Is Palo Alto Networks Bouncing Back or Headed for a Downward Spiral?

Palo Alto Networks' (NASDAQ: PANW) stock dipped 4% on May 21 after the cybersecurity company posted its latest earnings report. For the third quarter of fiscal 2024, which ended on April 30, its revenue increased 15% year over year to $1.98 billion and exceeded analysts' estimates by $10 million. Its adjusted earnings per share grew 20% to $1.32 and also cleared the consensus forecast by $0.07.

Those headline numbers looked healthy, but investors weren't impressed by its near-term outlook. Let's see if Palo Alto Networks' stock will bounce back after its latest decline -- or if it will head even lower over the next few quarters.

Image source: Getty Images.

Another quarter of decelerating growth

From fiscal 2017 to fiscal 2023, which ended in July 2023, Palo Alto Networks' revenue grew at a compound annual growth rate (CAGR) of 25%, its billings increased at a CAGR of 26%, and its adjusted EPS rose at a CAGR of 30%.

Those robust growth rates made Palo Alto Networks one of the top plays on the expansion of the cybersecurity market. But over the past year, its year-over-year growth in revenue, billings, and adjusted EPS all decelerated.

Data source: Palo Alto Networks. YOY = Year-over-year.

The company mainly attributed that slowdown to the macro headwinds, which made it tougher to secure new customers and lock them into longer contracts. But the company is also facing stiff competition from other large cybersecurity companies such as Fortinet and cloud-native challengers such as CrowdStrike.

To counter those threats, Palo Alto is trying to consolidate its existing customers onto a single unified platform to curb their dependence on smaller cybersecurity companies for specific services. However, it's been driving that strategy with free trials and deferred-billings deals that won't boost its top-line growth over the next few quarters.

That's why the company's billing growth dropped to the single digits in the third quarter, and why it anticipates just 9% to 10% billings growth in the fourth quarter. It expects its total revenue to only rise 10% to 11% as its adjusted EPS dips 1% to 3%.

For the full year, it expects billings to grow 10% to 11%, revenue to rise 16%, and adjusted EPS to increase 25% to 26%. It's still growing, but it could face an even uglier slowdown in fiscal 2025 if its loss-leading strategies don't pay off.

For now, analysts expect Palo Alto Networks' revenue and adjusted EPS to rise 14% and 12%, respectively, in fiscal 2025. But based on those estimates, the company's stock still doesn't seem like a bargain at 50 times forward earnings. Fortinet, which is growing at a similar rate, trades at 35 times forward earnings. CrowdStrike, which is growing significantly faster than both companies, trades at nearly 90 times forward earnings.

But don't ignore Palo Alto's other strengths

Palo Alto's top-line growth was disappointing, but it still expects its operating margin to rise from 24.1% in fiscal 2023 to 26.8% to 27% in fiscal 2024 as it reins in spending. The company also expects its adjusted free cash flow (FCF) margin to hold steady year over year at 38.5% to 39%. It's also stayed profitable on a generally accepted accounting principles (GAAP) basis for eight consecutive quarters -- so it isn't aggressively sacrificing profits to lock more customers into its unified platform.

Most of Palo Alto's recent growth has been driven by Prisma, which houses its cloud-based services, and Cortex, which handles its AI-driven tools. Those two "next-gen security" (NGS) platforms have been offsetting the slower growth of Strata, which houses older on-site network security services and next-gen firewalls.

In the third quarter, Palo Alto's NGS annual recurring revenue (ARR) surged 47% year over year to $3.79 billion and accounted for 49% of its trailing 12-month revenue. That represented a slight slowdown from its 50% growth in the second quarter and 53% growth in the first quarter. Therefore, its recent top line deceleration was mainly caused by Strata instead of its more closely watched NGS platforms. So if the macro environment warms and the company successfully consolidates its three ecosystems into a single unified platform, its top line growth should stabilize and accelerate again.

So what will happen to Palo Alto's stock?

Palo Alto's stock still seems a bit pricey relative to its near-term growth, so I don't think it will bounce back until it proves its "platformization" strategy can succeed. That said, I also don't think its stock will drop much lower because its operating margins are still expanding, it's generating plenty of cash, and its GAAP profits are rising.

Therefore, I believe Palo Alto stock will trade sideways for at least the next few quarters until more green shoots appear. It's not a turnaround play yet, but its downside potential should be limited as investors see how its platformization strategy pans out.

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Leo Sun has positions in CrowdStrike and Palo Alto Networks. The Motley Fool has positions in and recommends CrowdStrike, Fortinet, and Palo Alto Networks. The Motley Fool has a disclosure policy.