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Buy Palo Alto Networks? Here Are 3 Things You Need to Know

By Rich Smith - Mar 11, 2016 at 12:15PM

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For one, this is a much better bet than FireEye.

Up 7% in 52 weeks, Palo Alto Networks (PANW 0.16%), is on a tear -- and outperforming the S&P 500 by 10 percentage points. But this good news could get even better...

And Palo Alto Networks could go to $200.

The news
This happy news comes to you courtesy of the friendly analysts at Bernstein, which this morning announced they're initiating coverage of Palo Alto Networks with an outperform rating and a very bullish outlook. According to Bernstein, Palo Alto is its pick to become "the most likely winner of the infrastructure security race." And judging from the analyst's new price target, that promises to produce a 29% profit for investors who buy Palo Alto now.

Here are three things you need to know about the new recommendation.

IDC Security sees the cybersecurity market growing at 7.1% annually over the next three years -- and Bernstein sees Palo Alto winning nearly half of that business. Image source: Palo Alto Networks.

Thing No. 1: Not every problem is a nail
As explained in a write-up on this morning, Bernstein believes that the old system of point-based defense against cyber breaches is insufficient to defeat modern cyber threats, and "infrastructure security needs [are] converging toward integrated solutions leveraging cloud-based services, next generation firewalls and endpoint security.

And wouldn't you know it? This is just what Palo Alto Networks agrees. According to the company, its "innovative approach and highly differentiated cyberthreat prevention capabilities" are "far superior to legacy or point products." If both the analyst and the company are right, this could set up Palo Alto Networks for years of outperformance.

Thing No. 2: You have no idea how big this could get
"Outperformance" is a pretty vague and overused term in stock market research -- so let's get specific. As Bernstein estimates it, Palo Alto Networks "owns ~7% share of the installed base" in Internet security today. But it's capturing "~43% of the market growth."

The way Bernstein does the math, this works out to a very real possibility that Palo Alto Networks "can easily double revenues in three years and materially step up profitability."

Now read that again. Bernstein is predicting more than a doubling of profits in just three years.

Thing No. 3: Bernstein's price target isn't even that aggressive
At the same time as Bernstein predicts a doubling of revenues in three years, and a more-than-doubling of profits in the same period of time, the analyst is only predicting a less than 2 times increase in market cap -- to roughly $22 billion -- over the next four years.

That leaves open the possibility that Palo Alto Networks' stock could outperform even Bernstein's ambitious targets.

And one more thing...
And Bernstein could actually be right about this. Crunching the numbers on Palo Alto Networks myself, I see a $12.9 billion enterprise generating $440 million a year in positive free cash flow -- so an enterprise value-to-free-cash-flow ratio of 29.

That sounds expensive. But according to data from on S&P Global Market Intelligence, analysts who follow Palo Alto Networks are, on average, predicting a long-term profits growth rate of more than 40% per year over the next five years.

If they're right, even 29 times free cash flow may not be too much to pay for Palo Alto Networks. (For proof, you need look no farther than rival cybersecurity operator FireEye (MNDT -0.02%), which scored its second big analyst upgrade in as many months earlier this week. FireEye generates no free cash flow, and so technically sells for an enterprise value-to-free-cash-flow ratio of...infinity.)

Long story short? There's a reason that we've been tracking Bernstein's stock picks for 10 years here on Motley Fool CAPS. Time and again over the past decade, this analyst has proven itself capable of beating the market, crushing other analysts' returns, and earning itself a place on our list of Wall Street's best stock pickers.

In Palo Alto Networks, I think they've found another winner.

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 282 out of more than 75,000 rated members.

The Motley Fool owns shares of and recommends FireEye. The Motley Fool recommends Palo Alto Networks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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