After yesterday’s earnings report–the company beat Wall Street estimates for the quarter–and radically lowered guidance for the next quarter and the rest of 2024–total billings for next quarter will grow by just 2% to 4% and revenue for all of 2024 will grow by just 15% to 16% from 2023–shares of Palo Alto Networks (PANW) took a big hit right between the eyes. The stock fell 28.44% today at the close and lost $104.12 a share to $261.97.
What do I recommend? I’d say “buy” with a couple of caveats.
Why buy?
A drop back to $260 or so takes the stock back to an attractive price. I’d be a willing to buy at today’s close and would buy with even more certainty at $250.
I think the slow down in revenue is indeed important and a drop in growth of this size is never good news. But I think the market today largely misunderstood the reasons behind the lower guidance for the next quarter and the rest of the year.
A narrative that I kept hearing today is that Palo Alto Networks is seeing a drop off in appetite for its cyber security software because customer and potential customers are experiencing spending fatigue after buying so much cyber security and AI software in recent quarters.
I think that’s dead wrong as an explanation. The forecast of a drop in billing and revenue growth is the result of a conscious decision by CEO Nikesh Arora and Palo Alto to force feed a transition among customers and potential customers away from individual cyber-secuueity software products to a cyber-security platform running a wide variety of Palo Alto products.
Palo Alto makes a whole lot more money–and locks it in for a long time–from customers who use a Palo Alto platform to run programs that address edge security, fire wall security, threat detection, real-time threat protection and more than from customers who buy individual security products. Plus once a company has gone with the platform approach, there’s a huge barrier to switching to another cyber-security vendor.
The problem, as Arora explained in the company’s guidance is how do you get a customer to buy into the platform approach. Many potential customers run cyber security products from multiple vendors to protect their networks at different stages and from different kinds of attacks. They’re reluctant, Arora pointed out, to rip out those legacy products to adopt a cyber-security platform that is untested for their company. The solution, Palo Alto has decided, is to essentially finance the conversion of a customer from a multiple single product environment to a Palo Alto platform by delaying the billing and payment for the Palo Alto platform software so that the customer can continue to pay its current cyber-security vendors while the Palo Alto platform is being put in place.
Here’s how CEO Arora put it:
“I think let me clarify in terms of the discounting notion. What’s happening today is when I go to a customer and say, Listen, I’d like to replace your [current security suite] with [the Palo Alto] platform. The customer says, Wait, wait a minute, I got this vendor for IPS, this for SD-WAN, this for SSC. And I got half of my firewalls from another vendor, and they all expire at different points in time. I’d love to deploy Zero Trust [the platform from Palo Alto], but it’s going to take me two, three years for the end of life to these vendors to happen. And I’m scared that if I rip and replace this at this point in time, it is going to create execution risk, and not just that, it’s going to hit economic risk. So the propositions we’re going to customers with is, Listen, let’s lay out a two-year, three-year cybersecurity consolidation and platformization plan. We’ll go start implementing today, you pay us when they’re done. So what it is, is more of a sort of like you can use our services while you have to keep paying the other vendor, and we’ll take it from there. But that’s taking away a lot of the economic exposure and the execution risk for our customers. Now you can call that a discount or you can call that a free offer. Our estimate is approximately it works out to about six months’ worth of free product capabilities to our customers on a rolling basis. I think in about 12 months, as our offers start lapping each other, we should go back to our growth rate we’ve been talking about.”
The near-term pain is obvious. That’s what’s in the guidance that crushed the stock today.
The long term projected upside is very attractive. Palo Alto projects that its annual recurring revenue will go to $15 billion in fiscal 2030 from roughly $4 billion in fiscal 2024. Recurring revenue will go to 90% of total revenue from 79% now. (More recurring revenue means higher operating margins.)
In essence what Palo Alto Nerworks is proposing is to leverage its current very healthy cash flow to create an even bigger future cash flow. As of the end of the fiscal second quarter, Palo Alto Networks had $3.4 billon in cash and short-term investments (with an upcoming convertible debt payment of $1.95 billion in 2025 that could be paid in stock.) Even after the lowered guidance, the company is forecast to generate $3 billion in free cash flow in fiscal 2024.
Now about those caveats.
I would buy Palo Alto at today’s price if I were an investor with at least a two-year time horizon. I’d also want to be an investor who won’t be too upset to miss an absolute bottom if the stock should drift lower. (Or you could decide to dollar cost average into the stock over the next two months or so)
I own Palo Alto in all of the appropriate online portfolios from Jubak’s Picks (up 252% from July 27, 2019) to my kong-term 50 Stocks Portfolio (up 220% from January 21, 2020) to my Volatility Portfolio to my very long term Millennial Portfolio.
