Colin Anderson Productions pty ltd
Investment Thesis
Last time I talked about Palo Alto Networks (NASDAQ:PANW), I discussed the company’s Q2 performance and argued how the company’s pivot to platformization is a smart decision for long-term growth. My rating on the stock was a Hold. Since my article was published in February 2024, the stock has gained 8.31%, handily outperforming the S&P 500, which gained 4.2% during the same period.
In this article, I discuss the company’s Q3 earnings report, highlight the progress made so far on its platformization strategy, and argue why the partnership with IBM could be a strong growth catalyst for the company, especially concerning cybersecurity in the AI space.
Third Quarter Highlights
Palo Alto Networks had yet another impressive quarter. Revenues came in at $1.98 billion, up 15.33% y/y and beating analyst estimates by $17.86 million. Non-GAAP diluted EPS came in at $1.32, up 20% y/y and beating analyst estimates by $0.07. Non-GAAP operating margins came in strong for yet another quarter, up 200 bps to 26%. Remaining Performance Obligations did even better this quarter, growing 23% y/y to $11.3 billion.
Guidance was a lot better than last time. For FY24, total revenues are now expected to come in the range of $7.99 billion to $8.01 billion, better than the previous guidance of between $7.95 billion and $8 billion. FY24 adjusted EPS is now expected to be between $5.56 and $5.58, much higher than the previous guidance of a range between $5.45 and $5.55. Finally, the company now sees FY24 Adjusted free cash flow margin to be in the range of 38.5% to 39%. The only blemish was the guidance in billings, which are now expected to come in between $10.13 billion and $10.18 billion, slightly lower than the previous guidance of a range between $10.1 billion and $10.2 billion.
IBM Deal A Catalyst That Should Boost Company’s “AI Leadership”
One of the key messages of the company’s management during the second quarter earnings call was that they would be investing significantly to boost PANW’s “AI leadership.” This quarter, we got significant evidence of this when the company announced that it has partnered with IBM to offer “AI-powered security outcomes for customers.”
As part of the deal, PANW would acquire IBM’s QRadar SaaS assets, which would subsequently be migrated to the company’s XSIAM platform. In addition, IBM’s watsonx large language models (LLMs) will be integrated into XSIAM, thereby allowing PANW to leverage IBM’s models to power its AI capabilities. watsonx’s advanced AI algorithms are known to process and analyze large amounts of data more efficiently than “traditional methods,” which should allow PANW’s products to offer faster and more accurate threat detection.
In my opinion, this deal brings tremendous benefits for PANW. First of all, the market for AI cybersecurity, according to Statista, is expected to grow from $24.3 billion in 2023 to nearly $134 billion by 2030. The market opportunity, therefore, is tremendous. By partnering with a company such as IBM, and by leveraging watsonx, PANW would be able to capitalize on this opportunity.
Second, PANW’s competitors are all ramping up their AI-related features, either through partnerships or on their own. CrowdStrike, for instance, recently announced a partnership with NVIDIA to help enterprise customers tackle AI-related threats. And while Zscaler and Fortinet haven’t partnered with anyone, they have unveiled their own AI solutions. In fact, it could also be the case that PANW grabbed the opportunity to partner with IBM ahead of either of them.
The partnership also allows PANW to leverage IBM’s cloud expertise, which should allow the company’s Prisma Cloud to deal with threats against enterprise customers’ AI-related deployment on the cloud.
Finally, as part of the deal, IBM will adopt the company’s products and train over 1,000 of its consultants on PANW’s products. IBM Consulting, as part of the deal, will become a preferred Managed Security Services Provider (MSSP) for PANW’s customers. This partnership, therefore, allows PANW to accelerate its platformisation strategy with the help of IBM’s consultants. According to a report from Firsthand.co and Consultancy.org, IBM Consulting was voted the second-best IT strategy firm behind Accenture. As such, PANW has chosen a reliable partner who could help the company convince customers of the value of platformization.
Taken together, the partnership with IBM, in my opinion, is a win for PANW, one that not only furthers its ambition to be a leader in cybersecurity in the AI space, but also that offers the perfect opportunity to accelerate its platformization strategy.
Billings Guidance Don’t Give the Full Picture
One metric, which left investors unimpressed, was the company’s billings guidance, which, as mentioned earlier, was further slashed by the company during the latest outlook. The stock dropped 8% following the earnings release, and while it recovered during the trading session, still ended the day down 3.7%.
A lot of Wall Street Analysts have, since then, called for investors to not panic over the guidance, and I couldn’t agree with them more. First of all, as acknowledged by CEO Nikesh Arora, the lower-than-expected billings guidance is a result of customers choosing to defer their payments and also showing a preference for annual billing plans.
Furthermore, as a result of the company’s decision to pivot to platformization, it had already warned during the second quarter that it expects headwinds on billings growth for the next 12 to 18 months. At the same time, it had also warned investors to expect headwinds on revenue growth as well over the same period. However, in the latest earnings report, the company actually boosted its revenue guidance, as mentioned earlier, which suggests that the underlying business continues to remain strong.
Moreover, there were other metrics such as the 47% y/y growth in NGS ARR as well as a 23% y/y growth in RPOs, which demonstrated that PANW’s business continues to remain strong.
As for the progress on the platformization strategy, the evidence so far is encouraging, as seen by the difference in the ARR range. More specifically, while NGS ARR for non-platformized customers was in the range between $200,000 to $800,000, for fully platformized customers, it was in the range of $2 million to $14 million, a significant jump. The company’s conversion rates are also showing significant growth, with Q3 seeing 65 incremental platformization sales, which translates to a 40% growth since Q2.
Overall, if one takes a holistic view, then the billings guidance is not something to be concerned about in my opinion. The platformization strategy is progressing well, which is the more important factor for investors to consider, and the underlying business continues to remain strong.
Valuation
|
Forward P/E Approach |
|
|
Price Target |
$344.00 |
|
Projected Forward P/E Multiple |
51.3x |
|
Projected FY24 EPS |
$5.57 |
|
Projected PEG Ratio |
2.5 |
|
FY25 Earnings Growth |
20.5% |
|
Projected FY25 EPS |
$6.71 |
Source: Company’s Q3FY24 Press Release, LSEG Workspace (formerly Refinitiv), Seeking Alpha and Author’s Calculations
PANW, according to LSEG Workspace (formerly Refinitiv), currently trades at a forward P/E of 51.3, slightly more than its historical multiple of 48x. The stock continues to be more expensive than its peers such as Zscaler which trades at 56x and CrowdStrike which trades at 83.1x.
The company has boosted its EPS guidance and the platformization strategy is moving in the right direction. Furthermore, the deal with IBM is a positive catalyst for the company, in my opinion, especially in the field of AI cybersecurity. Given all these positive factors, I have assumed a forward P/E of 51.3x for my calculations, higher than my previous estimate of 45.4x.
The company now expects FY24 diluted non-GAAP EPS to come in between $5.56 and $5.58. I have assumed the midpoint of this guidance for my calculations, which would be $5.57. The company, according to Seeking Alpha, currently trades at a forward PEG multiple of 2.5x, which is the multiple I have assumed for my calculations.
A forward PEG ratio of 2.5x and a forward P/E of 51.3x would imply an earnings growth of 20.5%. While this figure is higher than the mean long-term EPS growth of 16.83%, given the developments happening around AI cybersecurity, this growth rate is reasonable in my opinion. At this growth rate, FY25 EPS is projected to come in at $6.71, which is higher than my previous estimate of $6.48. A forward P/E of 51.3x and an EPS of $6.71 would result in a price target of $344. This implies an upside of about 10.4% from current levels.
I think the stock would continue to suffer a hangover from the weaker-than-expected billings guidance, which to me, amounts to an overreaction. As such, any weakness in the stock over the coming days would present a good buying opportunity. As I mentioned last time I wrote about PANW, the cybersecurity industry continues to have a lot of structural tailwinds, especially with respect to AI. The IBM deal is a testament to that. For the long term, therefore, I continue to love this company.
Risk Factors
PANW has to ramp up its AI investments, while at the same time ensuring that its pivot to platformization goes smoothly. How the company manages to balance these two tasks would be a risk factor for investors to consider.
Then there are PANW’s competitors, who are also ramping up their AI investments, as mentioned earlier. And while PANW has a reliable partner in IBM, CrowdStrike has partnered with the AI titan Nvidia. This should be an interesting battle, and the competition for AI-related security offerings would also be yet another factor that investors should keep an eye on, as it could have major implications on PANW’s margins going forward.
Concluding Thoughts
PANW had yet another brilliant quarter, in my opinion, which is not surprising these days. The company beat the street estimates on both the top and bottom lines and also bumped up the revenue and EPS guidance for the year.
Investors were, however, not thrilled with the company’s billings guidance, which is nothing but an overreaction in my opinion. The company’s underlying business continues to remain strong, and the pivot to platformization is showing some really encouraging results, as evidenced by the massive difference in NGS ARR for platformized customers and others.
For me, however, the biggest takeaway from the quarter is the partnership with IBM, which, I think, is a major win for PANW. Not only would the company be able to leverage IBM’s watsonx to boost its AI-related security offerings, but it also offers the company an avenue to accelerate platformization through IBM Consulting. This partnership, to me, has all the makings of a strong growth catalyst for the future.
While there is limited upside from current price levels, I would still look to start a small position in the stock and accumulate on any weakness. Nvidia’s yet another blowout earnings report has only demonstrated how much room there is to run for the AI boom. The same, in my opinion, can be said for AI-related cybersecurity offerings. The IBM partnership, therefore, may have come at the right time for PANW to capitalize on this boom.
