- PANW reported an upside surprise to sales and earnings Thursday after the close, and guided strongly.
- After opening sharply up Friday, PANW reversed to close down.
- One issue that could be hurting the stock is the GAAP losses; I analyze them and present my case to consider PANW as solidly profitable.
- My core reason to hold this name comes from the reengagement of the techie founders along with the chance that PANW's sales and marketing efforts can improve.
- The stock is in a downtrend and is expensive and risky, however.
Palo Alto Networks (NASDAQ:PANW) operates in the cybersecurity space. I last reviewed it three months ago, after reporting on it for the first time three months before that, upon the hiring of Nikesh Arora as CEO. I've seen widely varying estimates of what the cybersecurity market size is right now and what it will grow to in 4-5 years. Numbers such as $100 B current-year market opportunity and $200 B in 2023 have been floated. That would represent about 14% annual growth, but I've also seen estimates of a 4-5 year CAGR in the 10-11% range. In any case, cybersecurity is recession-resistant, an attractive feature for any stock.
There are many very large players in the field, such as Cisco (CSCO) and other giant companies that mostly focus on other sectors within IT, or may be aerospace companies primarily with consulting arms. There are also incumbents such as Symantec (SYMC) and Check Point (CHKP). Among the larger newcomers to the field that are gaining market share are Palo Alto and Fortinet (FTNT), which is a little older than PANW and about 2/3 the size of PANW measured by sales, but has GAAP profitability. Here is a comparison of stock market performances of several comparators since PANW went public:
The chart is busy. It shows that PANW has slightly outperformed FTNT, and both have beaten SYMC and CHKP as well as the general market.
Information about PANW and its business is found in a brief Corporate Background PDF.
The first point I want to address is why I think that PANW is solidly profitable, even though GAAP shows it losing money.
Should investors go with GAAP or non-GAAP for PANW's EPS (or neither)?
This is one of the sorts of topics where I believe that reasonable people can disagree. It's also a bit difficult to discuss over the Internet in a short-form article such as this, but I'll try.
PANW is out with its 10-Q for its latest quarter, Q1 of FY 2019, which ended in October. Page 4 shows GAAP numbers:
- Revenue of $656 MM
- Gross profit of $472.5 MM
- Pre-tax loss of $42 MM
- R&D expense of $113 MM, equaling 17% of revenue
- Diluted GAAP loss per share of $0.41
- 94 MM diluted share outstanding
- Billings of $758.5 MM, up 27% yoy
If it had spent only 10% of revenues on R&D rather than 17%, I believe that PANW would have been profitable using GAAP. Note, FTNT spends less on R&D as a percentage of sales than PANW.
Is GAAP appropriate, especially in its treatment of options expense? To decide, a look at the latest Q1 press release is needed. It shows PANW claiming non-GAAP EPS of $1.17 per diluted share versus $0.75 in Q1 of fiscal 2018.
This press release helpfully provides a table titled "Reconciliation of GAAP to Non-GAAP Financial Measures." It lists 7 line items, one of which is simply the tax effect. Of the other 6, the only truly important one is the first one listed, "Share-based compensation-related charges." This shows $140.7 MM in charges in Q1 2019, up yoy from $128.9 MM.
Are these charges really hits to profit? I think not, though I accept all the other line items as valid and go with GAAP for them.
Thus, my answer to the question in this section's title is "neither," but I'm closer to PANW's non-GAAP EPS than the GAAP loss. Here's my case:
Why stock-based compensation should not be in EPS for PANW
Most of PANW's stock-based compensation involves options, as follows from p. 21 of the 10-Q:
In October 2018, we granted 2.2 million PSOs with both a market condition and a service condition to certain executives. The market condition requires the price of our common stock to equal or exceed $297.75, $397.00, $496.25, and $595.50 (the “stock price targets”) during the four-, five-, six-, and seven-year periods following the date of grant, respectively. To the extent that the stock price targets have been met, one-fourth of the PSOs will vest on the anniversary date of the grant date for such PSOs, subject to continued service.
The aggregate fair value of the PSOs granted in October 2018 was $130.0 million based on a weighted-average fair value of $59.64 per share.
I don't see a real cost here. I don't even see a contingent bonus. I see an agreement that if PANW soars to at least $298 in 4 years, through $596 in 7 years, an executive who meets the service conditions will be able to force PANW to do a private secondary stock offering. I don't see that as a loss, just a financing matter. In addition, this would obviously bring cash into the business at what almost certainly be accretive to tangible book value per share.
These conditions are aggressive. PANW could show EPS of $10 in 4 years, trade up to a P/E of 29X, and despite this success, executives would be frozen out. Where's the current period loss under that scenario?
For the above sorts of reasons, I look at stock-based compensation the older way - as dilution - and use the company's projected 100 million diluted share count for Q2 to estimate the adjustment to GAAP I mentally make.
My estimate is that a more realistic adjusted EPS for PANW in Q1 was about $.70. Annualizing that at Friday's stock price around $173 gives a P/E above 60X. Assuming sales growth decelerates to 25% yoy, that's a P/E to growth, or PEG, ratio above 2X, so PANW is expensive by that criterion.
Getting back to the options story. I'm actually encouraged that senior people, some of whom have no financial need to work, are willing to accept options on these ambitious strike prices.
Now, on to the basic reason to stay with PANW and look for compounded growth over the years.
My core investment thesis for PANW
Anything that the company says in the conference call, such as that its top 25 customers increased the lifetime value of their business with PANW by 45% yoy, is of uncertain incremental value to me as an outside investor. The Street now knows it, too. That the company added over 2,500 new customers is also a positive. It appears it is drawing near to 60,000 customers, and is deepening its relationships with them. It is also getting ready to expand its reach into the service provider field and has been moving aggressively to enhance its appeal as a cloud (and multi-cloud) security company.
All that is good, but given the high valuation, I need a big picture thesis to want to hold this name given how many stronger, larger, dividend-paying techs have dropped in price lately.
For me, the reason to be long this name comes from the potential catalysts around the hiring of Mr. Arora, the CEO. His background at Google Europe was strong, leading it to a massive sales increase well above company expectations. Later, he had a brief stint as heir apparent to Masayoshi Son, leader of Softbank (OTCPK:SFTBY), but he left when Mr. Son decided to keep his job longer than planned.
That was the first part of my reason to buy the dip in PANW to $200 6 months ago.
Then, a second - and I suspect related - matter occurred.
What followed after Arora joined PANW was that PANW's founder, Nir Zuk, re-engaged with the company. In his latest prepared remarks, Arora simply said, in reviewing the R&D program:
We’re making good progress under the leadership of our founder Nir Zuk.
This confirms and updates the comment that Arora made in his first conference call:
I’m also delighted to say that Nir Zuk and Rajiv [Batra], our Co-Founders, have both reengaged, are in entrepreneurial mode helping to accelerate our development engine and ensure we stay ahead of the evolving threat landscape.
I'm not sure about Mr. Batra's level of involvement now, but my buy-and-hold case for PANW is that the tech visionary was Mr. Zuk, and he is now essentially partnering with a superior marketer, Mr. Arora.
That's my simple core thesis, that PANW is poised to up its game in both product development and marketing - and its current game under prior leadership was already strong. Could it become supercharged?
As an aside, it is interesting to see how Sequoia, the VC firm, discusses the founding of PANW.
Macro and technical concerns
Technically, PANW is in deteriorated condition. The 50-day exponential moving average, or EMA, has crossed below the 200-day EMA, thus signifying a "death cross." At $172.95, PANW is below its price of three years ago. All is not dismal, however. The stock remains above its 200-week EMA. Over all, though, the stock and therefore the company both have something to prove. One can only guess why PANW sold off Friday even as analysts had little bad to say publicly.
I'm tentatively putting this latest and ongoing weak action primarily in the risk-off mode that has seen so many defensive stocks act unusually well. Even though cybersecurity is a defensive part of tech, it still is tech, which is a risk-on part of the market.
Many other possibilities exist, including deeper analysis of the quarter done overnight by analysts that might suggest more weakness than was seen at first glance (I'm not aware of this having occurred, though). On a different plane, Arora ended the conference call by extending an invitation to analysts to meet him at the company's offices, saying: "I have been reading many of your notes, and I know that some of you are still anxious to understand me." Perhaps the Street is still not comfortable with this gentleman as CEO.
And maybe tax-loss selling has been hurting PANW.
In any case, the Federal Reserve may be talking more dovishly, but as of now, it's still acting like a hawk with sharp talons, and PANW is acting poorly.
Concluding remarks: PANW in context
PANW is one of a handful of no-dividend stocks I'm willing to own as a retiree. It's gaining share in a great space and has dual optionality from improved sales and marketing and improved R&D. No guarantees on either, of course, but I think it's realistic to look to the upside potential here.
In summary, I believe that PANW is solidly profitable using a common-sense approach to its financials, and that its options grants are not "expenses" in the sense in which I think of profit and loss. Then, I believe that its value proposition comes first from its growing niche in a tech sector that itself is gaining share within the giant tech space. The reason I'm long this particular name comes, then, from the upside potential that under the leadership of Nikesh Arora as CEO and his handpicked top management team (including a new president), with R&D headed by Nir Zuk and possibly with Rajiv Batra back in action, PANW may be able to improve its performance both in marketing and in product development. If that occurs, PANW may be able to force the Street to adjust its long-term growth rates higher, leading to a renewed bull market in the shares.
Risks are significant.
Thanks for reading and contributing any thoughts and knowledge of the company and the cybersecurity space.
This article was written by
Analyst’s Disclosure: I am/we are long PANW, 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.
Not investment advice. I am not an investment adviser.
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