QQQA - Palo Alto Networks: Secure Offerings For Investors?

• Palo Alto Networks has seen continued steady growth in sales for years now.
• The issue is that realistic losses only keep increasing, a very disappointing result for such an established business.
• I like the long-term performance, yet recent relative outperformance in this environment creates a not-so-interesting setup here.

At a time when many technology-related names have seen dreadful performance, shares of Palo Alto Networks, Inc. ( PANW ) have done quite well, vastly outperforming many other technology names out there.

At the verge of the Covid-19 pandemic in February 2020, I observed that growth was slowing down. I wondered what realistic margins could be(come) as a very established business at the time was unable to post profits. This left me wondering if it was a deliberate choice earmarked for growth, or the result of inherently weak margins.

A Quick Recap

Palo Alto Networks is well known and has been benefiting from secular growth trends being a driving force behind greater demand for more cybersecurity solutions. Back in 2015, this was a $1 billion business which was growing sales by around 50% per annum, at the time fetching a valuation of around $15 billion.

Since that period of time, the company has been growing in a solid fashion. Just ahead of the pandemic, it was evident that 2019 sales had advanced to $2.9 billion, yet billings already made a $3.5 billion number achievable. While this growth was solid, the enterprise valuation only rose to $17 billion early in 2020, as sales multiples have essentially fallen from about 15 times sales to around 5 times billings with a rapid increase in sales not being reflected in the valuation.

While that in itself is interesting, margins remained the issue. The company posted profits of around half a billion, but if we adjust for stock-based compensation, there were real losses reported, albeit very manageable. It is exactly this margin performance, and lack thereof, which made me cautious at $200 per share.

The New Stance

Forwarding to August 2021, Palo Alto posted its results for the fiscal year 2021, a year in which revenues rose from $3.4 billion to $4.2 billion. While that kind of topline growth is solid, it was GAAP losses of $499 million which nearly doubled, translating into a loss of $5.18 per share. While adjusted profits of $6.14 per share were posted, a huge portion of the discrepancy was caused by $9.50 per share in stock-based compensation expenses, a real, recurring and growing expense.

Of course, it was larger billings which created a real map for further growth in the fiscal year 2022, for which sales are seen up a quarter to $5.3 billion, driven by billings which comfortably run a billion higher than that.

Forwarding to May of this year, when Palo Alto posted its third quarter results, it was evident that the company was performing ahead of (revenue) expectations. Full year sales are now seen up 29% to $5.5 billion, with adjusted earnings seen a few pennies short of $7.50 per share, as billings are seen topping $7 billion.

Encouraging is that GAAP losses narrowed from $380 million to $270 million in the first three-quarters following stronger growth, operating leverage and reduced stock-based compensation. While the progress was more pronounced in the third quarter, this remains a challenging situation. While I am happy to account and adjust for a $100 million impairment charge so far this year, the realistic losses remain (large).

With a diluted share count of 108 million shares which now trade around the $500 mark, we see the business supporting a $54 billion equity valuation, or about $50 billion valuation if we factor in $4 billion in net cash and assume that convertible debt will be converted indeed, triggering some dilution. This means that sales multiples have expanded to 9 times sales again compared to 2020, all while the tech sector has seen tough times and realistic break-even levels have actually turned into realistic losses here!

A Great Performer - Creating A Bad Setup

The quality of actual services and long-term growth of Palo Alto is undisputed, it is just the margin (potential) which causes real questions here. In the meantime, the company has seen very strong growth as shares traded just above the $200 mark early in 2020.

By April of this year, shares hit a high at nearly $650, undoubtedly driven by a need for greater cybersecurity in the wake of the latest geopolitical events. While shares have sold off to $508 here, this marks just a single-digit percentage share price decline from the start of the year, a dramatic outperformance.

It is exactly this kind of outperformance which makes me cautious here, simply for the fact that valuation multiple expansion in an environment in which many names have seen severe multiple contraction marks a strange contradiction. It is exactly this set-up why I do not like Palo Alto here, being very happy to continue to shy away from the current valuation, with realistic losses only on the increase.

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