On Tuesday evening, Sarge-fave Palo Alto Networks (PANW) released the firm's fiscal third quarter financial results. When I write "Sarge-fave", I mean it. I have favored cybersecurity probably over any other sub-sector (industry) than any other through the first half of 2023, and I have repeatedly stated that I thought of Palo Alto Networks as "best in class" across the space.
Followers know that I have also been behind CrowdStrike (CRWD) and SentinelOne (S) . We stand this morning up quite significantly (+30%+) in all three names. The question after going through this report will be "what now?" We do have some turf to protect here. That said, let's dig in.
The Quarter
For the three month period ended April 30th, Palo Alto Networks posted an adjusted EPS of $1.10 (GAAP EPS: $0.31) on revenue of $1.721B. The adjusted earnings print beat Wall Street quite decisively. The revenue number met Wall Street consensus view while sporting year over year growth of 23.7%. Billings grew 26% to $2.256B as Remaining performance obligation (RPO) grew 35% to $9.2B.
Subscription revenue increased 28.8% to $1.333B, as product-driven revenue increased 10.4% to $388.1M. Cost of that subscription revenue increased 21.3% as the cost of product-driven revenue decreased 25.9%, bringing total cost of revenue to $474.8B (+7.8%). This put gross profit at $1.246B (+31.7%, as gross margin popped from the year ago comp of 68.2% to an even more impressive 72.4%.
Operating expenses grew 18.3% to $1.167B taking GAAP operating income to $78.7B, up from $-47.6M a year ago. After accounting for interest and taxes, GAAP net income grew to $107.8M from $-73.2M. The lion's share (actually more than) of the adjustments made ($0.91 worth) were made for a $293.5M share-based compensation related charge.
Guidance
For the current (fiscal fourth) quarter, Palo Alto sees total billings in the range of $3.15B to $3.2B, which would be good for year over year growth of 17% to 19%. Total revenue is seen at $1.937B to $1.967B, leaving the midpoint close to consensus view of $1.95B and good for growth of 25% to 27%. The firm also sees adjusted EPS at $1.26 to $1.30, which is well above the $1.18 or so that Wall Street had in mind. This projection, based on the above mentioned and implied margin expansion, is a primary reason for the stock's overnight rally.
For the full fiscal year, total billings are expected to land at $9.18B to $9.23B, representing y/y growth of 23% to 24%. The firm sees total revenue of $6.88B to $6.91B, again encircling consensus view ($6.9B) and good for growth of 25% to 26%. Finally, for the full year, Palo Alto sees adjusted EPS of $4.25 to $4.29, which as for the quarter projected, is well above what Wall Street was looking for ($3.99).
Fundamentals
For the quarter, Palo Alto generated $432.1M in operating cash flow. Out of that came $31.2M in the purchase of property and equipment and $18.9M in business acquisitions net of cash acquired, bringing the firm's free cash flow to $382M. The firm did not repurchase any common stock during the quarter and does not pay out a dividend.
Turning to the balance sheet, the firm ended the quarter with a cash position of $3.958B and current assets of $6.414B. Current liabilities add up to $8.641B, including $3.682B in convertible senior notes. On the surface, this current ratio of 0.74 might look awful, until the investor spots the $4.147B entry for deferred revenue. Deferred revenue is not a financial liability at all, but one of goods, labor or services owed. Hence, this distorts metrics like current or quick ratios, making them appear less healthy than they really are.
Total assets amount to $14.171B, including $3.268B in goodwill and other intangibles. At 23.1% of total assets, I do not see this as a problem. Total liabilities less equity comes to $12.938B. This includes no long-term debt and another $3.943B in longer-term deferred revenue. That brings total deferred revenue to $8.09B, which makes up 62.5% of total liabilities. Now, that's a first world problem if I ever saw one. This is a healthy balance sheet. The only issue I see is the short-term nature of those convertible notes, which means that the firm will have to handle that item this year.
Wall Street
Since the firm released this report, I have come across 11 sell-side analysts who both opined on PANW and are rated at a minimum of four stars by TipRanks. All 11 of these analysts hold "buy" or buy-equivalent ratings on PANW. The average target price across the 11 is $237.18 with a high of $260 (Sami Badri of Credit Suisse) and a low of $210 (Daniel Ives of Wedbush). Omitting this high and low as potential outliers, barely moves the average target for the other nine to $237.67.
My Thoughts
Performance is strong. Margin is growing. Free cash flow is solid. The balance sheet is in good shape. The guidance is good. This firm is hitting on all cylinders. If there are problems brewing under the surface, they are twofold.
One, the macroeconomic environment is tough, and corporate spending is being pulled back on.
Two, the stock is expensive by traditional metrics for measurement. At 47 times forward looking earnings, the stock is both overvalued relative to the S&P 500 and undervalued versus peers like CrowdStrike at 62 times and Zscaler (ZS) at 80 times.
Should the broader market run into trouble, profits will be taken where profits are, and cybersecurity is where a lot of profits are.
Readers will easily spot the December through February cup with handle pattern that produced a failed breakout. We had a $220 target on PANW coming out of that pattern. The stock petered out at $203. Now, a much smaller cup with handle pattern has developed with a pivot of $201. This puts my target at $232.
However, the 50 day SMA (simple moving average) is now, at $190. This means that as the stock retakes that line this morning, we'll be watching the stock's ability to hold that line. Should PANW lose the 50 day line at some point today, we'll take anywhere from 1/8 to 1/4 of our position off. If not, we'll hang on for $232, but you'll know where our panic point is.
