Is Palo Alto Networks on the road to recovery or heading for a downward spiral?

Palo Alto Networks' (PANW 3.26%) Shares fell 4% on May 21 after the cybersecurity company released its latest earnings report. Revenues for the third quarter of fiscal 2024, which ended April 30, increased 15% year over year to $1.98 billion, beating analysts' expectations by $10 million. Adjusted earnings per share increased 20% to $1.32, beating the consensus estimate by $0.07.

While these key figures look healthy, investors aren't satisfied with the company's near-term outlook. Let's see if Palo Alto Networks stock can recover from its recent decline or fall further in the coming quarters.

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A quarter of slower growth

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

These strong growth rates have made Palo Alto Networks one of the top companies in the expanding cybersecurity market. However, over the past year, year-over-year growth in revenue, billings, and adjusted EPS have all slowed.

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

The company blamed the slowdown primarily on macroeconomic headwinds that made it harder to land new customers and sign long-term contracts, but it also faces stiff competition from other large cybersecurity companies. Fortinet For cloud-native challengers, Crowdstrike.

To combat these threats, Palo Alto is consolidating existing customers onto a single, integrated platform and trying to reduce its reliance on smaller cybersecurity companies for specific services, but the company has promoted this strategy with free trials and pay-later deals that won't drive revenue growth in the coming quarters.

As a result, the company expects third-quarter sales growth to fall to single digits and fourth-quarter sales growth to be just 9% to 10%. The company expects total sales to grow just 10% to 11% while adjusted EPS will decline 1% to 3%.

For the full year, it sees sales growing 10% to 11%, revenue growing 16%, and adjusted EPS growing 25% to 26%. The company is still growing, but it could face a worse slowdown in fiscal 2025 if its loss-first strategy doesn't work.

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

But don't ignore Palo Alto's other strengths

While Palo Alto's revenue growth disappoints, the company expects its operating margin to rise to 26.8%-27% in fiscal 2024 from 24.1% in fiscal 2023 due to spending restraints. The company also expects its adjusted free cash flow (FCF) margin to remain flat at 38.5%-39% year-over-year. The company has also been profitable on a generally accepted accounting principles (GAAP) basis for eight consecutive quarters and is not actively sacrificing margins to lock in customers to its integrated platform.

Much of Palo Alto's recent growth has been driven by cloud-based services from Prisma and AI-driven tools from Cortex. These two “next-generation security” (NGS) platforms have offset slowing growth from Strata, which offers older on-site network security services and next-generation firewalls.

In the third quarter, Palo Alto's NGS annual recurring revenue (ARR) grew 47% year over year to $3.79 billion, representing 49% of its trailing-12-month revenue. This decelerated slightly from 50% growth in the second quarter and 53% growth in the first quarter. Thus, the recent revenue slowdown was primarily driven by Strata, rather than the more high-profile NGS platform. Thus, revenue growth should stabilize and accelerate again if the macro environment improves and the company is successful in integrating its three ecosystems into one unified platform.

So what's next for Palo Alto stock?

Palo Alto's stock price still seems a bit expensive relative to its near-term growth, so I don't think it will recover until the company's “platformization” strategy proves successful. That said, the company's operating margins are still expanding, it's generating plenty of cash, and its GAAP earnings are growing, so I don't think the stock will fall any further.

Therefore, I believe Palo Alto's stock will likely trade sideways for at least the next few quarters until further opportunities arise. Although there are no signs of a recovery yet, this should limit the potential for a further downside as investors wait to see how the company's platform strategy pans out.