The past six months have been a windfall for Palo Alto Networks’s shareholders. The company’s stock price has jumped 122%, hitting $363.43 per share. This was partly due to its solid quarterly results, and the run-up might have investors contemplating their next move.
Is there a buying opportunity in Palo Alto Networks, or does it present a risk to your portfolio? Dive into our full research report to see our analyst team’s opinion, it’s free.
Why Is Palo Alto Networks Not Exciting?
Despite the momentum, we’re sitting this one out for now. Here are three reasons why PANW doesn’t excite us, plus one stock we’d rather own.
1. Low Gross Margin Hinders Flexibility
For software companies like Palo Alto Networks, gross profit tells us how much money remains after paying for the base cost of products and services (typically servers, licenses, and certain personnel). These costs are usually low as a percentage of revenue, explaining why software is more lucrative than other sectors.
Palo Alto Networks’s gross margin is slightly below the average software company, giving it less room than its competitors to invest in areas such as product and sales. As you can see below, it averaged a 70.4% gross margin over the last year. Said differently, Palo Alto Networks had to pay a chunky $29.62 to its service providers for every $100 in revenue.
The market not only cares about gross margin levels but also how they change over time because expansion creates firepower for profitability and free cash generation. Palo Alto Networks has seen gross margins decline by 4 percentage points over the last 2 years, which is among the worst in the software space.
2. Long Payback Periods Delay Returns
The customer acquisition cost (CAC) payback period measures the months a company needs to recoup the money spent on acquiring a new customer. This metric helps assess how quickly a business can break even on its sales and marketing investments.
Palo Alto Networks’s recent customer acquisition efforts haven’t yielded returns as its CAC payback period was negative this quarter, meaning its incremental sales and marketing investments outpaced its revenue. The company’s inefficiency indicates it operates in a competitive market and must continue investing to grow.
3. Shrinking Operating Margin
Many software businesses adjust their profits for stock-based compensation (SBC), but we prioritize GAAP operating margin because SBC is a real expense used to attract and retain engineering and sales talent. This is one of the best measures of profitability because it shows how much money a company takes home after developing, marketing, and selling its products.
Analyzing the trend in its profitability, Palo Alto Networks’s operating margin decreased by 7.4 percentage points over the last two years. This raises questions about the company’s expense base because its revenue growth should have given it leverage on its fixed costs, resulting in better economies of scale and profitability. Its operating margin for the trailing 12 months was 6.1%.
Final Judgment
Palo Alto Networks isn’t a terrible business, but it doesn’t pass our quality test. After the recent surge, the stock trades at 21.6× forward price-to-sales (or $363.43 per share). At this valuation, there’s a lot of good news priced in - we think there are better stocks to buy right now. We’d recommend looking at the most dominant software business in the world.
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