Palo Alto Networks (PANW 1.37%) is one of the world's best-known cybersecurity companies. Founded in 2005, it now serves over 85,000 customers across more than 150 countries. The California-based company is one of the world's leading providers of next-gen firewall appliances, and it's expanded its ecosystem with newer cloud-based and AI-powered security services in recent years. It now generates a lot of its growth from these next-gen security (NGS) solutions.
I've been bullish on Palo Alto since early 2021 -- when I called it my "best cybersecurity stock" to own for the year -- and I'm still optimistic about the company's long-term prospects. But instead of revisiting the same bullish bullet points, I'd like to take a deeper dive into three other aspects of Palo Alto's business that are often overlooked.
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1. Palo Alto shares a lot of DNA with Check Point Software
Most investors likely think of Palo Alto as an American company, but it actually has deep roots in Israel and shares a lot of DNA with the Israeli-American cybersecurity company Check Point Software (CHKP 0.18%).
Palo Alto's founder Nir Zuk was born in Israel and cut his teeth at Unit 8200, the electronic intelligence arm of the Israel Defense Forces (IDF). At the IDF he worked under Gil Shwed, who would eventually co-found Check Point in 1993. Check Point recruited Zuk in 1994, and he helped the company build its flagship Firewall-1 product and stayed onboard for five more years.
Several years later Zuk was approached by Check Point's former VP Asheem Chandna, who had become a partner at the venture capital firm Greylock, to upgrade legacy firewalls with network device filtering tools. This "next-gen" firewall product led to the creation of Palo Alto Networks.
2. Palo Alto Networks operates 3 main ecosystems
Palo Alto's next-gen firewall made it one of the largest cybersecurity companies in the world. But in recent years the market for on-site appliances has been disrupted by cloud-native services like CrowdStrike's (CRWD 0.14%) Falcon, which doesn't require any on-site appliances, and automated AI-powered platforms like SentinelOne's (S -0.10%) Singularity, which cuts human analysts out of the loop.
To keep pace with that rapid technological shift, Palo Alto spent nearly $3 billion on cloud and AI-related acquisitions in fiscal 2020 and 2021 (which ended last July). That inorganic expansion created three distinct ecosystems with interlocking parts: Strata, Prisma, and Cortex.
Strata is its core security platform which runs across its on-site appliances. Prisma is its suite of cloud-native security services, and Cortex is its AI-powered threat detection platform. Together, these three ecosystems enable Palo Alto Networks to grow its core firewall business while widening its moat against CrowdStrike, SentinelOne, and other disruptive challengers.
Last quarter, Palo Alto generated 29% of its annual recurring revenue (ARR) from its NGS (Prisma and Cortex) services. That ratio, which has steadily risen from 19% in fiscal 2020, will likely remain one of the company's most important growth metrics for the foreseeable future.
3. Palo Alto doesn't plan to bite off more than it can chew
The bears claim Palo Alto's shopping spree is risky since it still isn't profitable by generally accepted accounting principles (GAAP) measures yet and could suffer acquisition indigestion as it integrates its new businesses.
But during Palo Alto's latest conference call in February, CEO Nikesh Arora said the second quarter marked an "end of all integrations of our acquired businesses over the last few years" and that all of its products were "now seamlessly integrated" and well-positioned for organic growth.
CFO Dipak Golechha said Palo Alto wouldn't make any more big acquisitions in the near future, and that it would gradually reduce the stock-based compensation expenses (11% of its revenue last quarter) that are preventing it from achieving GAAP profitability.
Those reassuring statements, along with the clear expansion of its business across three distinct ecosystems, indicates the company isn't blindly buying growth. Instead, it's taking calculated steps to stay competitive.
It still offers a great balance of growth and value
Palo Alto's revenue and adjusted earnings grew 27% and 26%, respectively, in fiscal 2021. For fiscal 2022, it expects its revenue to grow 27%-29% and for its adjusted earnings to increase 18%-19%.
The stock might seem a bit pricey at nearly 90 times forward earnings and 11 times this year's sales, but I believe its consistent growth, disciplined expansion, and the long-term growth of the cybersecurity market all justify those higher valuations.
