Palo Alto Networks: A Buy Opportunity On A Platform Strategy (NASDAQ:PANW) (2024)

Overview

Cybersecurity is important for companies, and threats grow each year. Nine out of ten companies say that cybersecurity risks are growing. I find this industry attractive because it is recession-proof: even if there are headwinds, companies won't stop protecting themselves and their clients' data from cyberattacks.

Inside the industry, one of the most interesting companies is Palo Alto Networks (NASDAQ:PANW). Palo Alto is one of the biggest companies in the cybersecurity space. Historically, it started as a firewall equipment provider, and until then, they have expanded its offering through software, cloud services, and, lately, AI.

Its strategy is defined by three pillars: 1) from hardware to software, 2) platformization, and 3) building an AI company. The first point is what they have worked on over the years and executed successfully. This pillar has been providing, and it will do over the years, higher margins. There is no discussion on this point.

Platformization is the strategy of giving away for free those services that the client doesn't buy because they have other providers but will complete a whole platform. That way, Palo Alto expects that along the contract, as other providers terminate their contracts, they will migrate to Palo Alto services. At the end of the contract, the client will use and pay more for services than at the contract's start. And they will have lower churn and better retention rates. This strategy has created discussions around the company. Since reporting for the quarterly period ended January 31, 2024, the stock has decreased by 12% as the new platformization strategy and some other things have caused concern among some investors.

The last pillar, AI, is something that almost all competitors are working on. Nowadays, it is too soon to analyze the competitive advantages of AI implementation, if any. My main point concerns platformization strategy: as long as Palo Alto gets more market share, more data will be managed, and AI algorithms will be more useful.

In the article, I try to identify whether it is a good investment opportunity. As I said, it is all about platformization. For that, I will analyze whether platformization is a good strategy to pursue, whether it is profitable, and whether it's working for Palo Alto.

Latest financial results

In the last quarterly report, on May 20, revenue grew 15% to $1.98 billion, and the RPO (Remaining Performance Obligation) grew 23% to $11.3 billion. Next Generation Services Annual Recurring Revenue (NGS ARR) grew 47% to $3.79 billion. Operating margin grew 200 bps yearly to 25.6% as software grows more than hardware. EPS grew 20% to $1.32 as a non-GAAP consideration, and Adjusted Free Cash Flow reached $492 million.

So far, Palo Alto has produced excellent results that probe a resilient business in a tough business environment. But Billings just grew 3% yearly to reach $2.33 billion. Management has declared that clients are changing their billing to annual payments due to the interest rate environment and the platformization strategy.

These reasons are reasonable, and I agree with management that Billings is not a key metric to monitor because it does not reflect the main business fundamentals and is not aligned with the current strategy. Maybe those payment terms have caused the growth rate they have enjoyed in RPOs.

Is Platformization a successful strategy?

It has been quite a while since the market has demanded simplifying operations to be more efficient and reduce costs. So, platformization is something the market is demanding. It is a well-directed strategy. Even if a big group of companies doesn't want to rely on just one security provider, that doesn't mean there will be a concentration of providers.

In this concentration process inside the industry, the bigger securities with a more complete portfolio will win. Let's see if Palo Alto is one of them.

As you can see in Figure 2, Palo Alto is the biggest player in the sector, so it is in a good position to be a leader in the market. However, if we compare the products that manage each company, including Microsoft and Cisco, we see that Palo Alto is missing multifactor authentication services (Figure 3); rather, it uses integrated third-party solutions. With this service, it doesn't have a complete suite like Fortinet and Cisco, but as long as it can use a third-party provider, it is not a big problem. I definitely consider Palo Alto Networks a clear winner in this concentration process. The problem is that they will have Cisco and Fortinet as potential big competitors.

Is the Platformization Strategy profitable?

I have built a case to grasp how profitable a "platformized" deal can be. I have assumed a $5 million deal. % Platformization means the customer has 30% left for complete platformization, so the total deal value is $7.1 million. The gross margin is 74%. The deal lasts three years, and free services are about two years. There is a difference between churn with the Platform and an ordinary landed customer. Platformization is based on the fact that as the customer has more products, their dependence is greater, and they stick more to the security company.

If we project gross margin for nine years in both cases, when the customer contracts the service individually or platformized, the company that uses platformization earns 30% more.

If you change the churn rate to the same 5% in both cases, the premium lowers to 29%, a low-impact variable. When you change the % Platformization to 10%, there is less room to platformize; the premium changes to 8%. So, I conclude that Platformization is a profitable strategy, and seeking it is worth it.

Is the current Platformization strategy working?

When clients start adopting services on Palo Alto Networks, the annual recurring revenue for a client with services in just one platform is $200K, but if that client enters into a contract for services in three platforms, the contract value rises to $800K. When platformization occurs, the client gets the service and the rest of the services from the platform for free, getting an average recurring revenue of $2 million when just one platform is included. The contract value rises to $14 million when three platforms are included. I see a natural correlation between the data in one and three platforms because a three-platform client is naturally bigger. So, in this aspect, for me, it is meaningless. I think we will be cautious, too, in the difference between landed clients and platformed clients. They try to "platformed" the biggest companies. This offering is not plug-and-play, and there is a personalized project, so they begin with the biggest clients, and when the process is more standardized, they will get to smaller clients. There have been 65 platformizations in Q3'24, up 40% from last quarter. It is only in the early innings of the strategy.

Management states clear benefits for the client. There is higher productivity, 10% lower security costs, and 34% more efficiency on security teams. They state that there is more security effectiveness with 40% faster detection of security events and 60% faster security problem fixes. It is hard to challenge this number, but conceptually, it is not strange, and it is what you expect to hear: dealing with a complete security platform is better than several small services with different providers. So, I give credit to this benefit. Even though, as I have said, it is still too early.

Valuation

In my analysis, I estimated that Palo Alto's platformization strategy will succeed but face tough competition. I project that the revenue growth rate will be 25% until 2028 and 20% from 2029 to 2033, and then it will lower to 20%. Later, the long-term growth rate will be 3%. I assume that the platformization strategy will be successful and that the revenue growth rate will increase close to RPO growth at 23%. Later, in 2028, competition will slow the growth rate to 20%, higher than the industry growth rate of 14%, as Palo Alto will keep gaining market share over smaller competitors.

Margins will improve due to the different mix of hardware and software (+0.5 pp improvement) and the platformization strategy plus AI implementation, where sales and marketing costs will be reduced for a better churn rate (from 22% to 21%) and internal AI efficiencies (+0.5 pp improvement). I estimate a total improvement of 2 percentage points from 2029.

I expect tax savings on non-cash items to be 17% of revenues, lower than the historical value as CAPEX remains at the same level, but pressure on SBC will ease respect revenue. Investment in net working capital will be 10%, like in 2023, which is worse than the historical value due to platformization. I expect CAPEX to be 2% of revenue, which aligns with the last years.

Cash flows will be discounted at a 9% WACC because the beta is 1.18 and risk-free at 4.2%. There is a 26% debt over capital.

As shown in Figure 5, my value estimate is $504 per share, a 57% premium over its current stock price, even when I am using a more conservative estimation than management that thinks revenue growth rates will increase due to platformization.

Risks

The main risk the company is facing is that the platformization strategy doesn't work. That means that Palo Alto gives those free services, but later on, the client churns at the same level, and the market share they get is not as high as expected. That will mean that growth rates will keep getting down; that is what has happened historically, as you can see in Figure 6. So, I estimate that the growth rate will lower to 15% by 2033. In this scenario, the value will be the same as the current price, at $321 per share.

Conclusion

We have seen that the key piece of Palo Alto's strategy is Platformization. This is a correct strategy that will be profitable for the company, and it fits with the current environment of market fragmentation and budget constraints. However, I identified that they will have tough competition from big players in the industry, so my expectations are lower than those of management.

I valued the company at $504 per share, with a downside value of $321 per share at the current stock price. Therefore, I recommend buying the stock and taking advantage of the misinterpretation of the Billings growth market.

Rafa F. Oliver, CFA