Palo Alto Networks was up more than 30% for the year heading into this week, but saw its year-to-date gains cut in half after a sluggish fiscal Q1 report.
Despite the weak quarter, annual EPS estimates remain strong, with new EPS highs expected in FY-2021 and FY-2022.
The bulls are going to want to defend the $200.00 level on a monthly close, as this is now the third test of the long-term uptrend line this year.
While the Software Sector (BATS:IGV) started the year off with a bang before getting derailed briefly in August, Palo Also Networks (NYSE:PANW) has been beating to its own drum. The stock topped in Q1 well ahead of other software leaders like Okta (NASDAQ:OKTA) and Zscaler (NASDAQ:ZS) before beginning a sharp 30% rally while the index was under pressure. Unfortunately, the company's fiscal Q1 2020 results missed the mark, with a slight revision lower in EPS guidance related to its Aporeto acquisition, and weakness in core firewall revenue. Besides, while revenue growth came in strong at 18% year over year, this marked the lowest sales growth rate of the past two years. Not surprisingly, Palo Alto Networks found itself down more than 10% following its report, and the stock is now near testing its long-term uptrend for the third time in the past twelve months. As long as the bulls can defend the $198.00 area on a monthly close, new highs aren't out of the question in 2020. However, a monthly close below $198.00 would be a negative development and the first sign of an intermediate-term change of character in the stock.
Palo Alto Networks continues to be a leader in the Software space, putting up an incredible 450% return since 2014, and an 18% return thus far this year. While the stock was outperforming the S&P 500 heading into the home stretch last week, this week's earnings release has derailed the stock a little, with a 12% gap down last Monday after a mixed fiscal Q1 report. The company reported revenue growth of $771.9 million, which was up 18% year over year, but this also marked a 400 basis point decline in revenue growth rates on a sequential basis. This is the second consecutive quarter of deceleration in revenue growth rates, with the last three quarters coming in at 28%, 22%, and 18%, respectively. Unfortunately, based on revenue estimates, it looks like the prior 28-32% range for revenue growth is a thing of the past. While this isn't a huge deal, it suggests that the company will likely have a tougher time delivering earnings surprises going forward. Let's take a closer look at the growth metrics below:
If we take a look at annual earnings per share (EPS) below, we can see that FY-2020 is expected to be a transition year for Palo Alto Networks, with the first year of negative earnings growth in nearly a decade. While FY-2019 earnings came in at $5.45, current estimates for FY-2020 earnings are sitting at $4.96, forecasting a 9% drop in profits for the year. The good news, however, is that this is expected to be a one-off. FY-2021 earnings estimates are sitting at $6.25, and FY-2021 EPS estimates are currently pegged at $7.69. Therefore, this minor hiccup in FY-2020 earnings is not a material issue as this is not likely to be the peak for earnings.
For my criteria when selecting growth stocks, I prefer growth stocks that are growing annual earnings per share at 12% at a minimum, and Palo Alto Networks has met these criteria for the last several years. While FY-2021 earnings growth is expected to come in at 27%, this significant jump is only coming after a 10% drop in earnings. Therefore, we can discount the 27% growth expected for FY-2021 as it's lapping a 10% drop. If we average out this growth on a two-year basis, annual EPS is only likely to grow a total of 15% (7.5% annually) from FY-2019's $5.45 to FY-2021's $6.25, and this is well below the 12% minimal EPS growth I'm looking for. Based on this, it's clear we are seeing some deceleration in earnings after three straight years of 30% plus earnings growth rates. To summarize, while annual earnings per share are expected to continue to new highs, which is a positive sign, the growth rates are somewhat underwhelming when compared to prior years.
If we move over to revenue growth rates, we also see some pretty material deceleration here. Revenue growth rates were consistently in the 28-32% range for FY-2018 and most of the FY-2019, but we've seen a deviation from this in the past two quarters. Q4 2019 revenue growth came in at $805.8 million, or 22% year over year, and fiscal Q1 2020 revenue growth came in at $771.9 million, or 18% year over year. This figure marked a 400 basis point deceleration sequentially in revenue growth rates in the most recent quarter, which followed a 600 basis point deceleration in Q4 2019. Based on this, we are seeing a bit of a drift from the prior robust revenue growth rates for a large-cap company that Palo Alto Networks was previously enjoying.
The blue line in the above chart represents the quarterly growth rate, while the white line represents the two-quarter average. I like to use a two-quarter average for revenue growth rates as it helps to smooth out any lumpy quarters and better dictates the overall trend. As we can see, the two-quarter average has now rolled over and is sitting at a 20% revenue growth rate, down from 29.0% to finish Q3 2019. This is a material change in trend, and we are not expecting to see a return to the prior growth rates any time soon. Q2 2020 revenue estimates are sitting at $844.5 million, which is forecasting 19% revenue growth year over year, only a slight uptick on a sequential basis. Meanwhile, Q3 2020 and Q4 2020 revenue estimates are each forecasting 20.5% revenue growth. Based on these revenue estimates, it's clear that revenue growth rates may have topped out in the 30% range.
While this deceleration in revenue growth rates is not a nail in the coffin for the stock by any means, it does make it more difficult for the company to generate earnings surprises. The highest quality earnings growth comes on the back of accelerating revenue growth rates, and this is something we no longer have. Instead, we have revenue growth rates decelerating materially and only expected to stabilize at a much lower run rate over the next few quarters. Based on this, I would argue that the company now has a higher probability of delivering earnings misses than it did in the past.
To summarize, while this isn't a massive red flag, it's clear we have pretty material deceleration on the horizon from both a top and bottom-line standpoint. For Palo Alto Networks to prevent this deceleration, investors are going to want to see a minimum of $840 million in revenues for Q2 2020. I believe a miss on this figure would likely see the stock take another leg lower.
Moving over to fund ownership, it looks like some growth funds may have got the deceleration memo early and packed their bags. While Palo Alto Networks' fund ownership has increased for the past ten quarters in a row, we saw the first quarter of fund ownership dropping since FY-2017. In the last ten quarters, fund ownership has nearly doubled from 740 funds to 1,325 funds, with an average of 50 new funds holding the stock each quarter. As of the end of Q3 2019 filings, we saw a drop in fund ownership of nearly 100 funds, from 1,325 to 1,232. While this isn't a massive issue, it does show that some funds likely see better value elsewhere, and I wouldn't be surprised to see this trend continue in the Q4 filings.
If we move over to a technical standpoint, we can see that minimal technical damage has been inflicted to Palo Alto Networks' long-term chart despite this drop. If we look at the below chart, we can see that Palo Alto Networks remains above its important 20-month moving average, and also slightly above its multi-year uptrend line since 2013. However, the one minor negative development is that tests of this uptrend line are becoming more frequent recently. Between 2013 and 2018, we saw only one test of this uptrend line. In the past twelve months alone, though, we've seen two tests of this uptrend line, and a potential third test if the stock heads towards the $210.00 level. While this isn't a cause for immediate concern, it can often be a minor red flag when a stock begins testing a key level more often as it shows sellers may be in control.
If we move over to a daily chart, we can get a better look at the stock's uptrend line, and the base the stock looks like it's trying to build. As the below daily chart shows, the stock is hovering just above its long-term uptrend line near $210.00 and looks like it may be forming the right side of a saucer-shaped base currently. The key to this base remaining valid is that the stock does not break below $198.00 on a monthly close. A monthly close below $198.00 would make for an abnormal look to this base, as well as a monthly close below the crucial 20-month moving average. Therefore, investors are going to want to watch closely to see if the bulls play defense at this critical spot.
Palo Alto Networks is coming down to test a critical support level, and we are going to want to see the bulls show up in a big way if the stock sees more weakness near the $200.00 level. While Palo Alto Networks has seen robust growth rates the past several years, the deceleration in the top and bottom line is suggesting the stock is riskier going forward for new purchases. The exception is for nimble traders looking to sell into bounces back towards the gap fill near $245.00. To summarize, I would view any rallies back over the $250.00 level as selling opportunities given the deceleration we've seen and would be going underweight the stock if it cannot hold the $198.00 area on a monthly close.
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.