Making a New Niche in Security

11/22/2012 8:00 am EST


Rob DeFrancesco

Founder, Tech-Stock Prospector

Everyone loves an underdog, especially when the underdog is punching above its weight and this security upstart is taking the fight to old guard, observes Rob DeFrancesco of Tech Stock Prospector.

It is interesting to see the performance disparity between shares of networking security veteran Check Point Software (CHKP) and the new kid on the block, Palo Alto Networks (PANW), since the latter’s IPO in the middle of July.

Check Point shares during this period are off 6%, while Palo Alto shares have advanced 47% from the IPO price of $42 and 12% from the opening price of $55.20. And that’s even with Palo Alto shares off 14% from the post-IPO high of $72.61 reached on September 5.

Palo Alto’s recent market cap of $4.2 billion is 44% of Check Point’s market cap, even though Palo Alto at this point is doing about 25% of Check Point’s revenue on a quarterly basis. The difference in valuation can be attributed to the top-line growth rates, with Check Point growing about 9% annually and Palo Alto’s fiscal 2013 (July) consensus revenue estimate indicating growth of at least 50%.

For the fiscal fourth quarter (ended July), Palo Alto’s revenue surged 88.1% to $75.6 million, beating the consensus estimate of $71.2 million, and per-share earnings of 3 cents topped the consensus by, well, 3 cents. Product revenue rose 70% to $49.4 million and support revenue jumped 135% to $26.2 million. Gross margin was flat sequentially at 71.9%.

Palo Alto continues to build out its channel, adding more than 200 partners over the past 24 months. The company, which now has close to 800 channel partners, is on track to keep adding new names, a big positive in terms of future revenue growth potential.

I agree with Northland Securities that Palo Alto “has fast emerged as the mindshare leader” in next-generation firewalls, an important sub-segment of the $10 billion networking security market. The more partners the better to push Palo Alto’s brand.

In the July quarter, Palo Alto brought on more than 1,000 new customers (the third consecutive quarter of 1,000+ customer additions) and the customer base now totals more than 9,000. On average, an existing customer purchases 3x the value of the initial purchase, indicating Palo Alto’s follow-on business is strong. For the company’s 25 largest customers, the rate goes to 8x the initial purchase.

While the vast majority of customer deals involve annual contracts, Palo Alto management said it’s seeing an uptick in the number of multi-year deals, with even some three-year contracts in the mix. Deferred revenue at the end of July stood at $135.8 million, up 102% year over year and 16% sequentially.

For fiscal Q1, Palo Alto forecasts revenue of $80 million to $84 million, representing growth of 40% to 47% year over year. Palo Alto is in hypergrowth mode (sales and marketing expenses were 45% of total revenue in fiscal 2012), but the company’s long-term model (three to four years out) shows gross margin of 70% to 73% and operating margin of 22% to 25%, with sales & marketing at 30% to 33% of revenue.

Palo Alto is pricey, trading at 11 times the forward consensus revenue estimate. But with just a 3% share of the overall networking security market, the company has plenty of room for growth. Still, from a valuation perspective, the stock would be more attractive on a pullback into the low $50s.

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