For Palo Alto Networks, Valuation Is Secondary Today

By Stephen D. Simpson, CFA | September 11, 2012 AAA

With its combination of disruptive technology and a large (and growing) addressable market, valuation just isn't going to be what moves or worries investors in Palo Alto Networks (NYSE:PANW) for the next few years. Instead, it will be all about the growth rate and the company's ability to grow market share against large entrenched players such as Cisco (Nasdaq:CSCO), Check Point (Nasdaq:CHKP) and Juniper (NYSE:JNPR). Consequently, while this stock does not look cheap today, that won't preclude further gains so long as the growth satisfies the momentum crowd.

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A Decent Debut Quarter
Palo Alto Networks did what it needed to do for this first quarter as a public company, but perhaps not as large of a margin as investors hoped. Revenue rose 88% from last year and 15% from the prior quarter, with product revenue growth of 70% and service growth of 135%. Billings rose 57% this quarter and Palo Alto definitely outgrew the enterprise security market.

Look at non-GAAP margins, gross margin was steady with the prior year and prior quarter (at about 72%), with product gross margin of 75%. The company reversed a year-ago operating loss, but saw operating income rise about 21% year-over-year. Palo Alto is currently spending a hefty amount on both R&D and marketing, and has yet to reach a revenue level that really leverages that cost structure. Consequently, today's operating profits are not a good indicator of the company's long-term profit potential.

Time to Leverage the Technology
Palo Alto Networks is a relatively young company that has created a next-generation security approach that combines the features and functions of traditional firewall, UTM, intrusion detection/prevention and VPNs. Not only does the company have its proprietary operating system, but it also offers a single-pass parallel processing architecture (powered in part by Cavium (Nasdaq:CAVM) chips) that offers superior performance.

Although Palo Alto's market share is still below 10% and centered largely in the high end of the market, the company is taking on the likes of Cisco, Check Point and Juniper with its technology. While Check Point introduced new technology last year and Cisco introduced the 5500-X in the second quarter of this year, it looks as though Palo Alto still has a technology and price-performance edge.

However, Palo Alto's gains usually have to come at the expense of existing players. That places a somewhat different burden on the sales force, as it largely means that they have to convince a would-be customer that their offerings are not only better, but better by a wide enough margin that it's worth the disruption and risk of switching over.

Can Palo Alto Fend off Its Own Threats?
Palo Alto's rivals are not going to sit on their hands. The major players are all investing in next-gen technologies and while Palo Alto may have a technology lead on the likes of Check Point, they don't have the edge in execution yet. Moreover, if patent litigation with Juniper goes badly for Palo Alto, who knows how much of that technology edge will still be in the picture by 2015. There are also emerging players like Fortinet (Nasdaq:FTNT), Sourcefire (Nasdaq:FIRE) and Dell's (Nasdaq:DELL) SonicWall to consider, particularly as Fortinet seems focused on improving its high-end offerings.

On the plus side, security is not a core focus for Cisco or Juniper and Palo Alto may benefit from its ability to focus exclusively on this market. With Check Point, the debate may be more about whether this large rival is able or willing to re-invest in competitive R&D. Check Point is much larger and cash-rich, but it's worth asking if management here has under-invested in maintaining a technology edge as the market transitions to next-gen firewalls and security platforms. Likewise, will Check Point's investor base be willing to accept the lower margins that would come with a greater commitment to R&D?

The Bottom Line
I'd be a little bit surprised if Palo Alto Networks is still independent in three or four years. The value of Palo Alto to a strategic buyer like IBM (NYSE:IBM) seems too large to ignore. Nevertheless, I don't think the company would look to sell itself anytime soon. Not surprisingly, this is not a cheap stock by conventional means.

For Palo Alto to support a stock fair value in the $80s, this company will have to deliver free cash flow growth on par with F5 (Nasdaq:FFIV) - not impossible, but certainly demanding. If the company can deliver beat-and-raise quarters and continue to gain share, aggressive growth investors probably won't pay much attention to the valuation for some time to come. Consequently, this isn't a stock for the value crowd, but that's nothing out of the norm for a tech IPO.

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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