Investing themes can come and go. From mid 2014 to mid 2015, the cyber security industry was the “hot buy.” Some cyber stock prices soared anywhere from 80% to nearly 300% in this time span. Ultimately, the buzz wore off and valuations sank to lower levels. With the White House making headlines about advanced cyber security spending, this sector is back in momentum traders’ crosshairs. This week’s Danger Zone pick is up 22% this year while the S&P is up just 5%. However, the fundamentals of the business make it hard to imagine a scenario where this firm can meet the expectations baked into its lofty valuation. For these reasons and more, Palo Alto Networks (PANW: $155/share) is in the Danger Zone this week.
Revenue Growth Without The Profits To Show
Palo Alto Network’s after-tax profit (NOPAT) declined from $2 million in 2012 to -$165 million in 2016. NOPAT has fallen to -$184 million over the last twelve months (TTM).This decline in profit comes despite revenue growing 52% compounded annually from 2012-2016, per Figure 1.
Figure 1: PANW’s Profits Fall Despite Soaring Revenue
Sources: New Constructs, LLC and company filings
The issues with PANW’s business run deeper than just NOPAT. The company’s return on invested capital (ROIC) is currently a bottom-quintile -25%. Additionally, the firm has burned through a cumulative $1 billion (7% of market cap) in free cash flow over the past four years. Palo Alto’s business is faltering across many different key metrics.
Compensation Plan Misaligns Executive Interests
Palo Alto’s executive compensation plan misaligns executive interests with those of shareholders and fuels the profit losses shown above. In fact, the current compensation plan allows executives to earn large bonuses while shareholder value is destroyed.
PANW executives are eligible for base salaries, cash bonuses, and long-term equity awards. The cash bonuses are tied to the achievement of revenue and EPS goals. Management believes “revenue is a key metric during this stage of our growth and enhances long-term value creation for our stockholders.” As shown in Figure 1, revenue growth has done little to enhance the profitability of the firm.
For 2017, a performance threshold was added to Palo Alto’s long-term equity awards. The performance portion of equity awards will now be paid out based on “billings.” “Billings” represent a non-GAAP measure for revenue and further misalign executive interests with those of shareholders.
As we’ve demonstrated before, ROIC, not revenue, EPS, or “billings”, is the primary driver of shareholder value creation. Without major changes to this compensation plan (e.g. emphasizing ROIC) investors should expect further value destruction.
Non-GAAP Metrics Create Illusion of Profitability
Non-GAAP metrics often mask the true economics of a business and create the illusion of profits. Palo Alto Networks uses non-GAAP metrics such as non-GAAP net income and “billings” to “provide investors an additional tool to evaluate ongoing operating results.” However, these metrics simply make the firm look profitable when it is, in fact, losing money. Below are some of the items PANW removes to calculate its non-GAAP net income:
- Share based compensation charges
- Acquisition related charges
- Litigation related charges
These adjustments have a significant impact on the disparity between GAAP net income, non-GAAP net income, and economic earnings. In 2016 and 2015, PANW removed over $408 million (30% of revenue) and $233 million (25% of revenue) respectively in charges related to share-based compensation to calculate non-GAAP net income. When added to the other adjustments, Palo Alto reported 2016 non-GAAP net income of $153 million. Per Figure 2, GAAP net income was -$226 and economic earnings were -$216 in 2016.
Figure 2: Disconnect Between Non-GAAP & Economic Earnings
Sources: New Constructs, LLC and company filings
Negative Profitability In A Highly Competitive Market
Palo Alto provides security solutions to businesses of all sizes. Its offerings include next generation firewall, endpoint protection, and cloud-based security solutions. This industry is fraught with competitors, ranging from platforms that meet one’s entire security needs to individual solutions that solve one piece of the security puzzle. Competitors include Cisco Systems (CSCO), International Business Machines (IBM), Fortinet (FTNT), Symantec (SYMC), and previous Long Idea, Check Point Software (CHKP).
The key takeaway from Figure 3 is Palo Alto Networks’ ROIC and NOPAT margin rank below nearly all competitors. The only company with lower margins than PANW is another Danger Zone pick, FireEye (FEYE), which is down 23% (S&P up 18%) since being placed in the Danger Zone. The firms with the highest profitability in the industry are those that have diversified businesses. Firms such as Cisco, Juniper Networks (JNPR), and Intel (INTC) provide security solutions in addition to business lines that are already profitable. The profits from these other business segments can be used to ensure security is a value-add to existing customers but not the main profit source of the firm. PANW doesn’t have that ability, which puts it at a competitive disadvantage.
Figure 3: Palo Alto Network’s Lack Of Profitability
Bulls Ignore Negative Margins After Reaching Scale
Palo Alto bulls will tout the firm’s impressive revenue growth as reason to invest in the company. This view fails to acknowledge that not only has PANW been unprofitable thus far, but revenue growth is also becoming more costly. Per Figure 4, as Palo Alto has grown revenue, its NOPAT margin has plummeted from 1% in 2012 to negative 12% TTM.
Figure 4: Growing Revenue Is Too Costly
A more detailed breakdown of the rampant cost growth can be seen in Figure 5. Palo Alto Networks’ research & development, sales & marketing, and general & administrative costs have grown 65%, 61%, and 52% compounded annually, respectively, since 2012. Over the same time, PANW’s revenue has grown 52% compounded annually.
Figure 5: PANW’s Expenses Growing Faster Than Revenue
Bulls will also argue that these high costs are required to “reach scale”, but it appears Palo Alto Networks has already achieved scale with over 35,000 customers across 150 countries. For reference, FireEye has over 5,300 customers.
No matter what you think about PANW’s business, the stock’s valuation is hard to justify. The expectations already baked into the stock price imply that not only will PANW immediately reach profitability, but that it will take significant market share, as we’ll show below.
PANW Is Already Priced For Perfection
To justify its current price of $155/share, PANW must achieve NOPAT margins of 5% (average of competitors in Figure 3, compared to -12% TTM) and grow revenue by 31% compounded annually for the next 11 years. In this scenario, Palo Alto would be generating $26 billion in revenue (11 years from now), which is half of Cisco’s last fiscal year revenue and greater than Juniper, Symantec, Check Point Software, Fortinet, and FireEye’s last fiscal year revenue combined. In other words, the expectations already baked