Palo Alto Networks (PANW 4.19%) recently posted strong third-quarter earnings that beat analysts' expectations. The cybersecurity company's revenue rose 24% year over year to $1.07 billion, beating estimates by $10 million, as its billings improved 27% to $1.29 billion.
Its adjusted net income grew 22% to $139.5 million, or $1.38 per share, which also cleared expectations by nine cents. But on a GAAP basis, its net loss widened from $74.8 million to $145.1 million, partly due to its high stock-based compensation expenses and recent acquisitions.
For the full year, Palo Alto expects its billings to grow 23%, its total revenue to increase 23%-24%, and its non-GAAP EPS to rise 22%-23%. All three estimates were higher than the guidance it provided in February. Its deferred revenue, a key indicator of future demand, grew 30% to $4.4 billion.
Palo Alto's stock price rose after the report, but it's remained relatively flat over the past three months as investors have rotated from growth to value stocks. However, I believe it's still a great long-term investment, for five reasons.
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1. Its cloud and AI evolution
Palo Alto's largest security platform, Strata, is built atop the foundations of its flagship firewall service, and primarily installed through on-site appliances. But over the past two years, the company has spent nearly $3 billion on acquisitions to expand its portfolio of cloud and AI services, which generate stickier recurring revenue and are easier to scale than on-site appliances.
Those recent acquisitions include the Internet of Things (IoT) security company Zingbox, the machine identity firm Aporeto, the software-defined networking company Cloudgenix, the attack surface management company Expanse, and the cloud security start-up Bridgecrew.
Palo Alto bought all those companies to expand its next-gen security (NGS) platforms, which include Prisma Cloud, its suite of cloud security services, and Cortex, its AI-powered threat detection platform.
Palo Alto expects its annual recurring revenue (ARR) from its NGS platforms to rise 77% year over year to $1.15 billion, or about 27% of its annual revenue, at the end of fiscal 2021. That expansion should lock in more customers and widen its moat against cloud-native challengers like CrowdStrike (CRWD 3.63%).
2. Landing and expanding
Palo Alto "lands and expands" by signing customers up for one service in order to cross-sell additional services. It's accelerating that strategy with the inorganic expansion of Prisma and Cortex.
During the third quarter, 70% of Palo Alto's Global 2000 customers had purchased products from more than one of its three main platforms (Strata, Prisma, and Cortex), up from 58% a year ago and 25% two years ago. Forty-one percent of its Global 2000 customers now use all three of its platforms.
3. Stable margins
Palo Alto's non-GAAP gross margin dipped 60 basis points year over year to 74.6% during the third quarter, due to a higher mix of its "less mature" NGS products. That temporary dip isn't surprising for a cybersecurity company shifting from on-site appliances to cloud-based services.
However, its non-GAAP operating margin still rose 60 basis points to 17%, supported by its revenue growth, lower travel and event expenses during the pandemic, and some postponed spending plans.
Palo Alto expects its operating costs to rise again as the pandemic passes, more people return to work, and it resumes its sales and R&D investments. However, its increased earnings guidance for the full year indicates its billings and revenue growth should easily cushion that blow.
4. Higher government spending
In mid-May, President Joe Biden issued an executive order to develop new cybersecurity standards and guidelines for the public and private sectors. His $2 trillion infrastructure proposal, which has yet to be approved, also calls for setting aside billions of dollars for upgrading cybersecurity services.
Palo Alto, which Gartner has named a Magic Quadrant leader in network firewalls for nine straight years, could attract a lot of that spending with its "best in breed" reputation. It already secured a "seven-figure" deal with an unnamed U.S. government agency during the third quarter, and it could win even more contracts in the near future.
5. It's still reasonably valued
Palo Alto trades at about 50 times forward earnings and eight times this year's sales. Those valuations aren't low, but it remains cheaper than many other tech stocks with comparable revenue growth rates.
Palo Alto is also cheap relative to its industry peers. CrowdStrike is growing faster than Palo Alto, but it trades at about 350 times forward earnings and nearly 40 times this year's sales. Therefore, Palo Alto's balance of growth and value might insulate it better from the ongoing sell-off in frothier tech stocks.
The key takeaways
Back in January, I chose Palo Alto Networks as my top cybersecurity pick for 2021. I'm reiterating that bullish view today, and I believe investors who buy more shares as the market temporarily shuns tech stocks could be well-rewarded as the cybersecurity market expands.
