Palo Alto Networks (PANW 0.11%) finished 2020 on a high note. After languishing for most of the year with lower than hoped for growth and with investors digesting multiple acquisitions from the last few years, shares surged during the fourth quarter and ended the year up 54%. The reason? A rosy outlook that indicates the cybersecurity leader's spending to keep pace with a fast-changing industry is starting to pay off. It's not my favorite stock in the security software space, but Palo Alto Networks is nevertheless worth keeping tabs on.
Trading cash for double-digit growth
The cybersecurity industry is constantly changing, but the pandemic accelerated trends that were already giving many organizations a headache. Cloud computing and the increasingly remote workforce it supports present new challenges like securing data centers, protecting data traveling via the web (versus within a closed network like an office building), and securing the at-home devices used by remote employees.
This has opened the door for a rapid disruption of the status quo. The recent SolarWinds security breach underscores the important task of staying ahead of the bad guys. Palo Alto Networks, itself a legacy security firm, has been dealing with a slew of upstart competitors addressing today's pressing digital security needs. Its response has been to go shopping -- the company has acquired 11 smaller software vendors since the beginning of 2018, tallying up to a few billion dollars in spending. Its latest was $800 million for data and attack monitoring firm Expanse.
Image source: Getty Images.
Palo Alto Networks has been able to pay for these takeovers with a combination of cash on its balance sheet, new debt, issuance of stock, and a generally high rate of cash generation from its profitable operation. In fact, cash and short-term investments have stayed stable the last few years thanks in large part to the company's profitability. There was $3.2 billion on the balance sheet at the end of the fiscal 2021 first quarter (the three months ended Oct. 31, 2020). Debt has crept up to $3.1 billion (the company has issued a couple rounds of convertible debt), but for the most part, Palo Alto has been able to pay for its acquisitions out of pocket thanks to free-cash-flow generation (revenue minus cash operating expenses and capital expenditures), which was over $1.1 billion for the trailing 12-month stretch.
In exchange for its heavy spending, the company is maintaining and building on its lead as the largest cybersecurity pure-play around. The company expects full-year 2021 revenue growth of 20% to 21%. Compared to industry research showing global cybersecurity spending is averaging about 10% to 15% growth a year, the company's acquisition-happy strategy is at least leading to the desired result: It's continuing to outpace its average competitor as a new era of security dominated by the cloud and remote work takes over.
Is it worth a buy?
This expected acceleration in sales (up from 17.5% growth in fiscal 2020) is good news. CEO Nikesh Arora has stated the company's goal is to deliver growth in the 20% range over the next few years. However, the fact the company has purchased its way to meeting that goal may not jibe with all investors.
Other cybersecurity names are creating higher growth without the need for blockbuster takeovers. Endpoint security firm CrowdStrike Holdings (CRWD -0.68%), for example, has nearly doubled its sales during the first nine months of its fiscal 2021. Flush with cash ($1.1 billion at the end of October), it recently raised an additional $740 million in net cash via issuance of debt and is free cash flow positive. It could be poised to venture beyond its core security functionality and disrupt the broader industry.
Fellow legacy security vendor Fortinet (FTNT 1.00%) is also worth a look. It grew 19% through the first three quarters of 2020, nearly all of it organic without big acquisition spending. And as a result, Fortinet has one of the highest profit margins in the industry, generating $684 million in free cash flow on revenue of $1.85 billion with just a quarter left to report in its 2020 fiscal year. It, too, has ample cash and no debt.
Palo Alto Networks stock could nevertheless be a part of a broader investment in the cybersecurity space. It isn't putting up the near triple-digit percentage growth rates of CrowdStrike, but it trades for 31 times trailing 12-month free cash flow compared to CrowdStrike's almost 200. The premium on the smaller firm accounts for its momentum and the potential the company has as a disruptor, so the high price tag might be worth it -- if investors are willing to ride out what is sure to be a volatile journey in the decade ahead.
But for a 28 times free cash flow multiple, investors can purchase Fortinet, which gets my nod as the best buy right now among legacy security vendors. I own Palo Alto Networks stock, but I'm not buying any more right now after the big run-up at the tail end of 2020. The company's outlook for an acceleration in sales growth in the year ahead looks baked in, and more acquisitions that might weigh on profitability are likely, given management's track record. Palo Alto is a solid stock, but there are better buys right now in the cybersecurity industry.
