2018. I didn't include Cisco in the chart as security represents a small part of Cisco's revenue.

PANW data by YCharts

And despite the fiscal Q1 2019 earnings above expectations, the stock price is still stagnating. Several reasons explain this situation.

Before June 2018, the EV/S ratio exceeded 8 while Fortinet's PS ratio stayed below 6. The market is now giving a similar EV/S ratio value for the two fast-growing security companies. The profile of Check Point is different and the valuation comparison doesn't apply. The Israeli vendor is a slow growth company realizing net margins above 40%. Palo Alto and Fortinet are generating much lower net margins, privileging revenue growth.

PANW EV to Revenues (TTM) data by YCharts

Another reason for the lack of enthusiasm comes from Amazon (AMZN). The giant cloud provider announced some new security services two days before Palo Alto's earnings. The features Amazon provides don't compete with Palo Alto's solutions. But the market worries about a further expansion of Amazon into the security market.

This concern is exaggerated, though. Amazon is one of the giant public cloud providers. It can't offer the multi-cloud solutions Palo Alto propose. Amazon would need to partner with its biggest competitors like Microsoft (MSFT) and Alphabet (GOOG) (GOOGL).

Finally, the GAAP results are not as spectacular as the headlines suggest. As I wrote here and here, Palo Alto offers large SBC to employees. The annualized Q1 2019 SBC represents about $100,000 per employee.

With SBC amounting to $1.44 per share during Q1, the non-GAAP EPS of $1.17 turn into negative GAAP earnings. The table below highlights the impact of the SBC on the GAAP results.

Source: Q1 2019 press release

We can also see the dilution effect of the SBC with the increasing number of shares YoY despite $125 million of share buyback during fiscal Q2 2018.

Sales and marketing expenses still represent about 48% of revenue. With scale, these expenses as a percentage of revenue are decreasing. But the sustainability of revenue growth with lower marketing expenses is uncertain.

The CEO also mentioned being aware of some doubts about him. At the end of the conference call, he proposed - in a funny way - some discussions to remove doubts:

I have been reading many of your notes, and I know that some of you are still anxious to understand me. [...] We're going to try and schedule over the next three weeks for sales side analyst to come visit. [...] That way hopefully next time around when I read your notes, you won't be as anxious about me. I am anxious enough about myself. I don't know need you to be more anxious about me.

In any case, with an EV/S ratio above 7, this valuation doesn't provide a margin of safety if the growth expectations don't materialize in the long run.

Conclusion

The company reported Q1 2019 results beyond expectations across all segments and all geographies. The revenue growth, way above the security market growth, is expected to continue. Besides the billing and deferred revenue growth, the company provided an optimistic guidance.

But despite these results and despite the recent stock price underperformance, the stock price is staying around $176. From an EV/S ratio perspective, the market now values Palo Alto at the same price as Fortinet. The SBC scheme and the high marketing expenses can explain the stock underperformance.

At an EV/S ratio above 6, the stock price doesn't provide a margin of safety. If the company can't keep on growing at this pace while reducing the SBC and the marketing expenses, the stock price will drop further.

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Analyst’s Disclosure: I am/we are long CSCO. 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.

Comments

[tradeduck]

Also, my big concern right now is the high volume. Lots of distribution... Volume through the roof on good news ... Concerning short term ... Investor are nervous, does someone sees something I don’t? But I don’t understand why those risk would not apply to ftnt .

[tradeduck]

Love your perspective and well explained argument. However, how does it make sense to value PANW same as FTNT if PAN is growing faster ? Also the threat of cloud should affect both cie. In fact, the leadership change in PAN by bringing cloud native leaders should reassure market. I think PAN should use period of weakness to buy back stock to offset dilution, and then can do a calculation of how much the sbc is really costing the cie. That would clear up some opinions. Maybe the management would realize the true cost, or the street would see it as more benign (don’t know how it would fall).

[Option007]

Ridiculous. I'm glad you shared your bias (Cisco disclosure) in your interpretation of the information. Let me share a different point of view on your points.
1. SBC: Surely you're aware of how competitive the Tech field is. To be the best you need to recruit and retain the best possible employees. ESPECIALLY in cyber security! If it takes a generous SBC then you stay the course.
2. Marketing: Again, large cost but.. is it working when you compared the growth of PANW to other companies? Yes? Stay the course.
3. Amazon: As you said, not an issue.

Bottom line this company continues to give strong guidance and then beat It! No one should be questioning how they spend as long as they keep it up. And it makes it worth the higher valuation.
Long PANW

[Howard Hunt]

Agree this is a good write up, but as a long term holder of PANW, I'm not seeing anything really new here. The level of SBC is certainly not new. So with a beat on top and bottom, an increase in mkt sh, and a raise on guidance, I feel comfortable continuing to hold, and a further dip in the px would no doubt: tempt me further. Also, I'd like to propose another tempting idea. At least for me, and given the generous SBC wouldn't a sharing of some cash flow...say ...a 2 cents a qtr. for starters be nice?... (My 2 c.).

[Puche]

Interesting article. I happen to agree with many of your points. PANW is a solid company that appears to be a leader in the security space. The recent pullback from the $235 range definitely makes the stock cheaper but not cheap enough for me to want to build a position. IMO PANW does an excellent job marketing itself to the street and less time developing innovative. I know I’m in the minority when I say that PANW is a current leader in the security space that IMO continues to be overvalued. Of course that’s just my two cents.

Slow and steady! Good luck to all!

[douglascoates]

Thanks for the article - I hadn't spotted the SBC scale or impact.
I hold PANW but I'm convinced it will just drift downward for a quarter or two, maybe longer.
I'm on a loss but I'll cut it now I think.

[Hervé Blandin]

Thanks! Do you have some explanation about the market reaction despite better results than expected?

[Raymond Chung, CFA]

i would not cut, this is probably the best time to get in, since a few years ago.

[douglascoates]

Herve - where's e acute on a Mac keyboard?!!
Saw this with CYBR recently, excellent results, one day bump then back to pre-results level, then a drift down.
My guess is macro market mood is cautious to negative. Up to end September this year we'd have seen an 8% gain maybe, now even really good results get a hold. And weaker results get you a 40% drop - see NVDA :)