Palo Alto Networks Inc. (PANW:US) has had an exciting week, leaping over 10% due to an positive earnings call. This jump would be significant for any stock, but is particularly noteworthy in the notoriously cutthroat sector of enterprise and network security. Given this, we decided to take a deeper dive.
SumZero interviewed two of our top ranked analysts, one short the stock and one long, for a lively conversation and debate about the company.
Jeremy Kahan, who posted a long to SumZero on July 27th, is the Portfolio Manager and Co-founder of North Peak Capital.
What about the Company initially caught your eye as a value investor? Walk us through you investment thesis.
The main characteristics that I usually search for in a company are sustainable competitive advantages. I like companies that have built a moat and can continue defending their positions in the industry. What drew me to Palo Alto Networks was the lack of these boundaries to enter. Palo Alto is a player in a very competitive space with low product differentiation and low customer switching costs and loyalty. Given the company’s high valuations and negative GAAP profit margins, I got interested in analyzing the company.
As for Palo Alto Networks, I think their competitive advantages are not sustainable. In an industry where customers don’t differentiate much between the products and price plays an important part, the companies have to compete on price. Now this has always been the case with PANW. What has changed in the industry is a renewed focus from one of the largest players, Cisco, on innovation. Palo Alto Networks has been able to grow its market share in the past years, mostly due to the lack of competition in the space from a technology point of view. With Cisco back in the playing ground, and over $30bn in net cash, the competition can get tougher.
Why does this opportunity exist now? The company has mentioned multiple times that their refresh cycle is coming up. Although this may present an opportunity for the company to sign on the existing customers at higher prices, it gives competition a chance to snag customers away from the company by offering lower prices. In addition to tough competition in the industry, there are multiple company-specific issues that add to the validity of the thesis. The company is non-profitable in GAAP metrics and even though their revenue has been growing, their GAAP operating loss has been increasing. Finally, one the most important aspects of investing in a company is its management team and how they are incentivized. The management team of PANW is incentivized based on revenue and billing growth and not at all by how much their ROIC increases. To me, this combination signals a short on this company.
Our investment thesis in Palo Alto Networks is similar to other enterprise software investments we have made over the past two years: invest in a market leader, capturing share in a large, growing market at a reasonable valuation. In today’s frothy market, it is rare to find a Company with 20%+ growth and strong recurring profits trading at a 7% unlevered free cash flow yield.
We expect cybersecurity spending to continue to grow at a healthy rate as network architectures grow more complex and cyber criminals and cybersecurity vendors continue their global arms race for the foreseeable future. High profile cyberattacks such as the recent WannaCry ransomware attack suggest that enterprises will consistently need to upgrade and update their cybersecurity infrastructure. We believe that corporate security buyers will continue to shift wallet share to Palo Alto, as they have the most effective product currently on the market.
What is the market missing?
In my opinion, the market is too focused on the company’s past performance and growth. I believe the market does see the lack of the exponential growth that the company saw in the past. However, what the market is missing is the extent to which pricing pressure is high for the company, especially given that the refresh cycles for the company is close. Additionally, the market is too comfortable with the company’s stock based compensation and lack of profitability as well as adjusted metrics. Accounting for these metrics properly shows a non-profitable company that does not deserve the multiples and valuation it is being awarded.
The bulls on this name argue that the company’s technology is best of the kind and the new additions of products as well as new markets will allow the company to continue growing. I believe that the company offers the state of the art technology. However, customers in this industry are not loyal and at the point of the refresh they can always change providers given equal or better protection and pricing.
The market often focuses myopically on the the most recent quarter and extrapolates a growth trend in perpetuity. Palo Alto’s growth slowed over the last several quarters as a result of a poorly executed sales force reorganization, but the underlying demand drivers and the Company’s competitive position have remained stable. Stocks are much more volatile than underlying, long term business fundamentals and this creates opportunities for value investors.
What does the opposing thesis get right? What does it get wrong?
In my opinion, Jeremy makes a great point when it comes to the industry’s secular tailwinds. Given the growing importance of network security, the market will continue to grow at a double- digit rate. The controversy of this stock arises when we have to figure out the future market share of Palo Alto Networks. So, in my opinion, what Jeremy may not be getting right is the continued growth in the company’s slice out of this pie. I believe, given the inflection point for the company and the increased competition (other players are catching up with the new generation firewall products), the company may be losing its market leading status. This will in turn result in on par or slower than market growth in revenues and billings.
Maryam rightly points out that Palo Alto participates in a highly competitive industry. I agree, but the industry has been highly competitive since the advent of next generation firewalls. Palo Alto has consistently gained market share by having a superior product offering. The company spends roughly twice as much on research and development as Checkpoint and Fortinet, its two closest competitors, broadening their competitive moat and solidifying their ability to charge a premium price for a premium product.
She incorrectly knocks Palo Alto’s profitability and free cash flow generation. Over the last four years, free cash flow has grown from $52 million in fiscal 2014 to $797 million in fiscal 2017. The company guided to approximately $1 billion of free cash flow in fiscal 2018. While the company issues a lot of stock to their employees, free cash flow per share has increased from $0.71 in 2014 to over $10 per share next year.
What do you find most interesting from the other analyst’s report?
What I find really interesting is Jeremy’s take on the reason for current revenue/billing slowdown. This is really where the stock gets interesting. Is the slowdown (or its return, as the last quarter results had a good rebound) a result of losing market share in a growing market or just a one-time problem due to the salesforce reorganization? Jeremy agrees with management that the company’s problems were a result of this re-org and not a matter of increased competition.
I believe this point needs more time to be proved or disproved. What makes this more interesting is the return to growth for the company in the most recent quarter. However, the management team did not bring up the salesforce re-org issue and briefly touched upon it when an analyst brought up the issue. Could the company have used the re-org as a scape goat last quarter? And should they have used this quarter’s positive results to showcase the success in re-org? I’d like to wait and see.
I think it is important to be skeptical of non-GAAP metrics, but cash flow and free cash flow per share are the ultimate arbiters of valuation.
What key metrics should investors be paying attention to as both of your theses mature?
The key risks to my thesis are the following:
1. Revenue growth could pick up due to new and improved technology: In June of this year, management of Palo Alto introduced new products and the new vision for the company at Ignite Conference. This could lead into a new demand for company’s products. However, my research shows that the market is not yet fully ready for an integrated product. Many customers prefer to pick and choose their products. This comes from the type of customers that are most important to Palo Alto.
2. If the industry grows faster than expected, even in a market share losing scenario, the company could grow revenues enough to justify the current valuation.
3. NOL: The company carries a large NOL of over $1bn. There is a risk that at a downturn the company would sell parts of the more unprofitable businesses to realize this NOL. However, this would only happen in a worst case scenario which means our short thesis has played out.
In order to prove my thesis wrong and Jeremy’s right, I’d need to see a continued growth in the deferred revenue/billings for PANW above the industry’s growth rate. That would show that the company has been able to take market share from other players amid tough competition and it would be a sentiment to existence of its competitive advantages.
PANW should be evaluated on the same metrics as other enterprise software companies: billings growth, net customer additions, ARPU, revenue retention, profitability, and free cash flow. The company also reports customer cohort lifetime values, which is key to understanding the quality of the business.
What are the biggest risks associated with your position? What are the biggest risks associated with the other analyst’s?
One of the biggest risks associated with my short position is the company getting bought out. That would show a jump in the stock and a loss for my position. Additionally, other developments in market growth such as increase in cyber security threats could drive the stock price (as well as others in the industry) up. Finally, a stronger than expected performance in a quarter would also be a risk to my position although if not permanent, this would result in a better short position (given proper portfolio management).
The risks in Jeremy’s position could arise from a continued net loss in operating profit and a slower than expected growth in billings/deferred revenue. This would push the stock down and would result in a loss. Additionally, Cisco or other big players announcing new products or having above market growth could be another risk to the long. Finally, M&A in the market that would hurt the company’s competitive position would be another downside catalyst.
I think the biggest risk in any technology investment is that someone develops a better mousetrap, or the network or the cloud changes in some way that makes Palo Alto’s solutions less relevant. I would be reluctant to short a Company that has consistently gained market share in a large, growing market; Palo Alto and their competitors can all do well given the growing costs and complexity of cybersecurity breaches.
Where else do you see value in the market?
I see secular trends in the payments and industrials space. I’d like to find companies that have sustainable competitive advantages in these spaces to own and short companies that lack barriers to entry in the industry.
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