Palo Alto Networks Should Keep Growing -- But its Stock Price Might Not

Palo Alto Networks (NYSE: PANW) just closed another fiscal year of high adjusted free cash flow margin and strong double-digit revenue growth. Management anticipates similar encouraging results next year -- but that means the upside potential of the cybersecurity specialist's stock price should remain limited.

More cloud cybersecurity

Palo Alto's results for the fiscal fourth quarter, which ended on July 31, confirmed that the company's transition from its legacy hardware offerings to a cloud-based cybersecurity portfolio is materializing. Total revenue grew 18% year over year to $950.4 million, despite product revenue, which includes hardware solutions, staying flat at $305.6 million.

Granted, the coronavirus pandemic had a negative impact on the company's legacy business, as testing and implementing physical appliances requires real-world interactions. But Palo Alto had been preparing for the inevitable shift to cloud computing for several years.

As a result, acquisitions and internally developed solutions boosted the company's cloud businesses, and fiscal 2020 next-generation security billings (a gauge of future revenue growth) reached $928 million -- 20% of total billings, up from 8% two years before. During the earnings call, CEO Nikesh Arora indicated he will still consider acquisitions and internal developments over the next year to fuel that transition to the cloud. The company borrowed $1.75 billion in June via convertible senior notes due in 2025 to increase its cash, cash equivalents, short-term, and long-term investments to $4.3 billion at the end of the last quarter for potential acquisitions.

As an illustration of its plans, this week the company announced its intention to acquire the consulting firm Crypsis Group for $265 million in cash to complement its threat intelligence platform Cortex XDR with extra response capabilities. That acquisition makes sense, as it will provide cross-selling opportunities between Palo Alto's solutions. And it is safe to assume similar deals will materialize over the next quarters. 

Looking forward, management expects revenue from the company's product segment to stay flat, at best, over the next fiscal year. But cloud businesses should support Palo Alto's top-line growth in the "high teens", which means next-year revenue growth should be comparable with that of the last 12 months. In addition, executives anticipate the company should also sustain its high adjusted free cash flow margin, which reached 28.4% in fiscal 2020.

With forecasts that lead to similar results compared to the past fiscal year, Palo Alto seems on the right path to succeed in its transition as a cloud cybersecurity player.

Man touching cloud with padlock icon on network connection.

Image source: Getty Images.

Limited stock price upside

AlliedMarketResearch anticipates the cybersecurity market will grow by 11.9% annually by 2025. Thus, Palo Alto's forecasted high-teens revenue growth over the next 12 months suggests the company should gain market share. However, that doesn't necessarily translate into an attractive investment opportunity -- the stock price is flirting with its recent all-time highs, even as revenue growth is not predicted to accelerate.

PANW Chart

PANW data by YCharts

Assuming fiscal 2021 revenue growth stays stable year over year at 18%, Palo Alto stock trades at a forward enterprise value-to-revenue ratio of 6.5, which remains elevated. In addition, acquisition-related expenses and higher debt costs should keep penalizing the company's bottom line. Losses under generally accepted accounting principles (GAAP) had already increased during fiscal 2020 to $267.0 million, compared to $81.9 million the prior year.

In contrast, taking into account management's expectations for stable year-over-year adjusted free cash flow margin, adjusted free cash flow should reach $1.14 billion during fiscal 2021. The company's market cap, at 23 times that estimated adjusted free cash flow, seems reasonable given the forecasted solid double-digit revenue growth.

But keep in mind that free cash flow paints a rosy picture of the company's profitability. Since free cash flow corresponds to cash flow from operations minus capital expenditures, acquisitions are not taken into account in free cash flow calculations. In addition, share-based compensation (SBC) is excluded from free cash flow, as it is a non-cash expense -- but Palo Alto's SBC remains significant (20% of revenue during fiscal 2020).

So investors should not get carried away with the company's encouraging shift to the cloud at a high free cash flow margin. And the stock price upside potential seems limited, as the market is already pricing in strong execution over the long term in the crowded and competitive cybersecurity market.

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Herve Blandin has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Palo Alto Networks. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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