Wall Street pros can overcomplicate a bullish thesis on a stock with differing short-term and long-term outlooks or with a long list of metrics bearing questionable usefulness. But superior returns often come from a simple strategy that involves owning a mix of strong businesses for long periods of time.
With that approach in mind, let's look at the main factors that make Palo Alto Networks (PANW 1.05%) an attractive stock for investors willing to take on some risk in exchange for potentially market-thumping returns through 2023 and beyond.
1. Cybersecurity isn't a luxury
Many tech companies are cutting back on their spending budgets today as economic growth rates slow. A shrinking digital advertising market is hurting social media companies, and even productivity software giants like Microsoft are dealing with falling demand.
But Palo Alto Networks' cybersecurity focus might help insulate it from some of these headwinds. Sales grew a surprisingly strong 25% in the most recent quarter as enterprise clients continued to prioritize investments in their cybersecurity architecture. That success allowed Palo Alto Networks to raise its fiscal year outlook at a time when many other tech companies are lowering their forecasts. Sales are now on track to rise by about 26% in fiscal 2023, an increase from the previous forecast of 25%.
2. There will be a slowdown
Smart investors know that Palo Alto Networks isn't immune to the challenges facing the wider software industry. While cybersecurity is a critical part of an enterprise's IT infrastructure, there's always room to tighten belts.
Palo Alto Networks is already seen signs of these pressures in its contract negotiations. "Cybersecurity deals are getting more scrutiny," CEO Nikesh Arora said in a recent call with investors, "suggesting deeper and longer reviews of transformational projects." Companies are getting pickier about spending and slowing down the rate of upgrades, executives said. But deals continue to grow in size. Palo Alto Networks counted 1,262 customers spending over $1 million per year, up from 1,025 a year ago.
3. Margin expansion is coming
Palo Alto Networks is new to the profitability world, having only recently posted its first quarter of positive net income. But the future should contain much more for shareholders in the way of earnings expansion.
In late November, the company raised its outlook on key financial metrics including earnings, cash flow, and operating profit margin. Sales should expand by about 1 percentage point faster than previously estimated. Adjusted free cash flow should land between 34.5% and 35.5% of sales, up from the prior range of between 33.5% and 34.5% of sales. And the forecast for operating profit margin improved by half of a percentage point. Annual free cash flow, a key metric to watch for software-as-a-service providers, is on track to expand by 30% this year, outpacing the 26% growth that's expected on overall revenue.
Management is focused on boosting those profit figures into 2023 and beyond. "Given that we're the largest independent cybersecurity business, we can meaningfully improve our margins over the next phase of our company's life cycle," Arora said.
PANW Operating Margin (TTM) data by YCharts
It is likely that Palo Alto Networks will set new records for the business on profitability, but it isn't yet clear where that figure will ultimately settle.
That murky outlook, plus the fact that IT spending is slowing, has Wall Street more focused on short-term problems. The stock is down 4% in 2022 even though the company has been blowing past its sales and earnings forecasts for much of the year. Investors seeking exposure to the cybersecurity niche should view that drop as a tempting discount on a business with excellent long-term growth potential.
