Shorting PANW ($52) - Part 2

• PANW’s own sec filings are opaque with respect to revenue generation and recurrence. PANW’s markets itself as a game-changer, with the implication that it can pull and retain clients from existing competitors such as CHKP.

• Services after the initial sale is only 1 year, and PANW admits it cannot predict renewal rates – is PANW’s customer base churning? Even after launching their Next-Generation Firewall in 2007 and with 5 years’ worth of data, PANW does not disclose renewal rates:

“…existing end-customers that purchase our subscriptions have no contractual obligation to renew their contracts after the initial contract period, which is typically one year, and we cannot accurately predict renewal rates[i]”

• Furthermore, their marketing pictures at the top of the recent prospectus “cumulative” end-customer counts, not current/ongoing:

From all this, the question is – how quickly is PANW running through old and new customers? I believe it is far less than the CRM/SaaS like rates, and more like traditional hardware with a far higher churn component.

To be fair, this is a tougher split (cumulative vs. on-going) customers, and the rest of the prospectus doesn’t say cumulative when referring to the 9,000 customer number. Is PANW counting initial appliance buyers (who do not renew) as part of their customers?

• Finally, PANW sells mainly through 3^rd party channel partners (distributors/resellers)[ii], and unlike competitors showed a decrease in revenue in a traditionally strong quarter (ending in January 2012).  

Again, from the recent prospectus:

We rely on third-party channel partners to sell substantially all of our products, and if our partners fail to perform, our ability to sell and distribute our products and services will be limited, and our operating results will be harmed.  

While not unusual, the lack of detail about these distributors (compared to say CHKP, which breaks out % of top 10[iii]) and the relative opaqueness invites “stuffing” of the distributors, where PANW ships excessive product in one quarter (or more) to artificially inflate revenues. This is similar to the M. Block/GMCR relationship shown by Greenlight[iv].

To be fair, I have not found direct evidence of the above, but when we look at sales on a quarter-by-quarter (from a Forbes article[v]), we see that PANW had weaker sales in a traditionally strong quarter for its competitors:

	Q3 2011	Q4 2011
Check Point	310.00	356.68
change (qoq)	0.55%	13.09%
Fortinet	103.00	116.40
change	9.42%	11.51%
SourceFire	36.16	53.20
change	42.31%	32.03%
Palo Alto Networks	57.11	56.68
change	29.57%	-0.76%

The reasoning is that companies push their sales force to sell at year-end, boosting sales. Yet, PANW is unable to grow/compete? This seems to be on purpose, as PANW is the only company among its major competitors (above) that has a year-end not in December (PANW’s in July, around its IPO).

That begs the question – did PANW purposely go public in July and have a July fiscal year-end to gloss over their December weakness and instead focus on temporarily strong year-over-year comparisons?

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[i] Prospectus pursuant to Rule 424(b)(4), October 17, 2012, page 15

[ii] Prospectus pursuant to Rule 424(b)(4), October 17, 2012, page 17

[iii] http://www.sec.gov/Archives/edgar/data/1015922/000119312512155119/d229899d20f.htm

[iv] http://www.reuters.com/article/2012/07/02/us-usa-greenmountain-mblock-idUSBRE8610YB20120702

[v] http://www.forbes.com/sites/richardstiennon/2012/04/18/tearing-away-the-veil-of-hype-from-palo-alto-networks-ipo/

Recap: GRPN

In September, I updated the short thesis on GRPN ($4.82 at the time)
http://leverageforthought.blogspot.com/2012/09/why-grpn-is-even-more-of-short-now-than.html

Since then, GRPN has fallen from $4.82 to 2.70 (~44%) after a disastrous Q3 earnings report (http://seekingalpha.com/currents/post/654611).

Here's the full release.

Besides the revenue growth of 32% yoy & 27-37% next q guidance, the specific catalyst was the tepid 12% growth in international business. Growth is not meeting expectations, while bottom-line earning (negative) because of stock-compensation/acquisition and marketing expenses.

I unfortunately closed the short too early ~4.40 because wanted to switch to different short (NOW/SPLK), but at these levels I would have closed 50%+ of the position otherwise. Next time, will scale out.

-Stanley

Shorting Palo Alto Networks, Inc. ($52) - Part 1

I prefer longs to shorts, but these days have been finding more compelling shorts than longs - perhaps that is the function of the market, but, nonetheless:

Palo Alto Networks, Inc. (Short @ 54 with 1-year target of 20)

November 9^th, 2012

Price	$52.00	Sector	Technology	52-week high	$72.61
Volume	648,301	Industry	Software and Programming	52-week low	$51.10

Date	11/9/2012	(FY ends July)	2011	2012	2013E
Price	$52.00	Earnings per Share	-$1.78	-$0.88	$0.18
Shares Outstanding (in mm)	67.890	P/E	#N/A	#N/A	288.89x
Market Cap (in $mm)	3,530.280	P/FCF	184.81x	56.21x	#N/A
Net Debt (in $mm)	-322.640	EBIT (in $mm)	-10.404	3.891	#N/A
TEV (in $mm)	3,207.640	TEV/EBIT	#N/A	824.37	#N/A
		P/S	41.63	20.24	9.17

*Historical data from company prospectus (Oct 17^th, 2012)[i]

Palo Alto Networks, Inc. (PANW) is a newly-public enterprise network security company which is highly overvalued given its highly competitive market, revenue opacity, and excessive insider selling. The market believes PANW’s platform is revolutionary in a growing industry- I believe that the network security business is a highly competitive industry and that PANW has little pricing power. Insiders seem to know this and seem desperate, hence a secondary offering of year’s revenue less than four months after ipo.

• Corporate internet security is a highly competitive market that is not growing as quickly as before and is forced to underprice its largest competitor to gain market share. From PANW’s own prospectus, its market (defined as “Network Security market and Web Security[ii]) is expected to grow from $10B in 2012 to $13.4B in 2016 – that’s only 7.59% per annum vs. 11.6% from 2009 to 2010[iii]. Earlier forecasts of 2012-2016 were more optimistic as well, as the market has been lowering expectations

• Despite a next-generation product, PANW’s gross margins are lower than CHKP, its main competitor. Check Point Software Technologies Ltd., the leader in the firewall and UTM (Unified Threat Management) market, the main focus of PANW, has gross margins of 87.6% vs. 72.3%. At a high level, this means that PANW is underpricing CHKP to gain customers.

• Fundamentally, network security is a tail risk market and is therefore underpriced. Like seat belts, internet security is usually a time-waste/drain unless an actual attack/error happens. It is one of those cases where successes are unknown but failures (breaches) can make headlines (e.g. Google servers attacked[iv])

• Internet firewalls and network security face price competition due to mass availability of free-mium model. Free personal firewalls are a dime-a-dozen (see free Avast, Zonealarm), and so only very complex/large corporations require the added power of PANW and are willing to pay for it.

*To be continued.

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[i] Prospectus pursuant to Rule 424(b)(4), October 17, 2012, page 9

[ii] Prospectus pursuant to Rule 424(b)(4), October 17, 2012, page 2

[iii] http://www.websense.com/assets/white-papers/IDC_Web_Security_Excerpt_Oct2011.pdf

[iv] http://www.nytimes.com/2010/01/13/world/asia/13beijing.html?pagewanted=all

-Stanley

On Position Sizing

Monroe Trout, of New Market Wizards fame said in his interview that either a position/signal is valid and should be given full size, or not at all. How can we apply this to our own portfolio, if at all? 

10 positions x 10% (or fixed number)
When I first started building a (concentrated) portfolio, I followed this advice to find the top ten stocks I liked and buy them. Bought such disparate stocks as NEU and BIDU, and sizing was easy (especially with a small account).

The beauty of this approach was its simplicity - buy 10% of the total equity and focus on the research behind the position. Maverick Capital (a Tiger Cub) and Kynikos/Chanos (short seller) both limits to 5% of portfolio.

However, its disadvantages are multiple: 1) lack of accounting for volatility. BIDU moves 5% a day often, while bond (etfs) moves are quoted often in 1/100 of a 1% (i.e. one basis point). 2) arbitrary portfolio sizing. Why 10% or 5%? 3) no relation to conviction/forcing poor positions. If you have only 5 good ideas (for 10x10), you either have to be happy with 50% exposure or buy positions you don't want

A more dynamic (and tougher approach): 5-10-20%
Now, I typically start with 5%, and increase in the next week or two in accordance with conviction and volatility. This is a scale-in/out strategy that aims to smooth out new/old positions, but plenty more to think about.

But this is a tough issue indeed, and especially for large portfolios ($100mm+).