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Morningstar | PANW Updated Forecasts and Estimates from 11 Sep 2018

Palo Alto Networks reported solid fourth-quarter and fiscal-year 2018 results and we are raising our fair value estimate to $217 per share, from $190 previously, as we roll our model for the new fiscal year. Additionally, we are maintaining our no-moat, positive trend rating. Our expectations for fiscal 2019 track modestly ahead of consensus. We note our thesis on Palo Alto is that while it disrupted the industry through the introduction of a next-generation firewall, the firm is increasingly becoming a subscription, rather than a product business, leading to more recurring revenue. For the quarter, we got notable evidence that the firm is successfully diversifying, moving from devices to a suite of products. The firm reported that 3,000 customers were utilizing Traps, the firm’s endpoint tool, and cloud security is becoming more relevant.

As a reminder, this was the first quarter with new CEO Nikesh Arora at the helm. Arora comes as a seasoned dealmaker, previously serving at the second-in-command at Softbank and as a longtime executive at Google. However, one of Arora’s first comments on the conference call was that investors should not extrapolate that Palo Alto will become aggressively acquisitive under his tenure.

From Nikesh, we will be looking for a couple things. First, we would like to see a tangible path to the firm achieving GAAP profitability. Currently, we model the firm becoming profitable on a GAAP basis in fiscal 2020. Second, while we expect some deals from Nikesh, we will be closely tracking the integration of recent purchases of cloud security vendor Evident.io (purchased for $300 million) and Sedco, an endpoint security vendor. Arora indicated that he believes the firm could do a lot better in terms of cloud security, also indicating the importance of AI in security.

Investors should be aware that the company will formally shift to ASC 606 reporting for first quarter 2019, but the firm gave a reconciliation for the past two fiscal years.

Palo Alto is reporting earnings at the tail-end of the summer sell-side earnings season, following other cyber security vendors such as Cisco, Fortinet, and Zscaler. The prevailing sentiment across all these security vendors in our coverage list is that hardware and software demand is strong as corporations update their IT infrastructure and prepare for the next generation of cyber security attacks. We think this has contributed to a run-up in stock prices across the space. However, we want to reiterate that we have seen spending cycles ebb and flow over the years. Palo Also experienced expeditious growth in 2015, before muted demand led to a cool down in the firm’s share price. Longer term, we think the software and subscription-based nature of the security industry is making it less cyclical than these firms have been historically, but risks remain.

In a converse manner, we think complexity and consolidation remain the stories across cyber security. First, in terms of complexity, enterprises have an increasing number of vectors of attack, such as endpoint, cloud, mobile, network, and Internet of things. The risk of lax cyber security protection can lead to catastrophic problems for major corporations, which we saw play at out firms like Target and Equifax. Second, in terms of consolidation, cyber security vendors used to have their own niches, such as Check Point in network security and Symantec in endpoint, but those lines have become blurred. With Palo Alto, its foray into Traps (endpoint protection) and cloud security, helps make the firm service an enterprise’s ecosystem of security needs rather than just firewall and network protection. We saw evidence of this with the firm’s upgrades. Palo Alto reported customers of over 51,000, previously indicating that they are adding 2,500 to 3,000 customer per quarter. The firm’s 25 largest customers each purchased additional offerings from Palo Alto this quarter, demonstrating that the firm can increase its wallet share of current customers.

Palo Alto continues to produce strong revenue growth, but we keep coming back to the firm’s liberal stock-based compensation, or SBC, policy. While TMT companies as a sector generally draw criticism for their stock-based compensation expenses, with notable highfliers like wide-moat Salesforce.com drawing the ire of some investors, Palo Alto’s SBC expenses as a percentage of the firm’s SG&A costs sits at the high end of our enterprise software coverage. We applaud the firm for beginning to repurchase stock this current fiscal year and would look favorably upon continued repurchases ahead.