Palo Alto Networks, Inc. (NASDAQ:PANW) is one of the leading cybersecurity stocks that has seen a resurgence in interest among investors. Under CEO Nikesh Arora’s competent leadership, it has created its next-gen security to compete against pure-play cybersecurity companies like Zscaler (ZS) and CrowdStrike (CRWD).
Notably, Palo Alto doesn’t consider it an integrated platform comprising relatively weak offerings. Arora articulated (edited):
I agree that our customers want best-of-breed. So we don’t sell just an integrated platform. We sell an integrated platform, which is comprising the best-of-breed. We have 10 solutions we can sell you independently, which will meet or beat any public vendor out there in the same space or you can have them from us. And, they will also work together better. (Morgan Stanley TMT Conference 2022)
PANW stock has also performed admirably over the last two months. We initiated our Buy rating before the start of the Russia-Ukraine conflict, as its valuation seemed reasonable. The stock has since gained 28.2% (S&P 500: 3.9%).
Therefore, we believe that PANW stock has already reflected the near-term upside from its February bottom. Furthermore, its price action also seems well-overbought, which could do with some necessary selling digestion.
As such, we revise our rating on PANW stock from Buy to Hold. We encourage investors to wait patiently for the next meaningful retracement before adding exposure.
Robust Adoption by Customers Validate Its Integrated Platform
Palo Alto believes that it’s the leading SASE player with a highly capable integrated portfolio. The company’s pivot to focus on cloud security, zero-trust, and XDR within a multi-cloud environment has benefited its cross-selling capability.
Notably, the company emphasized that 75% of customers on its next-gen platform are existing customers. While pure-play peers such as Zscaler argue that network security is not fundamental to the SSE framework (excluding SD-WAN), Palo Alto considers otherwise. Arora accentuated (edited):
Customers come in all flavors and types and they have their own strategies. But most customers want to deploy a consistent security protocol across, everything, across their data center, public cloud, and their remote or branch use case.
We’re the only cybersecurity company, which can deploy the same security policies in your public cloud and your remote use case or in the data center.
Nobody else can do that because nobody provides all those 3 solutions. So where we’re seeing our growth is our existing very large enterprise customers want to be consistent in how they deploy zero trust. (Morgan Stanley Conference)
Furthermore, Palo Alto also recently launched its cloud-native next-gen firewall (NGFW) with AWS (AMZN), customized for the AWS cloud. We believe that it demonstrated that network security is well and alive as it pivots towards the cloud. Palo Alto emphasized (edited): “We aim 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 of those elements.”
Therefore, we believe that the company is well-positioned to compete against the pure-play leaders, who don’t have Palo Alto’s network security advantage.
But, Investors Need To Focus On Its Path To GAAP Profitability
The company has continued to report robust growth in FQ2, with revenue up 29.5% YoY. The growth was also broad-based, especially on its software ARR growth which grew 70% YoY. However, investors need to note that the company has continued to be unprofitable on GAAP terms. Palo Alto explained that its spate of acquisitions necessitated the company to use stock-based compensation (SBC) which significantly impacted its OpEx. Arora elucidated (edited):
The way we bought them was, that we unvested the founders from their equity in their companies and revested them with Palo Alto stock over a period of 4 years.
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 embedded M&A cost of retaining founders. (Palo Alto’s FQ2’22 earnings call)
Notably, management clarified further that its M&A cadence has slowed down tremendously. It highlighted it had not completed any “significant M&A in the last two or three quarters.” Hence, investors should expect a “step change down” in its SBC moving forward. In addition, Palo Alto also communicated that it would guide its path to GAAP profitability at the end of FQ4’22 (July quarter). Therefore, investors are highly encouraged to pay attention to its guidance.
Investors have been justifiably concerned with the stock dilution from its SBC policies. However, Palo Alto has leveraged its robust FCF margins to conduct stock repurchase programs to offset the dilution partially.
For example, the company repurchased about $550M worth of stock (average price of $534) in FQ2. It still has $450M remaining from its current authorization for the rest of FY22.
While it has not wholly offset its stock dilution, we believe the impact has been mitigated. The company declared about $987M in SBC over the last twelve months. Therefore, its stock repurchase program has been instituted to keep in line with its stock dilution.
Still, the company has not telegraphed a clear timeline of when the SBC would taper off. Therefore, investors should continue to monitor closely.
Is PANW Stock A Buy, Sell, Or Hold?
PANW stock is a Hold. Its NTM EBIT multiple of 52.9x has surged well above its 3Y mean of 37.7x. In addition, its NTM FCF yield of 3.3% was also markedly below its 3Y mean of 4.4%. In addition, PANW stock has also reached its average consensus price targets (PTs) and was well above its most conservative PTs.
Furthermore, the stock has also been testing a critical resistance level, and therefore, we think it could attract significant selling pressure.
As such, we encourage investors to bide their time before adding this cybersecurity leader at the next meaningful retracement.