Palo Alto Networks, Inc. (NASDAQ:PANW) is one of the top cybersecurity stocks that has seen a resurgence of interest among investors. Under the able leadership of CEO Nikesh Arora, he has created his next generation security for compete against pure cybersecurity companies like Zscaler (ZS) and CrowdStrike (CRWD).
Notably, Palo Alto does not see it as an integrated platform comprising relatively weak offerings. Articulated Arora (edited):
I agree that our customers want the best in class. So we don’t just sell an integrated platform. We sell an integrated platform, comprising the best of its kind. We have 10 solutions that we can sell to you independently that will match or beat any public provider in the same space or you can get them from us. And, they will also work together better. (Morgan Stanley TMT Conference 2022)
PANW shares have also performed admirably in the last two months. We initiated our Buy rating before the start of the Russia-Ukraine conflict as their valuation seemed reasonable. Since then, the stock has gained 28.2% (S&P 500: 3.9%).
Therefore, we believe that PANW shares have already reflected the short-term upside from their February low. Furthermore, its price action also appears to be well overbought, which could work with some needed digesting of the sell-off.
As such, we are revising our rating on PANW stock from Buy to Hold. We encourage investors to patiently wait for the next significant pullback before adding exposure.
Strong customer adoption validates its integrated platform
Palo Alto believes that it is the leading SASE player with a highly capable integrated portfolio. The company’s shift to focus on cloud security, zero trust, and XDR within a multi-cloud environment has benefited its cross-selling capabilities.
In particular, the company emphasized that 75% of customers on its next-generation platform are existing customers. While pure gaming peers like Zscaler argue that network security is not critical to the SSE framework (excluding SD-WAN), Palo Alto takes the opposite view. Accented Arora (edited):
Clients come in all flavors and types and have their own strategies. But most customers want to implement a consistent security protocol across their data center, public cloud, and remote or branch office use case.
We are the only cybersecurity company that can implement the same security policies across your public cloud and your remote or data center use case.
Nobody else can do that because nobody provides those 3 solutions. So where we’re seeing our growth is our existing very large enterprise customers want to be consistent in how they implement zero trust. (Morgan Stanley Conference)
In addition, Palo Alto also recently launched its AWS Cloud-Native (AMZN) Next-Generation Firewall (NGFW), customized for the AWS Cloud. We think it proved that network security is well and alive as it pivots to the cloud. Palo Alto emphasized (edited): “Our goal is to provide “best in class network security” delivered with the simplicity of a native AWS service. It is the first cloud network security solution to offer a combination of both.”
Therefore, we believe that the company is well positioned to compete against the pure gaming leaders, who do not have the network security advantage of Palo Alto.
But investors need to focus on their path to GAAP profitability
The company has continued to report strong growth in the second quarter of the year, with revenue increasing 29.5% year-on-year. The growth was also broad-based, especially in its software ARR growth which grew 70% year over year. However, investors should note that the company remains unprofitable on a GAAP basis. Palo Alto explained that its rush of acquisitions required the company to use stock-based compensation (SBC), which significantly affected its operating expenses. Arora clarified (edited):
The way we bought them was that we unbundled the founders from their equity in their companies and reinvested them with Palo Alto stock over a 4 year period.
That was the only way we could secure the talent of all these founders of the companies we bought. So a significant part of our SBC is the integrated M&A cost of retaining founders. (Palo Alto FQ2’22 Earnings Call)
In particular, management further clarified that its pace of mergers and acquisitions has slowed dramatically. It noted that it had not completed any “significant mergers and acquisitions in the last two or three quarters.” Therefore, investors should expect a “gradual shift down” in its SBC going forward. In addition, Palo Alto also announced that it would guide its way to GAAP profitability at the end of FQ4’22 (July quarter). Therefore, investors are strongly advised to pay attention to its guidance.
Investors have been justifiably concerned about share dilution from his SBC policies. However, Palo Alto has taken advantage of its strong FCF margins to undertake share buyback programs to partially offset the dilution.
For example, the company repurchased shares worth approximately $550 million ($534 average price) in FQ2. He still has $450 million left of his current authorization for the remainder of FY22.
While it has not fully offset its share dilution, we believe the impact has been mitigated. The company reported around $987 million in SBC over the last twelve months. Therefore, its share buyback program has been instituted to keep in line with its share dilution.
Still, the company hasn’t telegraphed a clear timeline for when the SBC would drop. Therefore, investors should continue to monitor closely.
Are PANW shares buy, sell or hold?
PANW shares are on hold. Its EBIT NTM multiple of 52.9x has risen well above its 3-year average of 37.7x. Furthermore, its NTM FCF yield of 3.3% was also well below its 3-year average of 4.4%. Additionally, PANW shares also hit their average consensus price (PT) targets and were well above their more conservative PTs.
Additionally, the stock has also been testing a critical resistance level and therefore we believe it could attract significant selling pressure.
As such, we encourage investors to bide their time before adding this cybersecurity leader in the next significant pullback.