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3 Reasons Palo Alto Networks Inc. Stock Could Fall

If not for a surprisingly sound fiscal 2017 third quarter, Palo Alto Networks (NYSE: PANW) shareholders would likely still be in the red this year. As it happens, a better-than-expected top line and guidance for the current quarter above analyst estimates have pushed Palo Alto shares up 14% since it shared the good news.

That said, Palo Alto's losses continue to mount and it doesn't appear it will become profitable anytime soon. If that turns out to be the case, how long will investors give Palo Alto in what in essences is a free pass thanks to its revenue growth? There are also a couple of other areas that could cause Palo Alto's stock to fall if it doesn't deliver the goods.

Image source: Palo Alto Networks.

A turn for the worse

Prior to the rise in Palo Alto's stock price, it had been mired in a slump due to slower top-line growth. The mounting bottom-line losses and sky-high spending were overlooked due to Palo Alto's impressive streak of nearly two years of 50% plus quarterly revenue growth.

Expectations have been muted since the revenue streak was broken a few quarters ago, but its recent 25% year-over-year increase in sales to $431.8 million was well ahead of even Palo Alto's forecast. The icing on the cake was guidance for the current period of $481 million to $491 million, equal to a 20% to 23% jump.

The slightest miss, or even coming in at the low end of its revenue forecast, would be enough to cause Palo Alto's stock to fall. Palo Alto shares have already  eased nearly 4% since it hit $140 a share a few weeks ago, and would surely fall further if Palo Alto suffers a revenue mishap.

Baby steps

There was progress, albeit very little, on CEO Mark McLaughlin's efforts to rein in spending last quarter, particularly Palo Alto's exorbitant sales and marketing-related expenses. Palo Alto spent $226.9 million in sales costs in the third quarter, equal to 53% of total revenue.

To put Palo Alto's open checkbook approach in perspective, sales-related overhead was "only" 16% higher than a year ago which is a slight improvement but not close to where it needs to be. McLaughlin can look to FireEye (NASDAQ: FEYE) for an example of how it's done.

FireEye shelled out $94.88 million to fund its sales efforts last quarter, also well above 50% of its $173.74 million in revenue. CEO Kevin Mandia's first order of business when he took the helm was to shave costs, though still high, FireEye's sales spending shrank 16% last quarter, and total operating expenses were cut 29% to $180.85 million. Palo Alto? Its total operating expenses jumped 18% to $357.2 million.

Slow but steady wins the day

Another much-needed effort of Palo Alto's is to drive its software subscription results to boost more predictable recurring revenue, and despite all the applause its top line received last quarter, it was the stellar growth of the subscription and support unit that warrants the praise.

Last quarter, product sales climbed a meager 1.5% to $164.2 million, which would have been a concern if not for Palo Alto's jaw-dropping 46% pop in subscription and support revenue to $267.6 million. At 62% of total sales, subscription-driven recurring revenue continues to make up a larger portion of Palo Alto's sales, as it should to build relative stability over time.

However, should there be any sort of stumble in what has quickly become Palo Alto's bread and butter, total revenue growth would be nowhere close to where it needs to be and its stock would almost certainly go into a free fall. Palo Alto took some positive baby steps in the third quarter, but it remains just a slip or two away from the bears again seizing the day.

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Tim Brugger has no position in any stocks mentioned. The Motley Fool recommends FireEye and Palo Alto Networks. The Motley Fool has a disclosure policy.