And despite GAAP net income losses, its adjusted free cash flow margin exceeds 40%. The company's subscription-based business and the high share-based compensation favor the cash generation. But one of the main uncertainties remains the operating margin the company can generate when it reaches maturity.
Palo Alto's stock has gained more than 35% since mid-November to exceed $225. Its $21+ billion market capitalization, corresponding to an EV/sales ratio above 8, is becoming demanding.
Even with a growth rate above the market and potential for a 20%+ net margin , Palo Alto must deliver on the three following long-term growth dynamics to justify a higher valuation:
1. Building a Marketplace for Security
The application platform framework is part of the fast-growing cloud portfolio. The idea consists of taking advantage of the scale of Palo Alto to propose a marketplace for security applications. With this solution, small security players have the potential to deploy a niche software solution across a large installed base. And Palo Alto would benefit from the ecosystem these other security companies would develop.
A similar concept exists with the Apple (AAPL) - Get Apple Inc. Report store where Apple gets a cut on the revenue and a marketplace advantage from the applications external developers propose. The other large IT security vendors are lagging behind in developing a competitive alternative to Palo Alto's solution.
Being the first mover and increasing its scale, Palo Alto is growing its edge to propose a security marketplace. But the concept is new. It is still a long-term bet that could generate healthy profits. A failure is also possible if the marketplace doesn't attract enough security players to feed the supply side.
2. A New Focus on Service Providers
On its fiscal Q1 earnings call, management expressed the goal of addressing the service providers segment. The goal is to take advantage of the growth potential of 5G and IoT related businesses. The security solutions Palo Alto is developing for this market must combine high-bandwidth requirements with high-security standards. Also, the products will have to offer specific service providers features around 5G and IoT.
With this initiative, the execution risk is high. And due to the large size of a limited number of service providers, the business can be lumpy, with success depending on a few big deals. Even a much larger company such as Cisco (CSCO) - Get Cisco Systems Inc. Report cites the size of its deals with service providers as reasons for the volatility of some quarterly results.
3. Relevant Acquisitions
Palo Alto has a capital structure that allows for significant acquisitions. With more than $3 billion in cash and convertible debt of $1.3 billion, the company has the resources for an all-cash transaction. Also, a deal with a stock component could be attractive at Palo Alto's current high stock price. On several occasions, management has indicated it's looking for M&A if it's the right fit. Of course, not overpaying and successful integration are key for an acquisition to generate profitable long-term growth.
What About the Short Term?
Palo Alto's next earnings will be released on Feb. 26, and they will be an opportunity to get an update on these three long-term growth drivers. In the short term, the company must continue growing revenue and improving its operating margins.
Fiscal Q2 revenue is expected to be in the range of $675 million to $685 million, corresponding to a 24% to 26% year over year growth rate. And management guided on non-GAAP EPS in the range of $1.20 to $1.22. The company has beat expectations over the last few quarters, so analysts are more optimistic. The average revenue estimate from analysts amounts to $682 million, while EPS is expected to be in the range of $1.20 to $1.26.
The author owns a position in Cisco.