Palo Alto Networks: High Ambition, Affordable Stock

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About: Palo Alto Networks, Inc. (PANW)
by: D.M. Martins Research
Summary

Palo Alto Networks delivered fiscal 4Q19 results that did not inspire investors, but the company's vision for 2022 looked more encouraging.

I believe Palo Alto Networks will become an increasingly important, integrated player in the cyber-security space.

Once earnings growth expectations are taken into account, I believe a long-term PEG of 1.7x is a good price to pay on PANW.

On September 4, Palo Alto Networks (PANW) reported an all-round earnings beat for fiscal 4Q19 that, at first glance, failed to impress.

But as the company's management team laid out its vision for the next few years during the analyst meeting that followed the earnings conference call, investors seemed more willing to embrace Palo Alto Networks' growth story - one that will likely be fueled by acquisitions, integrated SaaS solutions and footprint expansion into cloud and IoT security.

Credit: TechGenix

Beyond the results of the quarter

Regarding fiscal 4Q19, results were more mixed than encouraging. The top-line beat of only $2 million was the narrowest since early 2017 but largely met the management team's revenue growth expectations. Quarterly billings reached the $1 billion mark for the first time, but grew at a 22% pace that was very much in line with the earlier-year trend.

Profitability looked a bit softer than I expected. Gross margins expanded YOY, likely the result of gains of scale. But SG&A came in on the rich side, probably driven by integration efforts of Palo Alto Networks' 2019 acquisitions of Demisto, Twistlock and PureSec. See P&L below, on a non-GAAP basis.

Source: DM Martins Research, historical data from company reports

The more bullish story came later, when the company discussed its growth plans for the next three years. Grounded on Palo Alto Networks' "secure the enterprise, secure the cloud, secure the future" strategy, management unveiled its expectations for "a 20%, three-year compound annual growth rate in total billings to around $6 billion and total revenue to $5 billion by fiscal 2022", above consensus by what I estimate to be about 70 bps in top-line growth per year.

Palo Alto Networks' approach boils down to using its large cash reserves to finance bolt-on acquisitions that should expose the company to favorable trends in cloud, IoT, distributed enterprise network, and endpoint protection and analytics. The end result is aggressive TAM (total addressable market) growth that the executive team estimates at more than 9% per year through 2022 - see graph below.

Source: company's analyst day slides

Should Palo Alto Networks be successful in the execution of its strategy, the company might be able to produce at least 20% in annual revenue growth while allowing earnings to increase at an even higher pace, due to margin expansion.

On the stock

In my view, Palo Alto Networks represents a balanced combination of solid (not outstanding) business fundamentals with decent (not impressive) and improving growth prospects, and an affordable (not bargain) stock.

The tech company has turned the M&A knob up a notch since CEO Nikesh Arora took over in order to have a more relevant footprint in key areas of growth. As a result of projected gains of scale, I believe Palo Alto Networks will become an increasingly important, integrated player in the cyber-security space, while margins and cash flow should benefit from the transition to cloud and subscription-based services over time.

Chart Data by YCharts

Value investors may not find a next fiscal year P/E multiple of 32.8x overly enticing. But once long-term earnings growth projections of nearly 24% are taken into account, buying a stock valued at a PEG of 1.7x (current-year P/E divided by bottom-line growth consensus times 100) does not seem like too much of a stretch, in my view. For comparison, peer Cisco (CSCO) trades at a more aggressive long-term PEG of 2.2x, while the stocks of faster-growth competitors like Zscaler (ZS) still command stratospheric earnings multiples.

Following fiscal 4Q19 earnings and the recent analyst meeting, I maintain my views that PANW is a compelling GARP (growth at reasonable price) stock to buy and hold.

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.