Palo Alto Networks fell more than 24% Wednesday, March 1st after reporting disappointing earnings results the prior afternoon after the close. Despite year on year growth of 26%, company guidance and comments regarding operational challenges related to their go-to-market strategy clearly disappointed the street. Among other things management suggested that the introduction of new products in February may also have delayed customer purchases, however when pressed on whether sales should be expected to rebound now that the new products have been released, management indicated that the operational challenges, mostly due to the way they segment and allocate accounts to the sales team(s) might not be resolved until the second half. Management attempted to allay other concerns regarding increased competition from the likes of Cisco and Checkpoint (from whence the founder of PANW came), and migration to the cloud. One analyst asked whether the slowing could be an industry-wide phenomena after also seeing slowdowns at Checkpoint and Barracuda, management attempted to dismiss that as well.
On Wednesday PANW traded 10x the average daily options volume, and the most active contract was the April 110 puts. I discussed the trading on Fast Money last night, watch here.
Strangely though many, if not most of the morning’s volume were opening sellers. A put seller is making a neutral to bullish bet because they are committing to be “put the stock” (purchase the stock) at the strike price if the holder of the option exercises. Given that the $110 strike is a mere 5% below Wednesday’s closing price after the sharp decline, that is expressing a surprising degree of confidence that the stock around the current price may actually represent a buying opportunity. Under normal circumstances selling puts is a strategy I happen to like. If one believes a stock represents a decent value at the strike price of the put one sells, one may be paid for the possibility of buying it there. In this case the average price the morning sellers were collecting was 2.60 per share. Given that these options expire in two months that represents a rate of return greater than 1% of the capital at risk per month, and in this case the risk is that one would buy the stock at roughly half the price it enjoyed only a few months ago.
As a cyber-security company, there’s little doubt that there is a growing market for Palo Alto’s products and services, and they had maintained an impressive growth rate until now – some could argue that a 26% YoY top-line growth rate is still impressive. On the call the company also mentioned their share repurchase plans and expectations that plans to overhaul account re-assignments to better preserve sales relationships. However it’s worth noting that the share buyback plan is less a material support for the stock price than it is a counter to the dilutive effects of a generous employee stock compensation plan which the company insists is necessary in the competitive landscape of silicon valley.
On a related note the company prefers to report adjusted non-GAAP results. On a GAAP basis the company’s $51m quarterly profit turns to a less attractive $61.8m loss. There is some value in evaluating the company’s performance excluding one-time charges such as the expenses related to moving into their new headquarters in this case, however persistent GAAP versus non-GAAP results aren’t really “one-time” charges are they if only the label for those exclusions change. If every quarter one could say “it’s always something with you”, making projections using GAAP earnings is likely a more sensible approach.
Of course for fast growing companies with good prospects investors may rightfully look to the future rather than the past, such as ongoing losses on a GAAP basis, however the slowing growth rate combined with the operational challenges might easily shake an investor’s faith. A put seller is thus assuming that large investors who did not sell today will not begin to in the coming days and weeks. Perhaps, but some investors respond more quickly while others may still be digesting the news. Presentations at the Morgan Stanley conference this week, and Raymond James conference next week may reassure them. It may not. If they were holding out hope for a positive investor day, they’re going to have to hold out longer, as management elected to delay it.
Perhaps the stock will not move much until investors get a more concrete update at the next quarterly earnings in May, but given the stock moved 24% in just one day, risking $107.40 to make $2.60 over two months doesn’t seem like a great risk / reward relationship at this juncture. The 110 puts remained active until the close, but those that traded them in the afternoon, unlike those in the morning, were buying the puts. With a bit more time to think about the results they are apparently less sanguine about PANW’s prospects over the next 60 days.