Despite the 2022 bear market, Palo Alto Networks (NASDAQ:PANW) is up 28% over the past year. However, at its Friday close of $511, the stock is down significantly (~20%) from its April closing high of around $628 (see chart below). While stocks last Scores very highly on most traditional metrics, and the company’s prospects for continued revenue and margin growth are excellent. I say that because the company has established itself as a global leader in cybersecurity, and as such, can feed on threat alerts from its large customer base to enhance its threat protection services. In addition, PANW should be able to integrate next-generation cyber analytics and machine learning to extend its leadership in the field. In the meantime, PANW’s SaaS-based platform should enable it to continually increase margins in the future.
As most of you know, cybersecurity is a rapidly growing sector that has outperformed the broad market average. The chart below compares the 3-year performance of Palo Alto Networks and the Global X Cybersecurity ETF (BUG) on the broad market averages of the S&P500, DJIA and Nasdaq-100, represented by the ETFs SPY, DIA and QQQ:
As you can see, despite a significant pullback since April, Palo Alto still leads the pack by a wide margin. That’s because PANW has established itself as a leader in cybersecurity by focusing on delivering solutions in three basic cybersecurity categories:
- Defend the network
- Secure the cloud
- Secure the future (SOC automation)
In a recent presentation at the BofA Global Technology conference, Nikesh Arora, CEO of PANW, discussed each of these categories in depth and highlighted the market opportunities each offers (see conference transcript here). Regarding the first category above, Arora said:
In this network security stack, the The biggest move will be a $20-$30 billion TAM that will be created as we talk about SASE, where we are one of 2.5 players. Here we are, Zscaler (ZS) and Netscopes. Nobody else delivers SASE. [Author Note: SASE means “Secure Access Service Edge”]
In the second category, Arora spoke of the many acquisitions PANW has made over the years. These include Evident (AWS security), RedLock (cloud workload security), Twistlock (container security specialist with 460 customers), Aporeto and Bridgecrew. As a result, PANW accelerated its growth in cloud security and now offers nine modules on its cloud platform. His largest cloud deal was worth more than $10 million.
The third major category is future-proofing through SOC automation (SOC stands for “Security Operations Centers”). Security automation relieves customers of constant tool management and alarm fatigue. Aora said:
A third business that’s still interesting is this whole confluence of endpoints and SOC automation. That will be a TAM of $30 or $40 billion over the next five to 10 years. This is the next big thing…
Palo Alto Networks released its Q3 EPS report in May, and it was more in line with what investors are expecting (in a word – outstanding):
While overall revenue growth of 29% year over year was impressive, it was the box in the lower-right corner that caught my eye: Free cash flow of $351 million was equivalent to an estimated $3.52 per share and grew 40% % YoY. This proves that PANW’s margins are increasing as the company continues to grow its SaaS-based business. Note that FCF was 25.2% of total revenue.
As previously mentioned, PANW is signing some very large deals and has seen 73% year-over-year growth in transactions over $5 million, while achieving 286 seven-digit deals.
PANW’s Prisma Cloud, Cortex, and Prisma SASE solutions all demonstrated strong year-over-year customer growth (23%, 64%, and 52%, respectively), while next-gen security Annual Recurring Revenue (“ARR”) for the quarter Exceeded $1.6 billion:
Operating margin for the third quarter was 18.2%, up significantly from 17.0% in the third quarter of last year. This will likely be a consistent trend for Palo Alto in the future.
The third quarter was so strong that management raised guidance for fiscal 2022 significantly:
Note that the midpoint of its operating margin guidance for fiscal 2022 is 18.75%. That’s another 55 basis points up from Q3, and with only one quarter left in the fiscal year, that means strong margin growth for Q4.
At the aforementioned BofA conference, CEO Arora broke down the public cloud market opportunity by pointing out that around $200 billion worth of public cloud sales last year Google’s (GOOG) GCP, Amazon’s (AMZN) AWS and Microsoft’s (MSFT) Azure.
Arora suggested that with Google, Amazon, and Microsoft taking care of data center security, cloud security should account for an estimated 2% to 5% of total public cloud revenue, representing a TAM of $4 billion to $10 billion. Dollar (in a year) that will ultimately change over time into a $1 trillion market. He believes half of that market will be captured by cloud providers, leaving a $10 billion to $25 billion security opportunity over $1 trillion in cloud spending. Right now, Arora says the market is only ~$1 billion. So that’s a 10x to 25x TAM opportunity for Palo Alto go forward. In other words, PANW should be able to continue its rapid revenue and margin growth for years to come.
Currently, Seeking Alpha shows that PANW has a market cap of $50.9 billion and is trading at an expected P/E of 68.6. As of Friday’s close, the company is trading at almost 9.6x price-to-sales and ~150x price-to-book. No argument from me that PANW is valued very highly compared to the overall market. But it should. That’s because I expect PANW to grow revenue by an average of 25%+ over the next 5 years, and I expect margin to increase over that period. In the meantime, I have already established that Palo Alto is an FCF generating machine today, and that machine will continue to grow bigger and stronger over time, with strong ARR growth giving investors a high level of confidence in a more stable base level There is revenue to grow from.
Meanwhile, investors should keep in mind that PANW’s cybersecurity ecosystem has a very wide moat. Also note that competitor Zscaler is currently trading at a forward P/E of 247x and CrowdStrike is trading at 151x. Note, however, that ZS’s FCF margin was just 15% last quarter. CRWD’s last quarter was more impressive, but does CRWD justify a forward P/E more than double PANW’s? I do not think so.
Risks include something Arora alluded to above: that public cloud providers could actually win the majority of cybersecurity business from their customers — especially if Google, Amazon, and Microsoft start offering cybersecurity products outside of their data centers. Note, however, that in June, Palo Alto was selected as the winner of the Google Cloud Partner of the Year Award for Security for working with GCP to develop easy-to-manage cloud-native security solutions. In my opinion, the fact that a company like Google is proactively working with PANW to bring cutting-edge cybersecurity solutions to its cloud customers bodes well for the future of both companies.
Although I don’t think any of PANW’s current competitors offer the same breadth of solutions, companies like Zscaler and CrowdStrike (CRWD) could enter PANW territory and take market share.
Palo Alto’s balance sheet is very strong: no debt and — as of the end of the most recent quarter — $3.9 billion in cash and short-term investments. That’s an estimated $38.86/share based on 99.6 million shares outstanding.
Summary & Conclusion
Palo Alto stock is down about 20% since April. However, May’s EPS report was stellar and a continuation of what investors routinely expect of the company. Based on the investment thesis above, I believe Palo Alto can sustain revenue growth at a rapid clip (25%+) for at least the next five years. I also expect margin to continue growing as the company expands its SaaS-based platform. PANW is a BUY.
I’ll end with a 5-year chart comparing Palo Alto, CrowdStrike, and Zscaler stock prices, noting that CrowdStrike is a strong contender in this space:
Because of this, some investors may want to take a more diversified bet in the cybersecurity sector. My pick for diversity is the BUG ETF (see BUG: Why you should own cybersecurity stocks now). Regardless of how one engages in cybersecurity, I think the potential for growth is just too great to ignore.