Positioning

Palo Alto Stock: The Industry Leader And Still Modestly Valued – Seeking Alpha

future-dyanmics

Padlocks networking like security system concept

D3Damon/iStock via Getty Images

D3Damon/iStock via Getty Images
The last 7 months has been an eternity for most investors in the high-growth IT space. At first the issue driving stocks lower was valuation in an environment in which the Fed committed to raising rates to curb inflation. And then, as inflation persisted, and comments from Fed governors became more strident, concerns about a recession appeared. At this point, regardless of some occasional one or two day rallies, investor sentiment has become fixated on mitigating risk, as risk is currently perceived.
One area of the IT firmament that is almost by definition neither cyclical or exposed to inflationary trends is cyber-security. Cyber security is not a new space, but it is one whose growth is seeing positive trends because of, rather than in spite of, geo-political and cyclical influences. There are many, many cyber security vendors to pick from as investments.
There are always new cyber-security companies to consider, although given the state of the public equity markets, its seems unlikely that there will be new cyber-security IPOs in the coming months. For years now, my own investments in the space have been in the two leading companies, as I see them, Crowdstrike (CRWD) and Zscaler (ZS). I have felt that these companies were the leaders in their respective silos of end-point and cloud security, with strong management, and excellent go-to-market strategies. That remains my conviction, despite the valuation implosion for these and other high growth names in the IT space.
At this point, and at this valuation, I think it is reasonable to add shares of Palo Alto (NASDAQ:PANW) to my list of recommendations in the cyber-security space. Not necessarily because I think PANW has improved its technology position vis-à-vis Zscaler, its principle rival in the cloud cyber-security market these days. But I think the market itself, in the wake of the war in Ukraine, government mandates, and what a recent report said was a 300% increase in encrypted attacks year on year, is just getting stronger, and overweighting the cyber security sector, especially as some commentators call for a recession and a pullback in IT spend, is a reasonable strategy.
In the years I have invested in IT names, getting sectors right has been an avenue second to none in achieving relative performance. That may not have been the case since the rerating of high-valued IT names started last November, but over many years, pursing that strategy has been a consistent factor in my own personal performance.
Last quarter, Palo Alto achieved its strongest sales growth in several years. No, the reported growth at 29% for revenues wasn’t of the magnitude of that of ZS, or what I anticipate that Crowdstrike will report in terms of its revenue growth rate on June 2nd. But it was quite strong, and suggested that the company has been able to right its ship from a go to market perspective and that its product strategies, while again, not as elegant as those offered by ZS, are good enough to achieve success within a burgeoning market.
Palo Alto burst on the cybersecurity scene about 15 years ago as the pioneer in the space best known as next generation firewall (NGFW), rapidly overhauling industry pioneer Checkpoint (CHKP), and other cyber-security vendors. The company was founder led for some years and then appointed Mark McLaughlin to the CEO position. After the company experienced slowing growth, and management didn’t focus on cloud based security solutions, McLaughlin stepped down and was replaced by Nikesh Aurora. Aurora had been the Chief Business Officer of Google (GOOG) (GOOGL). Aurora had a background in mergers and acquisitions – he had been President of SoftBank and an advisor to Silver Lake Partners and since he arrived, the company has consummated 8 acquisitions of various sizes to pivot the company’s focus to cloud based security solutions.
Palo Alto still sells legacy security products and these include hardware appliances. At this point, Appliances represent about 25% and the balance of the revenues are from subscriptions and support. The company’s NGFW solution, including appliances, is called Strata. The growth rate of Strata, is now, and will continue to be, a gaiting factor in the percentage growth this company will be able to achieve. The company’s software pivot is high priority and is progressing at strong rates. That said, and despite the well known supply chain issues that have impacted some companies selling IT hardware, thus far this company has been able to navigate those shoals, with hardware revenues growing by more than 20%. On its latest conference call, the company said that revenues of its Strata line of appliances were being constrained at current levels because of supply chain issues.
The company’s other 2 product platforms are and should continue to grow far more rapidly than Strata. The company’s cloud security offerings are those of its Prisma products, and it appears as though growth for Prisma is around or slightly greater than 40%. The company also offers a set of Security Automation products called Cortex. Cortex, while currently the smallest revenue contributor appears to have the fastest revenue growth of the 3 PANW product families. These are the 3 major platforms that constitute the vast preponderance of the company’s offerings and are likely to do so for the foreseeable future. It also offers an Endpoint Protection product called TRAPS along with Wildfire; these are no longer an emphasis for the company.
There are and have been countless arguments about how Prisma stacks up against the offerings of Zscaler in particular and cloud security solutions of many other vendors. I am not going to try to solve those arguments here – I am not qualified to do so, and it is not necessary to make the case that there is one winner and that no one else can be successful in the cloud security space. For what it is worth, I actually do believe that Zscaler architecture is probably optimal for cloud security but that doesn’t mean that Palo Alto hasn’t and will not continue to compete successfully.
The market itself is so large with such strong growth, according to 3rd party analysts that no one company is going to dominate the entirety of the space. Specifically, this study projects that the cloud security space will be growing at a CAGR of 18%, and it is expected to reach well over $100 billion in annual revenues before the end of this decade. Gartner, taking a more holistic view of the market, projects that cyber-security spending will reach $250 billion by the middle of the decade. Currently, Palo Alto’s revenues have reached a run rate of just over $5.6 billion, so it has plenty of growth runway.
I used to own Palo Alto shares and had done so for many years. But as newer companies in the space arose, I chose to redeploy my cyber-security investment. For the record, starting in 2016, I had determined that the company’s product strategy and go to market motion had lost the momentum necessary for the company to remain a leader. And given the opportunities presented by the emergence of Crowdstrike and Zscaler, I never felt the need to return to a deep look at this company.
It has been about 18 months or so since the results of the many mergers engineered by the CEO started to achieve some impact on the company’s operational performance. Even with those improvements, not every quarter has achieved consistent relative progress in terms of bookings growth. But the results of the last two quarters have solidified the outlook for Palo Alto, with the 40% growth in calculated bookings as well as calculated billings representing multi-year highs for both metrics.
In the meanwhile, free cash flow margins have been rising consistently; the company is now projecting a free cash flow margin of 33% for this year compared to 30% projection it originally made. It should be noted that there are seasonal elements that create the highest level of revenues and margins in the company’s Q4 period, and that is expected to be the case this year. The combination of a falling share price and rising revenue growth and margins has created a compelling valuation narrative, and thus it seems an appropriate time to revisit the company through an in depth look at its products, competitive positioning and its go-to-market motion. Specifically, and even in the wake of share price appreciation in the wake of the strong earnings report and the recovery of some tech shares at the end of the pre-holiday trading week, PANW is valued, based on my current estimates, at less than 8X revenues. Perhaps more importantly, particularly in this environment, when looking at the company’s valuation based on the combination of free cash flow margins + growth, the shares have fallen to below average. And with a free cash flow margin that is already 33%, and likely to go a bit higher, the NPV based on my estimates for PANW shares is almost double the current share price.
During the course of the conference call one analyst asked management why its forecast for the balance of the year showed a contracting level of percentage growth. The CEO wound up saying this about articulated expectations,

Nikesh Arora
Andy, I look at it from the other side of the lens. The other side of the lens says, we had a great quarter. We’re upping guidance across the board for Q4. We’re upping guidance across the board for the full fiscal year way ahead of what we had promised to the markets in our Analyst Day not too long ago, and that seems to be a wonderful story and a happy place to be.
I believe that commentators should understand that in this environment, regardless of the visibility, companies in general, and this one in particular are going to be exceptionally cautious in forecasting growth. Like every other company that sells hardware, getting adequate supply remains a challenge. And while demand for cyber-security is experiencing a tailwind from the bad conduct of some specific nation states, trying to incorporate that tailwind into a forecast is at best a fraught undertaking.
Much of this latest call was taken up with various questions with regards to the macro impact on Palo Alto’s current business and outlook. The answer of the CEO to those concerns is best encapsulated by this quote,
“ So we’re not seeing the pressure from an inflation or reduced economic activity perspective. I will tell you when the pandemic hit, we were getting letters from CIOs saying, listen, our revenue has gone away. We’re not sure when it’s going to come back and how it’s going to come back. Oil prices were at $0 for a few days. So at that point in time, they were all in that scenario you described”
I believe that because the cyber-security space has less cyclicality in the perceptions of many investors when compared to many other IT sectors, that leaders in the space should be, and eventually will be accorded higher valuation. That has not really yet been seen in the share price performance of Palo Alto. Even in the wake of the company’s earnings, the shares are still down by 18% in the last 6 weeks. There is very little premium for visibility and counter-cyclicality built into the share price valuation, in my opinion. There are times when brokerages, in an effort to differentiate themselves, make bold calls about the macro environment. The fact is that it is easy to blame the macro environment for many things, and easier still to exaggerate the impacts of the macro environment on growth. Looking at the cyber-security space in general, and this company in particular, there really is now evidence of any kind that users are deferring any kind of investment into cyber-security-there are just too many threats and too many bad actors to try to economize on this particular element of software.
It is no secret that many alternatives exist in the cyber security space. Cyber-security, as I have commented previously in this article, is one of the largest spaces in the IT world, and no one vendor is ever going to be dominant, in my opinion. That said, most users do have a primary cyber-security vendor and there is a fair amount of land/expand activity that is part of the growth tailwind for a company like this. While naturally the company’s management contends that it has a stable of best of breed solutions – 20 of them by the count of the CEO – it really isn’t necessary to accept that assertion to suggest that the shares have plenty of appreciation potential.
Basically, many businesses choose Palo Alto because it offers them a one-stop cyber security stop. Of course it will be, rare, if never for a larger enterprise to have but a single cyber-security vendor. These days, in particular, with Palo Alto having more or less abandoned its end-point product offering that had been a past focus, even its most loyal users are likely to employ multiple vendors when developing their cyber-security capabilities. One of the principle KPI’s last quarter was the 73% growth in $5 million deals. These are deals that invariably involve at least 2 and sometimes 3 of PANW’s cyber-security platforms. The 73% growth of these larger deals is a validation of the company’s 3 platform strategy and provides more confidence that the company has really been able to address some of its product issues of the recent past.
Palo Alto, as mentioned earlier pioneered the NGFW solution. Many analysts, and to a limited extent, this writer, have expected the growth rate for appliances, and for firewalls in general, to descend to pedestrian levels. That really hasn’t happened. One executive at PANW suggested that actually because of the migration of applications to the cloud, there was a need to “secure higher bandwidth connectivity.” Many users, despite moving to the cloud, have had to upgrade their firewalls, and that has been an unanticipated demand tailwind for Palo Alto.
But the largest single factor that has accelerated the growth of Palo Alto has been its rising attach rates. The company just has more to sell into its installed base. 3 years ago, when the new CEO showed up, the company had 4 subscriptions that could be attached; that has grown to 10. The success of Cortex which reached a $500 million milestone in terms of ARR is just a single example of the companies success in getting users to attach new solutions to its hardware. Overall, with the attach rate rising so considerably, the stronger growth in hardware sales has translated into a much stronger growth for the company’s NGS billings metric, and that is really the underlying trend that is yielding higher CAGR estimates.
Some readers will, despite the results of the past two quarters, continue to have concerns about how Palo Alto’s Prisma is doing vis-à-vis Zscaler’s family of zero trust offerings. Perhaps surprisingly, according to this linked analysis, Zscaler has a greater market share in network security when compared to PANW. I have linked another product review here, and the gist is that there isn’t all that much to differentiate the two vendors as can be seen in the analysis to which I have linked. Perhaps Zscaler has some more attractive features, but Prisma is certainly competitive. I believe, however, that there is a noticeable difference in architecture and that this has enabled ZS to snag some large enterprise deals as its recent quarterly results highlighted. But again, while ZS is probably likely to grow faster vis-à-vis Palo Alto’s Prisma, I am not sure just how much that matters in an overall consideration of the investment merits of PANW shares.
Sometimes, despite ZS having architectural advantages that can enhance scalability, Palo Alto will win because of its broader offering. Many users want a suite of integrated products, and will bend on scalability. And ZS is hardly the only other competitor in the network security space-the other major vendors that compete with Prisma include offerings from VMware (VMW), Microsoft (MSFT), AWS (AMZN), Cisco (CSCO), Fortinet (FTNT) and a host of private companies. So, regardless of the specifics of the competition between Prisma and Zscaler, it is likely that Palo Alto will be able to grow faster than the overall cyber-security market for the foreseeable future.
It isn’t necessary to assert that Prisma is “better” than Zscaler, which is unlikely, to find merits in both investments.
One of the more significant statements during Palo Alto’s latest conference call related to its goal of reaching GAAP profitability. The CEO, in his prepared remarks said this.
“ We look forward to updating you in 3 months on our plans to continue accelerated growth, balanced profitability and look at how we intend to target GAAP profitability in the near future.”
This, coupled with the strong growth of Appliances was one of the major surprises during the call, although again, it has so far not gotten the attention it deserves in my opinion.
For as long as I can remember, Palo Alto’s investment thesis has been compromised to some extent by elevated levels of stock based comp. I am not going to resolve the controversy between the use of GAAP vs. non-GAAP. Personally, I prefer to adjust estimates for dilution caused by SBC in looking at valuation. I also look at free cash flow – and yes that metric does include SBC, but it does not include the proceeds company’s receive from the actual option exercise. And while almost all company’s use the Black-Scholes methodology in calculating the value of options, it has some significant issues as well that can distort a company’s business picture.
So, the company’s focus on reducing SBC expense should be significant to some potential investors and perhaps analysts as well. The emphasis on controlling SBC expense was quite noticeable in the latest quarter. Stock based comp was 19% of revenues this past quarter compared to 23% of revenues in the year earlier quarter. As a practical matter, for a company such as this, SBC expense is at least as much a function of the market for talent as it is management emphasis. For years now, there has been a shortage of cyber-security talent, and one way to achieve prodigious wealth has been to go to a cyber-security start-up and get lots of option shares as part of an employment package. According to this company’s CEO, one under-recognized facet of the implosion of tech valuations has been that prospective employees can no longer count on a road to riches by joining a new venture, and this has made it easier, and less expensive in terms of required SBC for Palo Alto to recruit talent. Indeed, some former employees who had left because of the lure of option created wealth, are now returning to Palo Alto.
The company also was very focused on controlling opex, to an extent that probably has been under-appreciated. In the quarter, and on a GAAP basis, research and development expense was 25.6% of revenues compared to 29% of revenues the prior year, and 27% in the preceding quarter. Sales and marketing expense fell to 39.2% from 41.7% the prior year and from 40.1% the prior quarter. And general and administrative expense showed similar trends falling to 6.8% of revenues, compared to 8.8% the prior year and to 7.4% the prior quarter. Overall, opex came to 71.6% of revenues compared to 79.5% of revenue in the year earlier quarter and to 74.8% in the prior sequential quarter. In all, the emphasis on controlling opex was quite remarkable. I am not sure if I have ever seen a company of this scale achieve a 320 basis point improvement in its operating expense ratio in a single quarter. According to the CFO, there was not any single element in the improvement, just a substantial and sustained effort on cost management.
The company’s gross margin was about 68% last quarter compared to 69% in the year earlier period and 69% in the prior sequential quarter. The decline in gross margins was entirely a function of the supply chain issues; this caused the gross margin on hardware sales to contract noticeably and is likely to continue to be a factor until supply chain problems are remediated.
While the emphasis on reducing SBC will not impact the company’s operating cashflow, its outsize billings growth last quarter was a significant factor in the company’s free cashflow margin. Specifically, the company’s increase in deferred revenue balance by last quarter was $410 million, and this was a significant factor in the company’s 33% free cashflow margin. As mentioned earlier, the overall increase in billings, which this company uses as a KPI, was 40%. It would be difficult to imagine a scenario in which the company can continue to achieve such elevated growth in billings for an extended period of time.
The current quarter is a fiscal Q4 which normally sees an elevated level of billings as many customers renew their subscriptions. Because the base is higher, the 26% forecast in billings growth does not really represent some kind of expected slowing momentum. I imagine the guidance is prudent, and will likely be exceeded. Overall, after considering the strong tailwinds from the company’s product portfolio, and the apparent strength in the cyber-security space, I have raised my estimate of a 3 year CAGR to 26% from a prior level of 24%. And I have increased my estimates of free cash flow margins to reflect the really impressive cost remediation goals the company has achieved. I haven’t really allowed for any long-term increase in the rate of billings growth vs. the growth in revenues.
The company hasn’t announced or consummated any mergers recently and it didn’t repurchase any shares last quarter. At this point its cash balance is nearing $4 billion and its receivables, while comparable to those in the year earlier period, rose $300 million sequentially and the collection of those receivables will be part of the operating cash flow this current quarter. Given just how severe the implosion of valuations has been, and the impact that has had on development stage private companies, as well as the propensity of this management to achieve strategic goals through M&A, I anticipate that there will likely be some activity in this area in the near future.
Writing about valuation on a day in which the head of JPMC has stated in rather sensational fashion that the economy is potentially facing a significant hurricane down the road is a fraught undertaking. That comment seemed a bit overwrought, and indeed the head of strategy at the bank’s brokerage unit said that stocks could make up all of the ground they have lost so far in 2022 with the economy avoiding a recession. But Jamie Dimon is high profile and the brokerage’s strategist, Marko Kolanovic, is not and thus Mr. Dimon’s rather provocative headline apparently impacted the stock market by more than strong results and better than feared guidance from Salesforce (CRM), although to be fair the last two days, even without Mr. Dimon’s warning, have seen major rates back-up with the yield on 2 year treasuries rising by 13 basis points as I write this on the morning of June 1st. As I have written about many other companies in the recent past, it will be difficult for PANW shares to rise when overall valuations are contracting and when investors continue to perceive the IT space as a death valley of a kind. If one believes that there is a Cat 5 hurricane on the horizon, why invest in stocks at all; buy gold, or US Treasury’s and not read long tedious articles.
The latest company in the cyber-security space to report was SentinelOne (S). The overlap between S and PANW is not great, and when it comes to growth and profitability, the two companies live in different universes. But the results of S, regardless of what one might think of the shares as an investment-in my case, not so much-strongly suggest the strength of underlying demand for cyber-security solutions in all segments of the market.
I am not going to reprise all that has been written about macro trends and overall tech valuation. Whatever else is true, and looking at Palo Alto specifically, the company’s growth rate assumptions are higher, operating margins are rising, and free cash flow margins are also rising. While I haven’t and will not forecast any dramatic market share trend reversals, overall the 3 platform approach of Palo Alto is leading to the ability of the company to grow faster than the market. And I remain surprised about the strength of the company’s appliance business. Growth in appliances + a rising attach rates is a formula for above market growth rates that I believe is underappreciated.
These days investors are focused more on profitability and free cash flow than has been true for some time now. And so too is Palo Alto. Notionally, I might have thought that would be reflected in the share price valuation-it really has not been the case.
The PANW CFO talked about the company exceeding a Rule of 60 metric for this current fiscal year. And it is a balanced beat, with revenue growth probably reaching more than 30% and with free cash flow margins of at least 33%. The published 1st Call consensus estimates for what will be fiscal year 2023 appear exceptionally constrained, particularly when it comes to EPS.
I ordinarily do not like to use free cash flow margins reaching to near 40% in preparing a NPV analysis. But given the guidance provided by this company, both on the call and in its past investor presentation, as well as the self-evident focus on improving operating margins, it seems reasonable to expect that free cash flow margins will continue to rise at a consistent rate for at least the next 2-3 years. And again, given management commentary, it seems likely that the ratio of stock based comp to revenue which has started to fall, will continue to do so, improving what some perceive to be the quality of free cash flow.
The company has a sizeable cash position, and many start-up cyber security firms no longer have a clear exit strategy with the IPO route basically closed at this point. This is a nice position to enjoy.
My estimates currently yield an NPV more than double Palo Alto’s share price, and that is even when using a weighted average cost of capital of 9.5%. I see Palo Alto as a conservative opportunity in one of the most recession resistant spaces in the IT sector, with a management laser-focused on profitability and free cash flow achieving very visible results.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Short position through short-selling of the stock, or purchase of put options or similar derivatives in PANW over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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future-dyanmics

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