Does Palo Alto Networks Deserve Its Premium Valuation?

Palo Alto Networks(NASDAQ: PANW) posted its latest earnings report on Aug. 19. For the fourth quarter of fiscal 2024, which ended on July 31, the cybersecurity leader's revenue rose 12% year over year to $2.19 billion and topped analysts' estimates by $40 million. Its adjusted earnings per share (EPS) grew 5% to $1.51 and beat the consensus forecast by $0.10.

Palo Alto's stock surged higher after that earnings beat and now trades just a few dollars shy of its all-time high of $376.90 from this February. It also looks historically expensive at 58 times its adjusted EPS estimate for fiscal 2025.

Does Palo Alto's stock actually deserve that premium valuation, or is it getting too hot to handle?

Image source: Getty Images.

Palo Alto's growth is still cooling off

Palo Alto Networks is one of the world's largest cybersecurity companies. It serves over 80,000 enterprise customers and splits its ecosystem into three main platforms: Strata, which houses its on-site 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-gen security (NGS) services.

Palo Alto's scale and diversification have enabled it to grow rapidly since its initial public offering in 2012. From fiscal 2012 to fiscal 2023, its revenue had a compound annual growth rate (CAGR) of 35%. But in fiscal 2024, its revenue only increased 16% as its billings growth decelerated through the first three quarters of the year.

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

That slowdown was caused by the macro headwinds, which made it harder to gain new customers and lock them into higher-value contracts, as well as fierce competition from cloud-native challengers like CrowdStrike Holdings(NASDAQ: CRWD), AI-driven newcomers like SentinelOne(NYSE: S), and more-diversified tech giants like Cisco Systems (NASDAQ: CSCO).

To counter all that pressure, Palo Alto is rolling out new features that compete against smaller niche cybersecurity companies. It believes that cross-selling those new tools with its core services will lock more customers into its platform, shore up its competitive defenses, and eventually boost its average billings per customer.

But for now, it's driving that "platformization" strategy with loss-leading trials, promotions, and deferred revenue deals that will squeeze its near-term margins and throttle its top-line growth. That's why its adjusted gross and operating margins shrank over the past year as its adjusted EPS growth cooled to the single digits.

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

Why did Palo Alto's stock rally?

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

Its rival Fortinet(NASDAQ: FTNT), which is growing at a similar rate, trades at just 40 times forward earnings. CrowdStrike, which is growing about twice as rapidly as Palo Alto Networks, trades at 68 times forward earnings.

Palo Alto's valuation seems to have been inflated by three factors. First, some investors might believe that CrowdStrike's flawed software update, which caused a devastating global IT outage in late July, might drive more customers to Palo Alto and other cybersecurity companies. However, investors might be overestimating that benefit because the switching costs for cybersecurity services are high, and CrowdStrike's customers remain locked into sticky contracts and subscription plans.

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

Lastly, expectations for lower interest rates are driving many tech stocks higher, and that rising tide could be lifting Palo Alto's stock higher and temporarily boosting its valuations. Its inclusion in the S&P 500 last year also means that anyone investing in the entire index through a fund is also blindly buying its stock.

Does Palo Alto Networks deserve its high valuation?

Palo Alto is a bellwether of 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 it would only be worth buying again if its valuations cool off to more reasonable levels. That's probably why its insiders were still net sellers over the past 12 months.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Cisco Systems, CrowdStrike, Fortinet, and Palo Alto Networks. The Motley Fool has a disclosure policy.