Palo Alto Networks is Profitable: Time to Buy?

Investors have dumped many cloud services stocks in the wake of the pandemic, fearing demand gains could tumble as the world returns to more normal working patterns. But the cloud security niche shows no signs of such a growing hangover.

Palo Alto Networks (PANW -1.09%) recently announced strong sales trends in its fourth fiscal quarter which ended in late July. Management also forecast another year of more than 20% annual sales gains ahead.

Yes, investors should not rely too heavily on short-term operating trends. But Palo Alto Networks’ success means bigger profit gains as the company prepares to hit $7 billion in annual sales.

Let’s take a closer look.

The growing industry

Investors were happy to hear management raised its outlook for the fiscal year in May, but it turns out the company isn’t done producing good surprises. Fiscal fourth-quarter revenue jumped 27% to $1.6 billion, beating Palo Alto Networks’ revised guidance.

During the year, the company gained market share in a spending niche that is becoming increasingly important to a growing number of large enterprises. “Our three-platform integrated strategy,” CEO Nikesh Arora said in a press release, “continues to drive significant deal momentum.”

Executives put that momentum into context in a presentation to shareholders that highlighted how the company has expanded its sales footprint into more categories around network and cloud security since 2018. This transformation has accelerated sales growth, but it also created more predictable cash and profit flows through the software-as-a-service (SAAS) sales model.

Finally profitable

A big knock against the stock has always been the company’s persistent net losses. For the year ending in late July, that red ink landed at $367 million versus $500 million the year before.

But this disappointing record could be over. Palo Alto Networks achieved profitability for the first time in four years this quarter, with GAAP earnings reaching $3 million. Yes, that equates to a tiny net margin on $1.6 billion in revenue. But this could be the start of a steady march towards impressive profitability. Software industry leader Microsoft enjoys operating profit margins of over 40%, after all.

Palo Alto Networks doesn’t appreciate anything that comes close to Microsoft’s huge and diverse portfolio. Still, there is room for it to become much more profitable over time.

Look forward

Investors shouldn’t get too excited about Palo Alto Network’s near-term earnings prospects. The company predicts barely breaking even this year. But two parameters imply much higher profits to come. The first is sales growth, which could reach 25% in the new fiscal year only to mark a modest slowdown from the previous year’s peak of 29%.

The second is cash flow, with Palo Alto Networks on track to convert more than 33% of sales to free cash flow this year, after adjustments. It’s conceivable that the operating profit margin will approach this rate over time, assuming the company continues to gain share in ever-growing niches around cloud and network security.

But investors interested in this space shouldn’t wait and just watch this stock from the sidelines until those gains happen. The tilt toward profitability over the past quarter, while modest, marks a good time to consider buying Palto Alto Networks if you’ve been on the fence about this tech stock.

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