The need for modern cybersecurity protection has attracted a lot of attention during the pandemic. Many organizations had been neglecting upgrading their IT infrastructure for years. Newly remote workforces, a rapid migration to cloud-based computing, and technologically advanced bad guys have resulted in cybersecurity software demand soaring since 2020.
However, many high-growth cybersecurity stocks trade for incredibly high premiums and have been falling lately given the expectation the Federal Reserve will start raising interest rates this year (high-growth stocks can be very sensitive to changes in interest rates, since higher rates lower the value of future cash flows). But companies that are growing and highly profitable could be poised for a great run in 2022. That's why oft-overlooked Palo Alto Networks (PANW 1.37%) and Fortinet (FTNT -0.97%) look like smart buys right now.
Image source: Getty Images.
Palo Alto Networks: The largest cybersecurity firm by revenue
Cloud-based security darling CrowdStrike Holdings (CRWD 0.14%) was the largest cybersecurity pure-play company by market cap in 2021, a title it has recently lost after shares have fallen sharply in recent months. But as measured by actual sales, Palo Alto Networks is far and away the largest stand-alone security business, having generated nearly $4.6 billion in sales over the last 12-month stretch.
Palo Alto's software predates the cloud era, so it spent a few billion dollars on nearly a dozen acquisitions the last few years to get itself up to speed with the times. What has emerged is a top software platform with thousands of customers and services that are stickier than ever. Palo Alto thinks it can sustain an average 23% revenue growth rate over the next few years as it scales up with its customers' need for various security services. For its fiscal 2022, it's forecasting a year-over-year increase of as much as 26%.
During its period of heightened spending to integrate all of the acquisitions it made, Palo Alto's profitability dipped. However, that's starting to change. Free cash flow was $1.44 billion over the last 12 months, equating to a healthy free cash flow profit margin of 32% that the company expects to be able to maintain in the year ahead. The balance sheet is in good shape, too, with $2.27 billion in cash and equivalents and another $2.09 billion in short- and long-term investments, offset by just $3.67 billion in debt (in the form of low-interest-rate debt that can eventually be converted into stock).
Shares have mostly bucked the recent market slump experienced by high-growth but richly valued tech stocks. Palo Alto's stock trades close to all-time highs while many smaller peers have tanked by double-digit percentages. Even so, at 35 times trailing-12-month free cash flow, the largest cybersecurity business can be purchased for a relative value and is in great shape as it tries to capture more security industry spending in the next few years.
Fortinet: Now the largest cybersecurity firm by market cap
Like Palo Alto Networks, Fortinet is often considered a "legacy" cybersecurity outfit that predates the cloud computing era. However, this is no slouch. Though it trails behind Palo Alto in revenue (it generated over $3.1 billion in sales in the last 12 months), at the moment Fortinet has overtaken both Palo Alto and CrowdStrike as the largest cybersecurity pure play as measured by market cap -- even after tumbling about 15% from all-time highs the last couple of months.
Data by YCharts.
There's a good reason for that outperformance. Fortinet is a cash-generating machine, opting for a more conservative strategy of developing new products and technology in-house rather than acquiring smaller peers. The result? Nearly as much free cash flow generation in the last year ($1.25 billion) as Palo Alto, even though Fortinet reports over $1 billion less in annualized sales. Fortinet's free cash flow profit margin was a whopping 40% in the last 12-month period.
Fortinet still looks like a fantastic investment. While it has built out a stable of software products that generate recurring revenue, the company is a best-in-class developer of chips that help protect data centers -- the assets that make cloud computing possible in the first place. As more companies upgrade their IT equipment and migrate to cloud and hybrid-cloud operations, Fortinet will have a foot in the door with its hardware.
Fortinet expects full-year 2021 revenue to be up about 29% year over year, a pace that could moderate heading into 2022. Nevertheless, with $1.85 billion in cash and equivalents and another $1.53 billion in short- and long-term investments, offset by debt of just $1 billion, this is a superb cybersecurity business to be invested in right now. Shares trade for 43 times trailing-12-month free cash flow, a worthy premium given this long-term winner's track record of exceptional shareholder returns.
