If you’ve ever used the internet, you understand how important a company like Palo Alto Networks Inc (NYSE:PANW) is. While technology has brought us extraordinary opportunities, that concept cuts both ways. Cybercrime is veritably exploding, making internet security a top priority. It’s no wonder then that PANW stock is up 268% over the trailing five years.
The money run for shareholders hasn’t stopped yet. Year-to-date, Palo Alto Networks stock is up 33%, which is a fantastic metric in any market condition. However, with the major indices struggling to gain traction, PANW simply stands out. Better yet, its industry is booming. Even sector laggards such as FireEye Inc (NASDAQ:FEYE) have put up impressive numbers this year.
On paper, the prognosis is nothing short of excellent for PANW stock. In my recent write-up for FireEye, I mentioned expert forecasts that predict cybercrime will lever a $6 trillion worldwide cost by the year 2021. That scale of damage is incomprehensible. Not only that, I mentioned the impact “digital fraud” was having on the workforce. I wrote:
More significantly, cybercrime exponentially exceeds the number of legitimate IT jobs. Quite literally, no shortage of cybersecurity-related employment opportunities exist. Crime may not pay, but it certainly keeps the unemployment line empty.
It’s the potential to tap into a recurring, multi-trillion dollar industry that keeps speculators coming back for more. And if such speculation can drive up a company like FireEye, surely, Palo Alto Networks stock will likewise benefit.
At least, that’s the theory. In reality, we have a far different story.
Palo Alto Networks Stock Is Stretched Too Thin
No matter how great an industry is, a participating company must first and foremost run an effective business. Nobody can afford to ignore the basics.
As InvestorPlace’s Vince Martin mentioned with Palo Alto’s Application Framework service, PANW has several exciting projects. But my concern is that management is getting carried away with product marketing endeavors, and not focusing on fiscal discipline.
On the bottom line, PANW stock generates negative earnings. That by itself isn’t a red flag. Not only have several major institutions fought their way out of red ink, the cybersecurity industry isn’t the most profitable. So I can forgive the money suck. But what bothers me is that its overhead expenses are getting a bit out of hand.
In contrast, FireEye has reduced its SGA expenses over the last four years while bumping up research and development expenditures. Additionally, it’s making significant progress in mitigating its net income damages. But Palo Alto in the same time frame has generally lost the same amount of money annually.
Again, that’s not necessarily a deal-breaker so long as PANW invests its resources effectively. Martin argues that the opposite is happening. Thanks to out-of-control stock-based compensation, its free cash flow is more diluted than it looks. He writes:
Indeed, Palo Alto Networks is unprofitable on a GAAP (generally accepted accounting principles) basis. Even adjusting for the other one-time factors, like one-time charges and non-cash expense, PANW still wouldn’t have turned a profit in the first half of 2018.
Ultimately, it comes down to Palo Alto Networks stock being stretched too thin. It’s enjoyed a tremendous run-up, but on what? I love their projects and all, but that’s likely been priced in. With nothing new in the product pipeline, investors need to see something substantive.
Bottom Line on Palo Alto Networks Stock
Please don’t get me wrong. I’m not suggesting that Palo Alto Networks stock is a permanent short candidate. What I’m saying is that the cybersecurity firm has enjoyed a spectacular rally, but the gas tank is nearly empty.
I believe the markets are overstating PANW’s capabilities. Since its third-quarter fiscal 2017 earnings report until its most recent release, PANW stock jumped nearly 43%. At the same time, earnings per share remains steeply negative. And, as my colleague mentioned, this is not a situation that is likely to reverse soon.
Not only that, since the most recent earnings report, PANW continues to rise. Currently, it’s a few dollars shy of $200. I don’t begrudge success, but this run-up is getting long in the tooth. Investors are likely best served waiting this one out until a more reasonable valuation is found.
As of this writing, Josh Enomoto did not hold a position in any of the aforementioned securities.
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