The past six months have been a windfall for Palo Alto Networks’s shareholders. The company’s stock price has jumped 82.4%, hitting $322.75 per share. This was partly due to its solid quarterly results, and the run-up might have investors contemplating their next move.

Is now the time to buy Palo Alto Networks, or should you be careful about including it in your portfolio? Get the full stock story straight from our expert analysts, it’s free.

Why Is Palo Alto Networks Not Exciting?

Despite the momentum, we don’t have much confidence in Palo Alto Networks. Here are three reasons why PANW doesn’t excite us, plus one stock we’d rather own.

1. Low Gross Margin Hinders Flexibility

For software companies like Palo Alto Networks, gross profit tells us how much money remains after paying for the base cost of products and services (typically servers, licenses, and certain personnel). These costs are usually low as a percentage of revenue, explaining why software is more lucrative than other sectors.

Palo Alto Networks’s gross margin is slightly below the average software company, giving it less room than its competitors to invest in areas such as product and sales. As you can see below, it averaged a 72% gross margin over the last year. That means Palo Alto Networks paid its providers a lot of money ($28.03 for every $100 in revenue) to run its business.

The market not only cares about gross margin levels but also how they change over time because expansion creates firepower for profitability and free cash generation. Palo Alto Networks has seen gross margins decline by 2.5 percentage points over the last 2 years, which is among the worst in the software space.

2. Long Payback Periods Delay Returns

The customer acquisition cost (CAC) payback period measures the months a company needs to recoup the money spent on acquiring a new customer. This metric helps assess how quickly a business can break even on its sales and marketing investments.

Palo Alto Networks’s recent customer acquisition efforts haven’t yielded returns as its CAC payback period was negative this quarter, meaning its incremental sales and marketing investments outpaced its revenue. The company’s inefficiency indicates it operates in a competitive market and must continue investing to grow.

3. Shrinking Operating Margin

While many software businesses point investors to their adjusted profits, which exclude stock-based compensation (SBC), we prefer GAAP operating margin because SBC is a legitimate expense used to attract and retain talent. This metric shows how much revenue remains after accounting for all core expenses — everything from the cost of goods sold to sales and R&D.

Analyzing the trend in its profitability, Palo Alto Networks’s operating margin decreased by 1.5 percentage points over the last two years. This raises questions about the company’s expense base because its revenue growth should have given it leverage on its fixed costs, resulting in better economies of scale and profitability. Its operating margin for the trailing 12 months was 9.6%.

Final Judgment

Palo Alto Networks isn’t a terrible business, but it doesn’t pass our quality test. After the recent rally, the stock trades at 19.1× forward price-to-sales (or $322.75 per share). This valuation tells us it’s a bit of a market darling with a lot of good news priced in - we think other companies feature superior fundamentals at the moment. We’d recommend looking at one of Charlie Munger’s all-time favorite businesses.

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