Palo Alto Networks: Leaders In Cybersecurity

Summary

• Palo Alto Networks reported Q3 earnings that beat estimates, but a revised guidance going forward has led to a pullback in share prices.
• Cybercriminal activity has been at the forefront of global security concerns and has fueled growth in the demand for cybersecurity solutions.
• An increase in R&D spending complemented with PANW's recent acquisitions bolster the company's leading position in the cybersecurity market and to take advantage of the anticipated surge in demand.

Overview

After sinking below the $200 mark in the beginning of June, Palo Alto Networks (NASDAQ: NASDAQ:PANW) seems to be picking up steam. Can the company sustain this pace to go over-and-above the 52-week high of $260.63? As the dominant player in the cybersecurity market, PANW is in an ideal position in benefiting from increased cybersecurity demand as the digital economy continues to develop. Corporations and governments continue to allocate more capital towards cybersecurity as evidenced by an expected 8.7% surge in worldwide cybersecurity spending in 2019. Strategic acquisitions, healthy gross margins, decreasing operating and spending rates, and continued investment in R&D will continue to generate strong profits over the next 9 to 12 months and will drive share prices to the $270 to $290 as cybersecurity continues to play an increasing role in corporate business.

Source: Yahoo Finance.

Q3 2019 Earnings

Summarizing Q3 2019 earnings:

• Actual EPS of $1.31 vs. Consensus EPS of $1.25.

• 28.12% YoY growth in revenue to $726.60 million.

• 13% YoY growth of billings to $821.9 million.

Despite posting Q3 results that topped expectations, a temporary selloff of PANW shares was triggered after a monotonous Q4 guidance going forward. PANW revised Q4 2019 EPS to $1.41-$1.42 versus the $1.55 consensus. Revenue was also revised down to $795-805 million from $793.81 million. The revised guidance factors in the approximate $15 million net expense related to the proposed Twistlock and PureSec acquisitions, as well as the completed Demisto acquisition. A $2.5 million impact from tariffs was also factored into the guidance stemming from the ongoing US-China trade feud.

Analysts highlighted their primary concern regarding PANW’s shift to annual cloud-based subscriptions, which they expect will curb cash flow and distort billings. The cybersecurity company missed the $872.6 million expected billings by posting $821.9 million in billings and attributed this to shorter-duration billings as they shift to annual subscriptions from three-year contracts. The impatience from investors regarding PANW’s transition to cloud offerings sparked a healthy selloff, which has now recovered thanks to the company’s recent acquisitions in cloud-focused tech companies and continued investment in R&D in a time where competitors are tightening R&D budgets. The cybersecurity space is highly competitive and is characterized by a variety of large and small enterprises looking to win market share. PANW’s expenses of $1 billion+ from its five recent acquisitions and recovery in R&D spending will pay off as competitors fight to demonstrate viable value-added components that result in consumers opting to pursue business with them over others.

Source: The Motley Fool.

The CyberSecurity Market

Worldwide demand for cybersecurity continues to grow at an exponential pace. Global research and advisory firm Gartner expects worldwide spending on cybersecurity products and services to surpass $114 billion in 2018, a sharp increase of 12.4% from 2017. Going forwards, Gartner expects the market to grow almost 9% to $124 billion in 2019 and $170.4 billion in 2022. It’s important to note that unlike other tech sectors, which derive growth from reduced inefficiencies and increased production, cybersecurity is driven by cybercriminal activity. Cybercriminal activity has reached unprecedented levels as the mediums by which hackers can attack continues to increase in addition to the spectrum of potential targets. The increasing complexity of cyberattacks against consumers, governments, corporations, and educational institutions globally complemented with a growing ransomware epidemic, the refocus of malware from PCs and laptops to mobile devices, and rapid deployment of under-protected Internet of Things (IoT) devices has brewed a perfect storm that will continue to drive cybersecurity demand going forward.

Analysis

PANW’s acquisitions have positioned the company to strategically integrate new technology in solidifying its already world-class product offerings and services. The $560 million acquisition of Demisto was motioned through to bring intelligent automation across PANW’s platform while accelerating its machine learning and AI capabilities. The transition to cloud was also aided by the company’s acquisitions of Evident.io and cloud security startup RedLock. By adding these to PANW’s existing cloud security offerings, customers will be attracted to a higher level of cloud security analytics, real-time remediation, compliance monitoring, and threat detection all within a single package. These are key pain points among existing and potential customers, and the simplicity PANW has strategized in the deployment of these products will reap rewards for the company through increased sales and order sizes.

Additionally, plans to acquire container security specialist Twistlock and the server-less security company PureSec are expected to be integrated into PANW’s new cloud security suite known as Prisma. Prisma, the company’s new, comprehensive cloud security suite, ensures customers can consistently govern access, secure applications, and protect data. Organizations utilizing Prisma will be able to adopt SaaS with cloud access security brokers, improve security through different multi-cloud channels, and connect office branches and mobile users to the cloud. PANW attributes its leading position as the largest cloud security business in the world with over 9,000 enterprise consumers thanks to the Prisma platform.

Finally, as cybercriminal activity continues to dominate global concerns, PANW is in a unique position to benefit from “Zero Trust”. Unlike traditional security models, zero trust is represented by a model that doesn’t deem users inside a given network as more trustworthy than those outside the network. The zero trust model essentially increases security by assuming hackers already exist inside the network and aims to stop these intruders from infiltrating the rest of the network by limiting their access within the network. Data breaches seem to only be increasing as major banks, healthcare companies, and other data-sensitive industries continue to announce the mismanagement of millions of customer records. Zero trust models are dominating the demand appetite of consumers, and PANW’s R&D investment to develop this product offering ensure they will be the ones who benefit greatest from this consumer shift.

Verdict

PANW’s most recent pullback and subsequent rally places share prices on a sustainable trajectory going forward. PANW’s customers have increased spending on services with the value of the company’s top 25 customers increasing 35% YoY to a minimum of $38.7 million in Q3. This has fueled an increase in gross margins which increased 30 basis points over the year and only continue to increase as PANW’s scope of offerings from its acquisitions widens. Compared to key cybersecurity competitors of similar size including Proofpoint (NASDAQ: PFPT) and CyberArk Software (CYBR), PANW is the obvious winner for those looking to ride the increase in cybersecurity global demand going forward. The P/E ratio of PANW is valued at 42.25 versus PFPT’s P/E ratio of 72.66 and CYBR’s P/E ratio of 90.72. Investors skeptical of the company’s transition to cloud services can be assured that this is being addressed head-on by the organization as evidenced by recent acquisitions and a recovery in R&D spending. The company boasts gross margins of 76% and expects to increase this as subscriptions sales grow. Its operating spending-rate will also continue to decrease with an expected 15% + in revenue growth for 2019. Share prices are in a prime position to rally to the $270 to $290 range over the next 9 to 12 months as PANW continues to build upon its reputation as the global leader in cybersecurity.

Source: The Motley Fool.

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.