Palo Alto Networks Inc. - Major thematic support
Palo Alto Networks Inc. is a global cyber security leader, providing next-generation solutions to thousands of customers globally, across all sectors. The company started as a firewall vendor but has grown to encompass all security areas. It offers integrated security solutions for cloud-native applications.
Cyber Security Market
Cyber Security remains an ever-evolving market. One of the most notable trends in the last few years has been the consolidation of cyber security appliances and solutions into more complete platforms offered by leading firewall vendors. A firewall is a network security device that monitors and filters incoming and outgoing network traffic. It basically provides a barrier between a private internal network and the public internet.
Over the past decade, cyber-attacks on computer networks and infrastructure have intensified, and these attacks have become more widespread because of the substantial financial incentives for hackers and the like. To curb these threats, governments and private companies are prioritising cyber security spending. Therefore, we expect increased demand for network firewalls, identity management, threat detection and endpoint security solutions. Furthermore, the increase in online commerce, cloud workloads and data require more protection, which supports the investment case for cyber-security stocks.
According to the Morgan Stanley Chief information officers (CIO) Survey for 4Q22, nearly 50% of all enterprise application workloads could move to the public cloud by 2025— from 27% at the end of 2022. In line with this mass migration to off-premise application workloads, CIOs also maintained cyber security spending is a priority. As a percentage of total responses, the projects with the largest spend increase during 2022 included Security Software (12%), Cloud Computing (10%), Data Warehousing/Business Value Analytics (9%), Digital Transformation (8.7%) and AI/Machine Learning (6.7%) amongst others.
While more capital is being allocated towards cyber security within organisations, this still only accounts for ~6% to 7% of total IT spend on aggregate and is now touching multiple parts of the organisation. This means cyber security companies have ample room for future growth and market penetration
Competition
Some of the key competitors in the cyber security market are BAE Systems (BA LN), Akamai Technologies (AKAM US), Microsoft (MSFT), MacAfee (MCFE), Cisco (CSCO), International Business Machines Corporation (IBM), Oracle (ORCL), CrowdStrike (CRWD), ForgeRock (FORG US) and AT&T (T US), amongst others.
Palo Alto's integrated cloud-native approach, i.e., building, deploying, and managing modern applications in cloud-based environments, provides a one-stop shop for enterprise security needs. This enables fast and frequent changes to applications without impacting service delivery, providing an innovative and competitive advantage.
Operating segments
Palo Alto offers network security, secure access service edge, cloud security, and end point security, through both products (~24% of revenue) as well as subscriptions and support services (~76%), to customers around the globe.
Within the product segment, the company sells firewall appliances and software, and its Panorama centralised security management solution. While the subscription division covers cloud-delivered security services solutions that are sold as options to its firewall appliances and software
2Q23 Results
Recent results for the second quarter came in ahead of consensus forecasts on both top and bottom-line growth metrics. The company generated robust revenue growth (+26%), reaching $1.7 billion, with billings improving by the same margin to $2 billion. The company's next generation security (NGS) business continues to grow its average recurring revenue (ARR) strongly, a positive read for future sales growth.
The Service Access Service Edge (SASE) business, which has made ~$1 billion in bookings over the last six quarters, has been a strong driver of growth. The segment remains hugely important as it converges two markets (wide-area networking and network security services) into one, cloud delivered platform. Management thus anticipates significant growth in this SASE market and, as such, continues to view this business as a priority.
Financial Outlook
Demand should continue to find support from some tailwinds due to changes in the security market, the primary change being consumers' preference for single-vendor supply of multiple security functions. As opposed to outsourcing to various service providers, cyber security customers increasingly prefer a vendor that offers a platform of interoperable solutions— firewall, antivirus, intrusion prevention etc. These changes, especially given the recent economic downturn, have accelerated the consolidation trend in the sector and have led to the company growing at roughly twice its total addressable market rate, as per management.
The strong results for the first half have supported upward revisions to internal targets, cash flow margin and operating profitability as the company remains focused on driving efficiency across the business.
Overall, the outlook for the company's long-term growth prospects remains robust. Shorter-term, management guided for 3Q23 total billings growth of between 22% and 25% as well as total revenue growth of between 22% and 24%. This is in line with Bloomberg consensus forecasts for growth of 23% and 24%, respectively. Diluted adjusted EPS is guided to be in the range of $0.90 to $0.94 (Bloomberg: $0.93).
Management also updated FY23 guidance and now expects billings and revenue to grow between 22% and 23% and 25% and 26%. This is in line with Bloomberg consensus forecasts for growth of 23% and 25%, respectively. Diluted adjusted EPS will be in the range of $3.97 to $4.03, which implies 59% growth y/y at the midpoint (Bloomberg: +59% to $4.02).
Investment case summary
Palo Alto is the largest IT security company by market capitalisation, with a substantial opportunity within its SASE business— which is a high-growth area with high gross margins, should it be able to transition its existing traditional firewall customer base.
CIOs maintain cyber security spending is a priority, which bolsters the investment case for cyber security stocks. We view this as an underappreciated theme, with resilience in an uncertain macro environment.
Specifically, we like Palo Alto for its strong balance sheet, top-line growth, margin, and ROE expansion.
Other supportive factors include inclusion in the S&P 500, sustained cyber security demand, trends fuelling a shift to software, as well as macro tailwinds from some easing inflationary pressures.
Overall, Palo Alto offers a disruptive platform, well-positioned to address the evolving cyber-threat landscape while differentiating itself from its peers.
Risks
Innovation and disruption. This remains both an opportunity and risk for the company. In general, if companies fail to adapt to the rapid global technological changes this can cause entities within the cyber security industry to quickly become obsolete. This was the case for Palo Alto in its early days, but the company was able to pivot timeously, moving beyond its original firewall offering into a more complete cyber security company.
Economic cycles. The cyber security market experienced a dip in 2020 because of the Covid-19 pandemic, which led to the closure of several organisations, especially during the first half of the year. However, the market rebounded towards the latter part of the year as a growing number of firms deployed cyber security solutions during the remote working phase. The work-from-home culture resulted in amplified organisational security risks as employees increasingly used personal devices for work purposes while connecting to private Wi-Fi.
Other risks include a potentially detractive slowdown in demand, and the fact that the company is priced as a growth stock - any disappointment on this front could result in share price pressure.
Consensus view and Valuation
Consensus is positive on Palo Alto, with 85% of sell-side analysts maintaining a BUY on the stock.
Bullish sentiment has increased over the last 24 months.
With strong secular positioning and the drive towards higher operating margins, we remain confident in the durability of our free cash flow (FCF) estimates. The stock is trading at 21 times CY24E FCF vs our model, which looks for 25% FCF compounded annual growth rate from CY22 to CY24E. We see attractive risk/reward in PANW shares.
