Palo Alto Networks: An Emerging Leader In Cyber Security

| About: Palo Alto (PANW)

Summary

Our recommendation is a long with a price target of $147.83 for a 16.7% upside over a 1-2 year time horizon.

Our thesis focuses on PANW’s ability to leverage its product and geographic differentiation.

PANW is uniquely placed to become a leader in this growing industry.

Industry Overview

$1 trillion will be spent in the cyber security industry cumulatively between 2016 and 2021. Cloud adoption will fuel more targeted attacks on cloud services. As enterprise perimeters expand so will security vulnerabilities. Enterprises will be more vulnerable than ever as the Internet of Things expands the attack surface. JPMorgan doubled their annual cyber security budget from $250 million to $500 million while the U.S. government increased annual cyber security budget by 35%, going from $14 billion in 2016 to 19 billion in 2017. The market's projected compound annual growth rate is over 12% from 2016-2024. Cyber security is a market where multiple vendors can be used by the same consumer.

Company Overview

Palo-Alto Networks (NYSE:PANW) is a cyber security company that provides its customers with a platform that allows enterprises, service providers and government entities to secure their organizations by safely enabling applications running on their networks and by preventing breaches that stem from targeted cyber attacks. The company creates value to its customers by simplifying customers' security infrastructure and eliminating the need for multiple, standalone security appliances and software products. Their Next-Generation Security Platform consists of three elements:

  • Next-Generation Firewall: Delivers application, user and content visibility and control as well as protection against network-based cyber threats integrated within the firewall through its proprietary hardware and software architecture

  • Advanced Endpoint Protection: Prevents cyber attacks that aim to run malicious code or exploit software vulnerabilities on a broad variety of fixed and virtual endpoints and servers

  • Threat Intelligence Cloud: Provides central intelligence capabilities, security for software as a service ("SaaS") applications and automated delivery of cyber attack prevention.

PANW's customers are predominantly medium to large enterprises in industries spanning a variety of industries including healthcare, energy, finance and education, as well as service providers and government entities. As of July 31, 2016, PANW had approximately 34,000 end-customers worldwide with no single end-customer accounting for more than 10% of its total revenue in fiscal 2016, 2015 or 2014. PANW primarily sells its products and services to end customers through channel partners. For fiscal 2016, 58.2% of total revenue was derived from sales to two distributors, and as of July 31, 2016, PANW had over 3,600 channel partners. PANW also sells its virtual firewalls directly to end-customers through Amazon's AWS Marketplace and Microsoft's Azure Marketplace under a usage-based licensing model. 70.6% of total revenue in fiscal 2016 was from the Americas, 17.9% from EMEA, and 11.5% from APAC with better sales occurring in the second and fourth fiscal quarters.

PANW's R&D expenditures were $284.2 million, $185.8 million and $104.8 million in fiscal 2016, 2015, and 2014, respectively.

It acquired Morta Secruity, Inc. in December 2013, Cyvera Ltd. in April 2014, and CirroSecure, Inc. in May 2015 (all three of these companies are cybersecurity companies).

Revenue Breakdown

48.7% of revenue comes from products and 51.3% of revenue comes from services of which 50.44% is subscription services and 49.66% is support and maintenance services.

Sales Channels

Palo Alto Networks partners with two main distributors: Arrow Electronics and Westcon Comcast. They also have a channel program called the NextWave Partnership Ecosystem.

Competitive Landscape

TICKER

COMPANY

1 YEARS PERCENT SALES CHANGE

3 YEAR PERCENT SALES CHANGE

DEBT / EBITDA

REVENUE

5 YEAR REVENUE CAGR

PANW

Palo Alto Networks

40.0 %

51.57 %

--

1.48 B

63.33 %

IMPV

Imperva

40.7 %

30.8 %

--

258.77 M

33.44 %

FTNT

Fortinet

32. 7 %

25.1 %

-13.97

1.21 B

25.46 %

CHKP

Checkpoint

8.9 %

7.1 %

-4.24

1.71 B

8.22 %

SYMC

Symantec

-5.6 %

2.0 %

-4.28

3.65 B

-10.27 %

CUDA

Barracuda Networks

15.4 %

17.20 %

-13.22

320.16 M

17.63 %

FEYE

FireEye

39.5 %

-

-

714.19 M

121.19 %

AVERAGE :

20.54 %

22.38 %

-3.69

1.08 B

29.75 %

Investment Thesis

  1. Growing Industry: Explosion of enterprise perimeters, IoT, etc. to pull forward industry growth at ~10% CAGR.

  2. Product differentiation

    1. Sticky relationships in hardware: PANW's single-pass technology captures the market trend in hardware toward integrated systems, giving them industry leading growth and customer retention rates.

    2. Agnostic hardware: Uniquely positioned to maintain product revenue as bedrock of their income, but still harness the trend of increasing service revenue. They have the services and the infrastructure. Their growth records and customer retention rates prove this.

    3. Service expansion: PANW's growth of services is expanding at a higher rate than any of its peers, which corroborates PANW's unique ability to innovate, and will provide a future outlet for steady growth.

  3. Geographical differentiation: PANW avoids macroeconomic exposure as most of its revenue comes from the Americas. It is uniquely positioned to make the most of both US budget allocations and EU legislation.

1. Growing Industry

Worldwide cloud spending to double from $70 billion in 2015 to $141 billion in 2019. ~30 billion IoT devices to be connected to the internet by 2020. The company has increased its investment in R&D every single quarter it has been public, for more than 21 consecutive quarters. PANW is one of the only providers able to fully integrate all aspects of threat prevention into a true end-to-end platform focused on prevention and is demonstrating a sustainable competitive advantage. PANW is winning in the marketplace against point solutions unable to offer a fully automated prevention platform and against incident response vendors as enterprises prefer a prevention architecture.

2. Product Differentation

a) Sticky Relationships in Hardware

Hardware firewalls are the preferred solutions for large organizations and corporations that want a single security umbrella that protects multiple systems and that are capable of having IT personnel who can manage and monitor such devices. The current trend in the hardware firewall market is a shrinking down in number of point products in use at large enterprises. PANW's Next-Generation Firewall Single Pass Software scans content based on the same stream. By adopting this methodology, PANW's Next-Generation Firewall is negating the use of separate scan engines and signature sets, which results in low latency and high throughput (more integration and better performance). In the past 12 months, PANW added 34,000 customers, which they attribute to their integrated firewall product, and have a customer retention rate of over 90%.

b) Agnostic Hardware

Next Generation Firewall made in United States can be uniquely tailored to fit a wide range of specifications and can be engineered to complement software, thus allowing a package that is extremely secure, adaptable and greater than the sum of its parts. There is projected to be approximately 30 billion IoT devices to be connected to the internet by 2020. PANW is uniquely positioned to maintain hardware product revenue as the bedrock of their income, but still harness the trend of increasing service revenue. Its unique blend of hardware and software solution leads to high customer retention rates, allowing them to capture more market share at a higher rate than peers (10 percent of market share in past 4 years (2-12 percent from 2012 to 2016).

TICKER

COMPANY

1 YEARS PERCENT SALES CHANGE

3 YEAR PERCENT SALES CHANGE

PANW

Palo Alto Networks

40.0 %

47.4 %

IMPV

Imperva

40.7 %

30.8 %

FTNT

Fortinet

32.7 %

25.1 %

CHKP

Checkpoint

8.9 %

7.1 %

SYMC

Symantec

-5.6 %

2.0 %

CUDA

Barracuda Networks

15.4 %

-

c) Service Expansion

There is a concentration on subscription services. Two new services were released during the first quarter of fiscal 2016: Aperture subscription service (provides added visibility and control within IT-sanctioned Software as a Service (SaaS) applications that are used to store and share end-customer's data) and AutoFocus cyber threat intelligence service (provides prioritized actionable intelligence on targeted cyber attacks). PANW's service expansion has grown at a higher rate than any of its peers, namely Checkpoint, Juniper Networks, Fortintet and Cisco. PANW have captured 10 percent of the market share in the past four years (2-12 percent from 2012 to 2016). Bernstein analysts estimate that "Palo Alto Networks own ~12% share of the base in Internet network security, but it's capturing ~43% of the market growth.

3. Geographical Differentiation

PANW avoids macroeconomic exposure as most of its revenue comes from the Americas. It is uniquely positioned to make the most of both US budget allocations and EU legislation.

Trump has called for a reinvestment in defense spending totaling over $500 billion over the next 10 years. It is unclear how much of this will be spent on cyber security but given current trends where the cyber security budget increased 15% to $6.7 billion last year, this is likely to provide a large boost to the industry.

PANW's next largest market is EMEA. New EU Data Breach Notification Laws mean that firms are held accountable for cybersecurity breaches and can be find for breach occurrences. This filters through to an increase in defense spending in EMEA.

Model Assumptions

Assumptions

Bull

50% 2017 subscription and support growth, tapers to 30% in 2020. 7 EV/sales multiple. Products revenue grows 15% in 2017 and tapers to 10% in 2020.

Base

45% 2017 subscription and support growth, tapers to 25% in 2021. 6.5 EV/sales multiple. Products revenue grows 15% in 2017 and tapers to 10% in 2019.

Bear

35% 2017 subscription and support growth, tapers to 15% in 2020. 6 EV/sales multiple. Products revenue grows 12% in 2017 and tapers to 0 in 2020.

Valuation

2021 revenue

Discounted share price

Bull

4,876.3

185.39

Base

4,191.2

152.65

Bear

2,867.1

95.80

Weighted average

147.83

Risks and Catalysts

Catalysts

We would like to see the following in Q2 and Q3 results:

  • Revenue growth accelerating

  • Cost restructuring with CapEx and Operating Costs decreasing

  • Margin expansion

  • Continually gaining accounts from competitors

Risks

PANW has experienced rapid revenue growth (>25%) year-on-year. If this growth slows, without cost restructuring and increased margins, historical experience shows these companies get hit hard. Palo Alto may expand more globally, causing more exposure to foreign currency risk. Palo Alto has recently partnered with two service providers in APAC. Palo Alto is more dependent on debt to grow. Failure to get more loans if when they need borrowed money to succeed may be detrimental. A small number of channel partners represent a large part of their revenue - two distributors represent 58% of the revenue. As with all cyber security companies, a data security problem that allows an unauthorized entity to get information can harm the company's reputation and consequently revenues.

Disclosure: I am/we are long PANW.

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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