Can Palo Alto Networks Grow Into Its Valuation?

“Hit or miss” is probably the most accurate way to describe the initial public offering market this year.

However, enterprise security darling Palo Alto Networks is one company of only a handful whose IPO might have been considered a success. After filing an expected trading range of $34 to $37, the company’s shares soared to over $55 last July on its first day of trading.

Today, the stock sits comfortably at $61 after hitting a 52-week high of $72.61 in early September.

Palo Alto has indeed pioneered what is considered next-generation security along with a platform that is considered one of the most innovative in the industry. Early-on investors have placed a lot of faith in its story.

But since the company is not yet fully established publicly, I wonder if all of this excitement is not premature, and if its valuation is deserved.

In its first quarter as a public company, Palo Alto did what it had to do to affirm investor confidence in its business. For its fiscal fourth quarter, the company saw its revenue jump to $75.6 million — representing an increase of 88 percent and topping the $40.2 million it reported in the same quarter of a year ago.

Its net loss for the quarter arrived at $4.6 million on a GAAP basis, 18 cents per share. This compares favorably to its net loss of $6 million in the same period of a year ago.

Overall revenue for fiscal 2012 grew 115 percent to $255.1 million — exceeding its 2011 mark of $118.6 million. Calling these numbers impressive would be an understatement.

Not only did the company’s revenue soar almost 90 percent from the previous year, it jumped 15 percent from its third quarter. In addition to billings, which rose by 57 percent, the company’s product revenue grew by 70 percent while revenue from services shot up a robust 135 percent.

For its exceptional performance, the company’s president and CEO, Mark McLaughlin offered this:

On the heels of such a performance, it’s hard to disagree with that statement. The company was on fire. I only wonder now about its second act as Palo Alto must answer to where it goes from here. Based on revenue and growing demand, the company has products and services for which enterprise customers are willing to pay handsomely.

Its platform helps corporate clients secure their network while safely enabling them to manage the increasingly complex and rapidly growing number of applications running on their networks.

But competitors Cisco Systems, Dell’s SonicWall, and CheckPointdon’t intend to roll over and allow Palo Alto to disrupt the market forever.

What’s more, with the company’s market share registering at only 10 percent, it is the one with the pressure to grow. What steps will it take to increase its market share absent significantly reducing cost and possibly hurting its margins?

Bottom Line

As noted earlier, my concern is Palo Alto is a relatively young company that is experiencing an impressive spurt of growth. But can it be sustained to the extent that it deserves a forward price-to-earnings ratio (P/E) of close to 150? Will it be able to deliver the level of free cash flow growth that will keep investors interested over the next few years?

As great of a quarter as this was, I worry that Cisco and other players including F5 and Juniper will make certain that it is no cakewalk for Palo Alto. In response, its challenge will be to beat expectations while also raising outlook if it wants to continue its momentum in the stock.

As expensive as valuation appears currently, I don’t see how else shares can rise absent these scenarios.

—By TheStreet.com Contributor Richard Saintvilus

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Disclosures:

At the time of publication, Richard Saintvilusheld no position in any of the stocks mentioned. 

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