Why Cisco Will Not Kill Off Palo Alto Networks

May.27.14 | About: Palo Alto (PANW)

Summary

Even with Cisco's size and scale, Palo Alto's capabilities are hard to trump.

Palo Alto's next-generation technology have proven efficient in protecting company networks from virus attacks, malware and other security breaches.

Palo Alto's hybrid hardware/software model makes it a likely acquisition target for a company like IBM that is looking to diversify its business into the realm of software delivery.

Investors of enterprise security giant Palo Alto Networks (NYSE:PANW) have felt anything but secure since shares hit a 52-week high of $80.84 on March 18. Since that peak, the stock has been down by close to 30%, hitting an intra-day low two weeks ago of $57.47. But they wouldn't stay down for long, rebounding by more than 15%, closing Friday at $66.99. Shares are up 16% year to date. But the share price gyrations are just some of the concerns investors have had.

Although Palo Alto has secured a double-digit market share position in the network security space, Cisco (NASDAQ:CSCO) has emerged as a worthwhile threat. And Cisco's $2.7 billion acquisition of anti-hacking giant Sourcefire (NASDAQ:FIRE) suggests that Cisco is going after Palo Alto's market position. But even with Cisco's size and scale, Palo Alto's capabilities are hard to trump.

Palo Alto's next-generation technology have proven efficient in protecting company networks from virus attacks, malware and other security breaches. Its platform includes network firewall software and appliances. It also offers subscription services for threat detection and prevention, which has gained excellent traction within the enterprise.

Don't discount that Palo Alto already generates above-average free cash flow margins, which is not expected for a growth company. Remarkably, management has been able to achieve this with less-than 15% market share.

While Cisco is indeed a worthwhile threat, Cisco should be as fearful of Palo Alto. With the company due to report fiscal third-quarter report Wednesday, investors would be wise to buy this stock before margin leverage sends the shares higher.

The Street will be looking for 10 cents in earnings per share on revenue of $146.21 million. Earnings are expected to grow 66% year over year, while revenue is projected to grow 44%. Given the better-than-expected results just released from other enterprise giants, analysts have grown more optimistic about Palo Alto's results.

Last week, while affirming his "Outperform" rating on the stock, Wells Fargo analyst Gray Powell, noted that Palo Alto's full-year revenue growth expectations of 37% may be too conservative. Unlike Cisco, which is by far a larger company, revenue has never been an issue for Palo Alto.

In the February quarter, the company posted revenue of $141 million, which was up 46% year over year. The company posted a 31% jump in product revenue, while the higher-margin services business grew 74% year over year. On Wednesday, I don't expect much divergence from these numbers.

The recent customer data breach impacting Target (NYSE:TGT) underscores the importance of enterprise security. Companies are now on high alert, especially since more applications are being accessed from the cloud. No company stands to benefit more from this improved spending environment than Palo Alto Networks.

Although the patent litigation with Juniper (NYSE:JNPR) does present some risk, I don't believe this threatens Palo Alto's long-term profitability. And the company's hybrid hardware/software model makes it a likely acquisition target for a company like IBM (NYSE:IBM) that is looking to diversify its business into the realm of software delivery.

With Palo Alto shares still down 17% from their all-time high, I would be a buyer here ahead of Wednesday's report and project fair value to reach $90 on the basis of double-digit long-term revenue and free cash flow growth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Wall Street Playbook's tech sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.