Palo Alto Networks: A Closer Look at Its Platformization Strategy and Growth Prospects
Palo Alto Networks is a fascinating cybersecurity company, particularly with its platformization strategy that it began implementing in late 2022. I’ve been tracking this company for several years, and it has been one of the standout cybersecurity stocks in the market. If you’ve been following me, you’ll know I’m quite bullish on the cybersecurity sector for the next decade or more, believing it will see substantial growth.
That said, the question remains: is Palo Alto Networks a buy, hold, or sell? In this video, I’ll explore that by analyzing the company's revenue growth, profit margins, cash flow, return on invested capital, and valuation, using my discounted cash flow model, along with its forward price-to-earnings and price-to-free-cash-flow ratios. Let’s dive in.
Earning Overview
Now, Palo Alto Networks' revenue growth has been slowing in recent years. Back in 2015, the company was experiencing nearly 60% annual growth, but in the latest quarter, that rate has dropped to just 14%. This slowdown is despite the platformization strategy they’ve been pursuing.
Fundamental
To elaborate, the platformization strategy involves Palo Alto Networks attempting to attract customers from competitors by offering them free services. For example, if a customer is locked into a contract with a rival, Palo Alto will tell them they don’t have to pay for their services for a year. They’ll let the customer continue paying their existing provider for the remainder of the contract while Palo Alto Networks provides free service for that duration. Once the contract with the rival expires, the customer will start paying Palo Alto.
They’ve been doing this regardless of how much time is left on the customer’s existing contract, whether it’s six months, a year, or even 18 months. The idea is to overcome the barrier of customers being tied to a competitor by simply offering them a free service until their contract is up. The strategy was rolled out in late 2022, but despite this, revenue growth has continued to decelerate for Palo Alto Networks.
Palo Alto Networks: Assessing the Impact of Its Free Trial Strategy and Financial Performance
We haven’t yet seen the full benefits of Palo Alto Networks’ platformization strategy, but that’s understandable since it will take time to manifest. For example, if they’re offering a one-year free term to a new customer, that won’t show up in revenue growth until the free period ends, and the customer starts paying. However, management has mentioned early successes with the strategy, noting that it has helped them attract more customers. As a result, it’s reasonable to expect Palo Alto Networks to see a revenue growth boost in the next 24 months as it begins to monetize these free trials that were introduced in late 2022, and into 2023 and 2024.
One of the things I’ve appreciated about Palo Alto Networks is the company's ability to expand its operating margins, which now stand at 11% over the trailing 12-month period. This is a significant improvement from a -6% margin in 2015. The company has managed to leverage its revenue growth to enhance its margins, showcasing economies of scale within the business. Even more impressively, their strategy of offering free trials hasn’t hurt margins, which I was initially concerned about. This demonstrates that Palo Alto Networks has been able to onboard new customers without negatively affecting its operating margins. I always keep a close eye on profit margins when companies take unique customer acquisition approaches, whether it’s Palo Alto Networks’ free trials or other strategies like lowering prices, increasing advertising, or adding new models. The fact that Palo Alto’s margins haven’t suffered while gaining new customers is a positive sign of the strategy’s effectiveness.
Cash Flow
When it comes to cash flow, Palo Alto Networks has had a somewhat volatile cash flow from operations to sales ratio, but at 36%, it’s still quite solid. This ratio is on par with other cybersecurity companies like CrowdStrike, which also stands at a similar percentage. The decline in this metric might be an industry-wide trend as companies start reaching the limits of their cash flow growth and need to invest more capital into their businesses.
Similarly, Palo Alto Networks has done a fantastic job growing its return on invested capital (ROIC), which peaked at nearly 60%, but recently dipped to 19.97%. I expect the ROIC to rebound in the future. While recent business developments have impacted the ROIC, the cybersecurity industry, being asset-light, has significant long-term potential for high returns on invested capital, given the relatively low capital requirements for the business.
Valuation
Moving to valuation, my intrinsic value calculation for Palo Alto Networks puts the stock’s intrinsic value at $155, compared to the current market price of $180. This is within my margin of safety range, but it could be considered slightly overvalued based on the discounted cash flow valuation model I used. However, when considering the company’s strong position in a highly attractive industry, I’m willing to pay a premium for stocks in this sector. The stock also appears fairly valued when measured by its forward price-to-earnings ratio of 49 and price-to-free cash flow ratio of 44, which is more in line with its market position.
Conclusion
Taking all of this into account, my recommendation for Palo Alto Networks stock is a borderline buy. What does that mean? A borderline buy is a stock that falls between a buy and a hold, but is closer to a buy. So, in this case, I would consider Palo Alto Networks to be a borderline buy, given its strong business performance and promising industry outlook.
Disclaimer: I want to make it clear that I am not a financial advisor, and nothing I say is intended to be a recommendation to buy or sell any financial instrument. Additionally, it's important to remember that there are no guarantees or certainties in trading or investing, and you should never invest money that you can't afford to lose.
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