Palo Alto Post-IPO Slide Is Getting Interesting

By Stephen D. Simpson, CFA | December 10, 2012 AAA

It's not uncommon at all for tech IPOs to selloff, sometimes sharply, once the hoopla of the IPO fades - Facebook (Nasdaq:FB) being perhaps the best recent example. While Palo Alto Networks (NYSE:PANW) debuted to much fanfare, the shares have been carving out new 52-week lows on worries about the macro IT environment and fading stock momentum. Palo Alto is still a long distance from value, but these shares are a lot more interesting today than just one quarter ago.

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Major Customer Adds Fuel Fiscal Q1 Results
This has not been a great quarter for tech hardware companies, as names like Cisco (Nasdaq:CSCO), Juniper (NYSE:JNPR), and IBM (NYSE:IBM) continue to see a great deal more caution among buyers. Nevertheless, Palo Alto managed to stay on track relative to sell-side expectations.

Revenue rose 50% from last year and 14% from the prior quarter, with product revenue up 30 and 12% and service revenue up 113 and 16%. Importantly, both Europe and government customers came in relatively strong, though Palo Alto is arguably not big enough yet to be subject to quite the same macro pressures. Billings were up 42 and 16% respectively, and readers should note that this was not an easy comp quarter for Palo Alto.

Palo Alto's profit growth wasn't really exemplary, but it was consistent with expectations. Gross margin (non-GAAP) slid 217 basis points (BPs) from last year, but did improve about 70 basis points sequentially as product margins weakened both annually and sequentially, but service margins improved on both comps. The company posted a GAAP operating loss, but non-GAAP operating income fell about a third from last year, while more than doubling from the prior quarter.

SEE: A Look At Corporate Profit Margins

New Products, New Customers
Palo Alto Networks management mentioned that the company added about 1,000 customers this quarter, increasing its customer base by about 80% from last year. The company has also been active on the product launch front. Back in November, the company announced several major launches. In addition to an updated operating system (PAN-OS 5.0), Palo Alto introduced the mid-range PA-3000 series, as well as a VM-series that integrates VMware's (NYSE:VMW) vSphere and targets the data center customer.

Innovation Vs. Competition Still a Key Debate
Palo Alto Networks definitely can count itself among a small group of companies setting a higher bar for network security. With so many security attacks targeting the application layer now, Palo Alto's best-in-class application control technology should have an enthusiastic customer base.

At the same time, Palo Alto has a very active base of competitors. Check Point's (Nasdaq:CHKP) newest products have similar capabilities and the company has a huge base of customers that have come to trust it over quite a few years. Elsewhere, companies like Fortinet (Nasdaq:FTNT), Cisco, Juniper, and Dell's (Nasdaq:DELL) are looking to get a piece of the next-gen firewall market through various means; with Fortinet offering its own unique technology, Cisco offering a new architecture, and Dell's SonicWall offering pretty compelling pricing.

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
As I have said before in reference to Palo Alto Networks, I believe a take-out is a "when, not if" event; I could see Cisco, Juniper, and IBM all wanting Palo Alto's technology and not being especially scared off by the multiple that a deal would require. Check Point, F5 (Nasdaq:FFIV), Oracle (Nasdaq:ORCL), and Hewlett-Packard (NYSE:HPQ) could also come into the picture, though I don't know that Check Point would want to pay so much and I think Hewlett-Packard is probably out of the M&A game for a while.

While Palo Alto is well off its highs, it still takes robust growth assumptions to fuel an attractive target price. In fact, a compound annual growth rate (CAGR) of nearly 30% for free cash flow (FCF) only gets you into the high $50s. That's a steep bar, but one that some high-quality hardware names (including Cisco and F5) have managed to deliver. Some investors will balk at paying over 12 times trailing sales, but this could be one of those relatively rare opportunities to buy a tech stock with strong growth prospects at what is at least a slightly less ridiculous valuation.

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

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