While inflation has cooled off from its peak level, it has been running at its hottest pace since the early 1980s. Now, most younger investors need to learn how to invest in a high inflationary environment since they've never had to deal with it before. In times like these, we should seek advice from those who've successfully invested when inflation rises.
There's no one better than investing legend Warren Buffett, who has given investors lots of advice throughout the years on how to deal with inflation. For example, Buffett wrote in his 1981 shareholder letter that investors should look for companies with two traits to combat inflation: pricing power and the ability to scale without making heavy capital investments.
Pricing power at its finest
Buffett loves to invest in companies with pricing power, which is their ability to raise prices well above inflation without affecting sales. Several factors can drive a company's pricing power, including irresistible demand for its products and its ability to expand relationships with existing customers.
Palo Alto Networks certainly benefits from irresistible demand. Cyber threats are growing more complex and costly. At the same time, digital transformation initiatives are bringing more business processes online, further increasing cyber risks. Add in the increase of hybrid and remote work, and companies need to upgrade their network security to keep their data safe.
As a global cybersecurity leader, Palo Alto Networks benefits from growing demand for its security offerings. Its revenue rose 25% in its fiscal first quarter, driven "by customers continuing to increase their commitments to our security platforms as they are able to choose our best-of-breed capability and simplify their security architecture," according to comments by CEO Nikesh Arora in the earnings release.
As Arora pointed out, Palo Alto Networks has industry-leading capabilities. That's due to its investments in innovation to build out security offerings to meet all its clients' needs. And those clients are steadily expanding their relationship with Palo Alto Networks by signing increasingly larger deals:
As that slide shows, the company is signing increasingly more comprehensive deals with customers as they consolidate their network security architecture with Palo Alto Networks' solutions. That's growing the number of customers that supply it with more than $1 million of revenue.
The company's pricing power factors not only help it battle inflation but are also helping it continue growing during the current economic uncertainty. Palo Alto is gaining market share as more companies switch to its comprehensive solutions to save money and improve network security.
Becoming a cash flow machine
Another inflation-fighting factor Buffett loves is businesses with low capital intensity. Instead of using cash to invest in capital projects during a rising cost environment, capital-light companies generate lots of free cash flow.
Palo Alto Networks also has this trait. It invested heavily in recent years to build out its integrated three-platform strategy. Those investments are now paying dividends by driving strong revenue growth and free cash flow margin expansion. Palo Alto Networks turned one-third of every dollar of sales into adjusted free cash flow last year. The company sees its free cash flow margin expanding to 34.5%-35.5% of revenue in fiscal 2023, up from its initial view of 33.5%-34.5%. That ability to grow its free cash flow margin in a tough economic and inflationary environment showcases the company's pricing power and capital-light business model. With sales projected to rise more than 20% to as much as $9.1 billion this year, Palo Alto Networks could produce more than $3 billion in free cash flow.
That gives it tremendous financial flexibility, a big competitive advantage nowadays. Whereas financially strapped peers need to be more conservative, Palo Alto Networks can opportunistically repurchase shares, make acquisitions, and fund additional growth-related investments.
Following Warren Buffett's formula for inflation-beating success
Palo Alto Networks has the two traits Buffett seeks in an inflation-fighting stock. It benefits from pricing power, and it has a capital-light business model. Even an economic slowdown in 2023 won't stop its revenue and cash flow growth. That makes it a great stock to buy for those seeking to get ahead of inflation.