Once more, IT security company Palo Alto Networks (PANW) - Get Report reported results above guidance. Revenue grew 28% year-over-year against an expected range of 23% to 25%, and non-GAAP EPS was $1.31 compared to a prediction of $1.23 to $1.25.
Revenue grew at a faster pace compared to many security vendors. During their respective latest quarters, for example, Fortinet (FTNT) - Get Report , Checkpoint (CHKP) - Get Report , and Cisco's (CSCO) - Get Report security segment grew 4%, 18%, and 21%, respectively. Palo Alto keeps on gaining market share in an IT security market that is expected to grow at a CAGR of 10.2% over the next several years.
Yet, after a 20% decline over the last few weeks, the stock price dropped in after hours and was down 6% to $202.16 on Thursday morning.
As is often the case, the weak guidance for the next quarter explains a part of the market reaction. Management expects fiscal Q4 revenue to grow by 21% to 22%, which still corresponds to important market share gains. But the forecasted growth rate is modest compared to the revenue growth well above 25% over the last several quarters.
"Overall, this quarter is a bit tough to judge," wrote the team at Jim Cramer's Action Alerts Plus Portfolio, which owns shares of Palo Alto Networks. "On one hand, the headline numbers and guidance forecast are suggesting that Palo Alto is continuing to win business and demand for its products and services is robust, however, there is a transition underway with the company's sales priorities and them focusing on new businesses...Nevertheless, what we believe to be is predictable is the secular demand for cybersecurity products and solutions which Palo Alto is a quintessential leader in and growing at roughly 2.5x the rate of the industry."
Besides the concerns about short-term guidance, acquisitions are becoming an important aspect of Palo Alto's performance.
Focus on M&A
During the fiscal Q2 (ending in January) earnings call, CEO Nikesh Arora highlighted the company's focus on integrating the previous acquisitions instead of looking for new deals:
"As I mentioned on the call we had last week, with the addition of Demisto, we now have made a couple of acquisitions over the last six months. While we continue to evaluate companies, my primary focus is on making sure these acquisitions are successful."
But Palo Alto announced two acquisitions on Wednesday, just ahead of the release of its fiscal Q3 (ending in April) earnings: Twistlock and PureSec. These acquisitions represent different operational and financial risks compared to organic growth. Both deals relate to the cloud business but the synergies between the solutions must be developed.
Management didn't provide much information about the financial metrics of the acquisitions. For instance, the terms of the PureSec transaction were not disclosed. But we know the $410 million Twistlock acquisition won't stress the balance sheet. The company had $3.72 billion of cash equivalents and investments at the end of fiscal Q3. Taking into account the $1.4 billion convertible debt, Palo Alto has a net cash position of about $2.32 billion.
With these acquisitions, goodwill is becoming an important part of the balance sheet. Before taking into account the Twistlock and PureSec acquisitions, goodwill represented more than 70% of the company's book value, increasing by about $390.6 million in the previous quarter to more than $1 billion.
The probability of Palo Alto making additional acquisitions to strengthen the cloud portfolio is high. Considering the expected 36% adjusted FCF margin in fiscal 2019, the company has the potential to proceed with more acquisitions without raising capital. Also, it seems management is preserving its cash position. In contrast with the previous quarter, the company didn't repurchase any shares.
Despite the risks, the company has had a positive recent history with cloud-related acquisitions. At the end of 2018, Palo Alto spent $158 million to acquire RedLock. And RedLock's billings run rate exceeded $100 million during fiscal Q3.
Still No GAAP Profit
Taking into account the midpoint of the guidance, fiscal 2019 revenue will reach $2.89 billion. Even with the drop in the stock price over the last few weeks, the market still values the company at an EV/Sales ratio above 6x.
A part of the reason for the high valuation that the revenue growth is above that of its peers. But Palo Alto still has to show it can generate profits while growing its business. During fiscal Q3, the company reported positive non-GAAP net income. But this metric excludes $145.8 million of share-based compensation (SBC), which is a real cost to the shareholders. Taking into account this compensation, net income turns negative. GAAP losses did diminish year-over-year, but losses increased compared to the previous quarter due to higher expenses.
Thus, there's no doubt the company has been successful in gaining market share. But, considering the valuation and the uncertainty around its profitability, I prefer to stay on the sidelines.
The author doesn't own any of the stocks mentioned in this story.