Does Palo Alto Networks deserve its premium valuation?

Palo Alto Networks (PANW 0.36%) released its most recent earnings report on August 19. For the fourth quarter of fiscal 2024, which ended July 31, the cybersecurity leader’s revenue rose 12 percent year over year to $2.19 billion and beat analysts’ estimates by $40 million. dollars. Its adjusted earnings per share (EPS) rose 5% to $1.51 and beat the consensus forecast by $0.10.

Palo Alto’s stock surged after the earnings beat and is now trading just a few dollars shy of its all-time high of $376.90 in February. It also looks historically expensive at 58 times FY2025 adjusted EPS estimates.

Is Palo Alto’s stock really worth that premium valuation, or is it getting too hot to handle?

Image source: Getty Images.

Palo Alto’s growth is still cooling

Palo Alto Networks is one of the largest cyber security companies in the world. It serves more than 80,000 enterprise customers and divides its ecosystem into three main platforms: Strata, which hosts on-premises firewall and network security services; Prisma, which handles its cloud-based security services; and Cortex, which detects and counters threats with artificial intelligence (AI) tools. Most of its recent growth has been driven by Prisma and Cortex, which it calls its next-generation security services (NGS).

Palo Alto’s scale and diversification has allowed it to grow rapidly since its initial public offering in 2012. From fiscal year 2012 to fiscal year 2023, its revenue has grown at a compound annual growth rate (CAGR) of 35%. But in fiscal 2024, its revenue grew just 16 percent as billings growth slowed in the first three quarters of the year.

Data source: Palo Alto Networks. YOY = Year Over Year.

This slowdown was caused by headwinds that made it difficult to win new customers and lock them into higher-value contracts, as well as stiff competition from cloud-native competitors such as CrowdStrike Holdings (CRWD 1.46%)AI-based newcomers like it SentinelOne (S 2.85%)and more diversified tech giants such as Cisco Systems (CSCO 1.03%).

To counter this pressure, Palo Alto is rolling out new features that compete with smaller niche cybersecurity companies. It believes that cross-selling these new tools with its core services will lock more customers into its platform, strengthen its competitive defenses and ultimately increase its average billings per customer.

But for now, it’s driving that “platforming” strategy with loss-making tests, promotions and deferred revenue deals that will squeeze its near-term margins and limit its top-line growth. That’s why its adjusted gross and operating margins have shrunk over the past year as adjusted EPS growth has cooled to single digits.

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

Why did Palo Alto’s stock go up?

For fiscal 2025, Palo Alto expects its revenue to grow 13% to 14%, adjusted operating margin to expand 20-70 basis points and adjusted EPS to increase 9% to 11%. That outlook is solid but uninspiring for a stock trading at nearly 60 times forward earnings.

His rival Fortinet (FTNT 0.32%)which is growing at a similar rate, trades at just 40 times forward earnings. CrowdStrike, which is growing about twice as fast as Palo Alto Networks, trades at 68 times forward earnings.

Palo Alto’s valuation appears to have been inflated by three factors. First, some investors may think CrowdStrike’s botched software update, which caused a devastating global IT outage in late July, could drive more customers to Palo Alto and other cybersecurity companies. However, investors may be overestimating this benefit, as switching costs for cybersecurity services are high and CrowdStrike customers remain locked into insecure contracts and subscription plans.

Second, bullies believe that Palo Alto’s platform strategy will pay off in the long run as it leverages its scale to drive smaller competitors out of the market. Its accelerated billings growth in the fourth quarter supports that bullish view, but its cautious outlook for fiscal 2025 also suggests those seeds won’t sprout anytime soon.

Finally, expectations of lower interest rates are driving many tech stocks higher, and this rising tide could send Palo Alto shares higher and valuations temporarily higher. Its inclusion in S&P 500 last year also means that anyone investing in the entire index through a fund is buying and blinding their shares.

Is Palo Alto Networks Worth a High Value?

Palo Alto is an outlier in the cybersecurity market, but its business is maturing and its valuations are too high relative to its growth. For now, I think its stock is too hot to handle — and would only be worth buying again if its valuations decline to more reasonable levels. This is probably why its insiders have still been net sellers over the past 12 months.