Palo Alto Networks

Palo Alto Networks  (PANW - Get Report)  reported fiscal second-quarter adjusted earnings above expectations. Revenue grew by 30% to reach $711 million, exceeding the top of the guidance range of $685 million. The growth above the roughly 10% forecasted market growth rate isn't a surprise, while the comparison with the competition confirmed the company is taking important IT security market share.

Billing and deferred revenue grew by 27% and 32%, respectively, which is consistent with the revenue growth.

Several factors explained the impressive results. Product revenue growth accelerated to 33% thanks to the strength of the overall portfolio. The next-generation firewall and the associated subscriptions contributed to the success. During the earnings call, management also listed several large deals and the better-than-expected results from previous acquisitions like RedLock.

With the operating leverage, marketing expenses kept on decreasing and the operating margin improved by 250 basis points year over year. The operating leverage also materialized compared to the previous quarter. Despite revenue growth of 8.4% quarter over quarter, operating expenses were lower during the second quarter.

The strong revenue growth and the operating leverage over the last few quarters brings the company to an inflection point. GAAP losses are shrinking and are close to turning to GAAP profits.

We had highlighted in a previous article that Palo Alto needed to develop its nascent application framework to drive long-term revenue growth. It didn't take long for the company to announce some development in this area.

Focus on the Application Framework

Cortex is the name of the new version of the application framework solution, also called application framework 2.0. Most of the major IT and security vendors claim that integrated solutions are the response to the increasing complexity of IT infrastructures. The IT security area is no exception and Palo Alto goes in this direction with Cortex and its first application, Cortex XDR. The idea of Cortex XDR consists of adapting the presentation of all the security information collected across the infrastructure, thanks to artificial intelligence and machine learning to facilitate the work of the security operators. The company will offer its Traps end-point protection for free with Cortex XDR to ease its adoption. These moves show the importance of the application platform for the company. But the monetization potential is still unknown.

Cash Is a Nice Problem to Have

Palo Alto now has about $3.6 billion of cash and equivalent against a convertible debt of $1.4 billion. Management indicated the adjusted free cash flow margin would represent approximately 36% of the revenue for fiscal 2019.

Thus, despite the $560 million purchase price for Demisto, the company still has plenty of dry powder to acquire some businesses and grow. But management also announced a $1 billion share repurchase authorization. With the results above expectations, the stock price is reaching all-time highs, which isn't an ideal time to proceed with share repurchase. Management will have a nice problem of wisely spending the cash to support the growth.

A Valuation That Is Still Demanding

Considering the impressive fiscal second-quarter results, the forecast 24% to 26% growth for the next quarter seems modest and fiscal third-quarter revenue is expected to be lower than this quarter. But the base comparison is challenging. And with this expected revenue growth, the company will keep on increasing its market share. 

Despite these excellent results, the valuation is still demanding. Considering the 10% stock price increase after market on Tuesday and with TTM revenue of about $2.6 billion, the EV/sales ratio amounts to about 7.7.

The company has to show it can keep on growing while improving the operating margin to drive the stock price higher. In the meantime, management guided on non-GAAP net income per share in the range of $1.23 to $1.25 for the next quarter.

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The author doesn't own any of the stocks discussed.