EUR 850.00 For Business Accounts Only

Morningstar | Landed as the Firewall Leader, Palo Alto Networks Ripe to Expand; Raising FVE to $305

Along the way to taking the firewall market crown, we believe Palo Alto Networks developed considerable customer switching costs. We are raising our economic moat rating to narrow from none while sustaining our positive moat trend rating. We think Palo Alto expanding its subscriptions to cover hybrid-cloud security concerns with items such as analytics, automated response, and machine learning are growth catalysts to supplement its strong firewall offerings. We posit that significant operating leverage will be gained throughout the coming decade as recurring subscription and support revenue streams flow from its expansive customer base. With higher top and bottom-line expectations, we are raising our fair value estimate for Palo Alto to $305 per share from $217. We believe this 4-star name represents an attractive investment opportunity in the cybersecurity market.

Palo Alto became a leading cybersecurity provider with its next-generation firewall appliance, forever altering the requirements of this essential piece of networking security. Its offerings grew to include diversified security subscriptions that attached to firewall appliances, as well as solutions such as protection and automated responses for cloud-based traffic and data, software-as-a-service applications, and endpoints. In our view, cybersecurity will remain a top concern for enterprises and governments as the growing quantity of data and traffic being generated outside of centralized data centers increases the possible attack vectors and drives up security management complexity. We posit that IT teams are clamoring for security consolidation and Palo Alto's security operating platform helps centralize security orchestration and management. We believe the ability to add technologies via subscriptions in the Palo Alto framework can alleviate security complications by providing a more holistic solution, which equates to sustainable demand for Palo Alto's solutions.

We expect a 19% five-year revenue CAGR, driven by subscriptions and support outpacing product growth. We believe Palo Alto's expansion into cybersecurity areas with higher growth trajectories than firewall appliances will increase stand-alone and product-attached subscription revenue. In our view, there are substantial greenfield subscription opportunities for cloud-based security, threat analytics and response, and holistic network-wide solutions. We expect Palo Alto's firewall ecosystem to benefit from entities favoring adding on additional Palo Alto subscriptions per product over managing various cybersecurity vendors. Our growth rate expects internal development efforts to be supplemented with acquisitions, especially within the areas of cloud security, analytics, and machine learning. As Palo Alto sells more nascent security technologies and attaches more subscriptions to its platform, we model subscription and support sales outpacing products revenue and becoming 67% of revenue in fiscal 2023 versus 61% in fiscal 2018.

We expect gross margin for subscriptions and support to increase towards 75% and for products to grow to 72% in fiscal 2023 versus 73% and 69%, comparatively, in fiscal 2018. Consolidated gross margins are modeled to expand towards 74% in fiscal 2023 versus 72% in fiscal 2018. In our view, Palo Alto will continue increasing its operating expenses at a healthy clip, albeit at a lower year-over-year rate as it reaps the benefits of developing a sizable customer base through previous elevated sales and marketing efforts. As a revenue percentage, we model sales and marketing to decline below 38% and for research and development to drop to around 15% in fiscal 2023, compared with 47% and 18%, respectively, in fiscal 2018. Based on these effects, we expect operating margin to be around 14% in fiscal 2023 versus a 5% loss in fiscal 2018.