Since I published my previous article on Palo Alto Networks, Inc. (NASDAQ:PANW) in February 2024, the stock price has surged by approximately 14%, outperforming the S&P 500 Index (SP500). I highlighted the company’s new strategy of platformization and the near-term risk of weak U.S. federal government business growth. The company released their Q3 results on May 20th after the market close, with 15% revenue growth and 26% adj. net income growth. I maintain a “Buy” rating and a fair value of $330 per share.
Platformization Strategy Continues
As mentioned in my previous article, Palo Alto has been implementing their platformization strategy, aiming to consolidate all of their services for their customers. If customers embrace their platformization, Palo Alto could potentially broaden their total addressable market and accelerate their future annual recurring revenue growth. As indicated over the earnings call, they achieved 65 incremental platformization sales in Q3 among their top 5,000 customers.
I think their platformization sales could be successful in the future for the following reasons:
- With platformization, customers can simplify their cybersecurity operations, by dealing with a single service vendor. Cybersecurity is a complex and holistic solution, requiring multiple types of products and services including firewalls, IDS, antivirus, end-point protection, and security operating centers, etc. These hardware and software components need to work seamlessly to achieve optimal cyber protection. As such, platformization would be a perfect way for enterprises to reduce the complexity of operations. As indicated over the call, Palo Alto estimates that customers can achieve 30%-40% efficiency improvements in security outcomes through platformization.
- Palo Alto is a leading provider of cybersecurity solutions, both in software and hardware. It appears to me that only Palo Alto has the capability to consolidate the platform effectively. As depicted in the slide below, Palo Alto offers three major platforms, consisting of AI-based solutions, cloud service APIs as well as a security operation center platform.
In fiscal Q3 FY24, Palo Alto delivered 15.3% revenue growth and 26.6% adjusted net income growth. However, the total billing only grew by 3% year-over-year, which disappointed the market. I don’t think billing is a good indicator of Palo Alto’s future growth, as the company is implementing their platformization strategy.
The slower billing growth is primarily caused by two major reasons:
- Due to the high-interest rate macro environment, enterprises are shifting from a multi-year payment approach to annual payment, which slows down Palo Alto’s billing growth. I expect annual payments to become more frequent among enterprise customers in the near future. The pattern might change when the macro environment improves.
- As Palo Alto is implementing their platformization strategy, deal sizes are more likely to be larger than silo product/service deals. In this case, customers may prefer an annual billing approach, in my opinion. Palo Alto’s management expects the slow growth in billings will persist in FY25 as the company is pushing platformization further next year.
Overall, I think it is a decent quarter for Palo Alto, and investors should not be surprised by the low billing growth.
FY25 Outlook
Considering the performance over the past 3 quarters, I won’t be surprised if Palo Alto delivers their FY24 results as guided below. At this point, I think the market would be more interested in FY25’s growth.
I am considering the following growth drivers for FY25:
- Large Deal Growth: as communicated in Q3, Palo Alto experienced robust growth in large-sized deals, with the number of deals exceeding $1 million growing by 22% year-over-year. Notably, the number of deals over $10 million grew by 28% year-over-year. The growth in large deals is driven by their platformization sales and new logo deals. It is clear that these large deals will contribute to their FY25 growth.
- Cloud Security: As discussed in my previous coverage, Palo Alto is well positioned in the cloud security market, with Prisma Cloud solutions. Under Prisma Cloud, the company successfully rolled out the first phase of data security posture management in the quarter. Fortune Business Insights forecasts that cloud security will grow at a CAGR of 18.1% from 2022 to 2029. In addition, Palo Alto is adding AI-related features to their Prisma Cloud. I forecast their cloud security business will grow at >20% annually in the near future.
- Palo Alto launched Cortex XSIAM, an autonomous security operations center (SOC), 18 months ago. SOC represents a vast untapped market for major cybersecurity players. The AI-driven platform could potentially automate cybersecurity workflows and speed up the cyber response times. Palo Alto discloses that they have $400 million in cumulative XSIAM bookings as of Q3 FY24, signaling accelerated industry adoptions.
Mordor Intelligence predicts the cybersecurity market will grow at a CAGR of 11.44% from 2019 to 2029. With the three major growth drivers outlined, I forecast Palo Alto will grow faster than the market growth, achieving a 15% annual revenue growth rate.
Valuation Updates
My assumptions for FY24 are aligned with their official guidance, as I don’t expect any big surprises for the last quarter in FY24. I forecast the company will achieve 15% organic revenue growth in the near future. The company has been making some small acquisitions, so I assume the company will spend 5% of its revenue on acquisitions, contributing 1.3% to revenue growth.
As I expect Palo Alto’s business will gradually shift more from hardware to platform solutions, the gross margin will potentially improve over time. In addition, I expect Palo Alto to generate operating leverage from both sales & marketing and R&D expenses. In sum, I calculate that Palo Alto will grow their operating expense by 13.5% annually in the model.
The WACC is calculated to be 8.6% with the following assumptions:
- -Risk free rate: 4.5% (US 10Y Treasury Yield).
- -equity risk premium 7%; cost of debt 7%.
- -Beta 1.1 (SA).
- -debt $2 billion; equity $3.7 billion.
- -tax rate: 22%.
Discounting all the future free cash flow and adjusting the net cash positions, the fair value is estimated to be $330 per share, as per my calculations.
Key Risks
On May 15th, Palo Alto agreed to acquire International Business Machines Corporation’s (IBM) QRadar SaaS assets, and both companies will facilitate the migration of QRadar SaaS clients to the XSIAM platform. In addition, IBM will platformize on Palo Alto products. Palo Alto will pay $500 million plus earn-out consideration based on the actual migration results. While I think the deal makes sense for Palo Alto and could potentially enhance their SOC platform, the customer migration from IBM to Palo Alto could pose some uncertainties. Customers might choose not to renew their contracts with Palo Alto.
In addition, investors need to monitor the performance of CrowdStrike Holdings, Inc. (CRWD), a rising star for end-point protection and SOC. I view CrowdStrike as the biggest threat to Palo Alto’s future growth, as CrowdStrike offers holistic solutions under a unified platform. For investors who are interested in CrowdStrike, please refer to my initiation report published in March 2024.
Conclusion
Palo Alto Networks, Inc.’s platformization strategy could potentially enhance their leadership position in the cybersecurity market, and accelerate their ARR growth driven by more large deals. I favor Palo Alto’s comprehensive solutions across hardware, software, SOC, and services. I maintain a “Buy” rating and a fair value of $330 per share.
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