Thanks to a few billion dollars' worth of acquisitions the last few years and steadily rising need for cybersecurity, Palo Alto Networks (NYSE:PANW) remains by far the largest security software vendor around as measured by revenue. But effects from the COVID-19 pandemic are hastening changes in the economy and creating new security challenges.

Palo Alto Networks is in good shape to continue its long-term evolution, but I don't think it's a top cybersecurity buy like it was back in the spring during the peak of the economic lockdown and stock market crash.  

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Image source: Getty Images.

Another solid quarter, another acquisition

While storm clouds remain over the economy overall headed into the final quarter of 2020, the digital economy is doing just fine. And due in no small part to its acquisition of smaller cloud computing-native rivals under the guidance of CEO Nikesh Arora, Palo Alto not only remains the largest cybersecurity pure-play, but also ranks as a top vendor for organizations trying to stay protected against those with nefarious intent. Tech researchers Forrester and Gartner respectively ranked Palo Alto as a leader in "zero trust security" and in software-defined network security (via its $420 million CloudGenix acquisition early in the year).

Palo Alto remains active on the acquisition front, recently completing the $265 million purchase of incident response and forensics firm Crypsis Group announced in tandem with its final fiscal 2020 quarterly report (for the 12 months ended July 31, 2020). Scooping up all of these small firms and plugging them into its own security ecosystem helped the company stay in growth mode over the last year, and its initial forecast for first-quarter 2021 is for year-over-year revenue growth of 19% to 20%. Full-year 2021 outlook is calling for revenue growth in the high teens percentage range.

Metric

12 Months Ended July 31, 2020

12 Months Ended July 31, 2019

Change

Revenue

$3.41 billion

$2.90 billion

18%

Gross profit margin

70.7%

72.1%

(1.4 pp)

Adjusted net income

$485 million

$539 million

(10%)

Free cash flow

$821 million

$924 million

(11%)

Pp = percentage point. Data source: Palo Alto Networks.

Decent growth, but at a cost

Shares are having a decent enough run this year, up 19% over the last 12-month stretch (including doubling in value from March 2020 lows) in line with the revenue advance. It makes sense that sales growth is what's driving the stock higher right now, as the torrid pace of purchases is starting to dent the bottom line. Free cash flow (basic profitability measured as revenue less cash operating and capital expenses) fell 11% in fiscal 2020 and should remain subdued as the company digests its takeovers.  

Spending has also left the company with a higher burden of debt than a year ago. At the end of July, Palo Alto had $4.3 billion in cash and investments (compared to $3.4 billion in cash and investments at the end of July 2019) and $3.1 billion in debt ($1.4 billion in debt a year ago). This is still a rock-solid balance sheet that continues to be replenished with positive free cash flow, but profit growth is simply not the strategy here right now.  

In the year ahead, if the stock continues to be driven by sales growth and Palo Alto can deliver on its expectation of high teens percentage revenue expansion, this won't be a terrible place to have some of your investment portfolio socked away in. But the company's bumpy bottom line will likely keep share prices bouncing around substantially.

Plus, there's always the threat of smaller cloud-native firms narrowing the gap. For investors looking for a more stable cybersecurity industry investment, I like fellow legacy security software firm Fortinet (NASDAQ:FTNT). It's growing at a similar pace to Palo Alto Networks, but because it has mostly developed its next-gen cloud security in-house versus via acquisition, it's generating far higher free cash flow margins over the last year (36% to Palo Alto at 24%), has zero debt, and trades for 24 times free cash flow (to Palo Alto at 30).  

I'm holding onto my Palo Alto Networks shares, but if I was looking to invest new money in cybersecurity, I'd start with Fortinet right now.