Tickers in this Article: PANW, CHKP, CSCO, FTNT
Once again a relatively well-regarded tech growth company is going to pay the price for disappointing the Street. While Palo Alto Networks (NYSE:PANW) has definitely sold the Street on the idea that it's a major leap forward in network security, the valuation simply doesn't leave room for any shortfalls – even if they're pretty small in the larger scheme of things. Although I do have some fears that Palo Alto has oversold its capabilities, I have to admit that the stock is getting more interesting.

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A Disappointing Fiscal Third Quarter
Prior to this quarterly report from Palo Alto, multiple sell-side analysts scrambled to publish reports claiming that reseller surveys and due diligence calls indicated that Palo Alto was not suffering from the widespread IT hardware malaise as much as feared. While those calls were mostly right, and they were also partly wrong and it's that last bit that's going to move the stock today after earnings.

Revenue rose 54% this quarter which, compared to other security companies like Check Point (Nasdaq:CHKP), Fortinet (Nasdaq:FTNT), and Sourcefire (Nasdaq:FIRE), is actually pretty fantastic. Still, it was slightly (as in $2 million or 2%) below the average Street estimate. What's worse, product revenue was up 40% and that figure missed the average by about 6%.

Margins continue to develop nicely. Gross margin improved more than two points from the year-ago level and about a point on a sequential basis. Operating income rose 91% and 11%, respectively, and the operating margin not only improved 140 bp from last year, but beat the average estimate by 60bp.

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Gaining Share, But Will It Get Harder From Here?
Management's guidance for the next quarter (the fiscal fourth quarter) was also disappointing relative to what analysts had been projecting prior to this quarter. With that, it seems as though even Palo Alto's impressive share gains (though from a low base) haven't immunized it completely from the weak macro environment in tech.

Speaking of those share gains, there's little doubt that Palo Alto has been taking business away from its more established rivals. It would seem that the majority of the competitive gains are coming from Cisco (Nasdaq:CSCO) and Check Point, with Juniper (NYSE:JNPR) and Fortinet seeing some as well.

But will this go on uninterrupted? Palo Alto has been talking openly (and loudly) about its technological, performance, and price/value superiority, but there are those that claim that Palo Alto has been making these claims on the basis of “apples to oranges” comparisons skewed in their favor. In short, some of my due diligence calls have said that, compared to Check Point, Palo Alto is actually a great deal better at marketing and self-promotion than technology.

Now, I don't believe that entirely. Palo Alto's revenue is coming at the expense of somebody, and the weak security revenue growth at Check Point, Cisco, and Juniper back that up. That said, I have to ask whether Palo Alto is burning through those customers that were never really fully satisfied with or committed to these legacy companies, and whether the share gains are going to get harder from here on.

A new anti-malware product should help support revenue growth, as should ongoing gains in the next-gen firewall space. Additionally, I believe Palo Alto can leverage partnerships with the likes of Ericsson (Nasdaq:ERIC) to support sales growth. Still, I think some analysts may be overestimating how much more market share is easily available. At the same time, I'm also concerned about the real underlying rate of demand growth in security, as industry demand seems to have slowed more than projected in the last few quarters.

SEE: How To Choose The Best Stock Valuation Method

The Bottom Line
Although I do have some concerns that Palo Alto will find it more difficult to take share from Cisco and Check Point from here, I still find this to be an interesting story and an interesting investment prospect. While I think that Check Point is more undervalued (on the basis of the Street apparently expecting almost no future growth), Palo Alto could be a rare growth stock at a reasonable price if this is just a momentary lull in the story.

If Palo Alto can grow its revenue at a long-term annual rate of about 24% and grow its free cash flow (FCF) at a similar rate, a fair value above $50 seems reasonable. Those are robust growth expectations, yes, but not unreasonable relative to what companies with breakthrough technology have achieved in the past. Timing is harder to call, though, as I think Palo Alto shares will be vulnerable to “disappointments” like this one so long as the IT spending market is weak and cautious.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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