Palo Alto: Negative Earnings, Strong Free Cash Flow Generation?

| About: Palo Alto (PANW)
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Palo Alto Networks is one of the fastest-growing cyber-security companies. The firm's reach and potential upselling opportunities are tremendous.

Estimates peg the cyber security market to surpass $150 billion by 2019 from under $100 billion in 2015. Palo Alto will have its hands in this large and growing pie.

Unlike many of its emerging cyber-security rivals, Palo Alto is significantly free cash flow positive, and we think this makes the firm a much more palatable investment idea.

Let's take a look at the firm's investment highlights as we walk through the valuation process and derive a fair value estimate for shares.

By The Valuentum Team

Palo Alto (NYSE:PANW) is a global cyber-security company that, unlike many of its peers, boasts free cash flow generation that is nothing short of impressive, which grew to over $315 million in fiscal 2015 from just over $50 million in fiscal 2014. The firm's addressable market is expected to continue to grow at a strong rate, giving Palo Alto a meaningful opportunity to continue its impressive top-line growth. For example, in the third quarter of fiscal 2016, ended April 30, revenue grew 48% on a year-over-year basis to $346 million. This tremendous revenue growth was outpaced by bookings growth of 61% from the year-ago period, indicating this high growth has a degree of sustainability.

Cyber-security is a rapidly changing industry, making it very difficult to pinpoint which firms will be industry leaders in the future. Not only do companies have to guard against all known threats, but they also have to be ready to develop a solution to prevent new threats that can arise at any given time. Ongoing innovation will be paramount for Palo Alto. Investors must also be cognizant of the competitive nature of the cyber security market. Companies such as Cisco (NASDAQ:CSCO) and Check Point (NASDAQ:CHKP) are constantly working to solve the next major security issue, and the threat of being left behind in the ever-evolving industry is all too real, especially for a firm that has yet to consistently generate profits on a GAAP basis.

Cyber-security currently ranks among the greatest worldwide threats to the US, giving Palo Alto the opportunity to seize increasing opportunities. The firm currently has more than 31,000 end-customers, giving it a leading position in enterprise security. Its focus on increasing its partner scale to companies like Verizon (NYSE:VZ) and AT&T (NYSE:T), along with its current partnerships, will give it a competitive edge as it continues to battle for market share in its cutthroat industry. The fact that Palo Alto is significantly free cash flow positive gives it a distinct advantage over peers, in our view.

Palo Alto's Investment Considerations

Investment Highlights

• Palo Alto Networks is one of the fastest-growing cyber-security companies. Its security platform protects thousands of enterprise, government, and service provider networks from intrusions. The company brings together all security functions into its service from advanced threat protection to URL filtering. It was founded in 2005.

• Palo Alto Networks' reach and potential upselling opportunities are tremendous. It has ~300,000 customers in over 140 countries, and more than 80 of the Fortune 100 and over half of the Global 2000 rely on Palo Alto Networks' platform.

• Some estimates peg the cyber security market to surpass $150 billion by 2019 from under $100 billion in 2015, but the reality is that the changing and evolving landscape could make this figure much larger. Palo Alto Networks will have its hands in this large and growing pie.

• The cyber-security market is incredibly dynamic and fast-changing. Continuous innovation to meet new and advanced threats will be the primary key to success. Partnerships with Vmware, Citrix, Splunk and Symantec will help Palo Networks stay ahead of the curve.

• Unlike many of its emerging cyber-security rivals, Palo Alto Networks is significantly free cash flow positive, and we think this makes the firm a much more palatable investment idea. It is also expected to have a profitable year in fiscal 2016.

Business Quality

Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. Palo Alto's 3-year historical return on invested capital (without goodwill) is 19.9%, which is above the estimate of its cost of capital of 10.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does notconsider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.

Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.

Click to enlarge

Image Source: Valuentum; EVA is trademarked by Stern Stewart & Co

In the chart below, we show the probable path of Palo Alto's ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Palo Alto's free cash flow margin has averaged about 22% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Palo Alto, cash flow from operations increased about 207% from levels registered two years ago, while capital expenditures expanded about 51% over the same time period.

Through the first three quarters of fiscal 2016, Palo Alto reported cash from operations of ~$471 million and capital expenditures of ~$56 million, resulting in free cash flow of ~$414 million. This is already nearly $100 million more than all of fiscal 2015. We like the trajectory of free cash flow generation.

Valuation Analysis

This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.

We think Palo Alto is worth $189 per share with a fair value range of $135-$243. Shares are currently trading at ~$135, near the lower bound of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at the moment.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.

We are anticipating continued robust revenue growth for Palo Alto for the foreseeable future. We also expect the firm to be meaningfully profitable on a non-GAAP basis in fiscal 2016. Significant levels of capital expenditures are assumed as well as the company continues to build its businesses to capture the growing demand of the cyber-security market.

Our model reflects a compound annual revenue growth rate of 32.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 32.8%. Our model reflects a 5-year projected average operating margin of 16%, which is above Palo Alto's trailing 3-year average.

Beyond year 5, we assume free cash flow will grow at an annual rate of 13.9% for the next 15 years and 3% in perpetuity. For Palo Alto, we use a 10.6% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $189 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Palo Alto. We think the firm is attractive below $135 per share (the green line), but quite expensive above $243 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Palo Alto's fair value at this point in time to be about $189 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Palo Alto's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $257 per share in Year 3 represents our existing fair value per share of $189 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.