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Palo Alto Networks: Now's The Time To Look At Defensive Tech

With eight consecutive weeks of declines, the NASDAQ has been seeing the full effects of a risk-off sentiment as multiples in the tech sector have contracted aggressively given the new macro environment highlighted by 8.0%+ y/y inflation, a concerted effort by the Fed to consistently hike rates and yields on the benchmark 10-year treasury recently hitting 3.0%. None of this is conducive to investing in the tech sector and as such, during the NASDAQ’s 8-week losing spell, the index has dropped by 28.4%. All of this said, we do believe that the market is coming to the realization (finally) of the new investment dynamic, seeing as the effects of inflation have been taking hold and that given constant communication from the Fed, there is near unanimity in understanding that there will be multiple 50bp rate hikes over the course of the next few FOMC meetings. It is our belief that the oversold conditions are slowly becoming recognized.... so no better time than now to be a contrarian and to look at the most beaten down sector – that being tech itself. And by tech, what we mean is quality tech – companies with long established business practices and networks, with current (and recurring) operating cashflows, along with dominant market shares in areas with high barriers for entry. What we particularly like within tech is the highly defensive and stable (from a SaaS recurring revenue standpoint) cashflows found within the cyber security and/or networking subsector of tech. Our favored basket within the cybersecurity/networking subsector includes Cisco Systems (CSCO), Juniper Networks (JNPR), Ciena Corp. (CIEN), Crowdstrike (CRWD) and Arista Networks (ANET). From within the limited preferred names in our basket, our current highest conviction is with Palo Alto Networks (PANW).

If our conviction wasn’t already high on PANW, the blowout Q3/2022 financial results (as released on May 19) further solidified our view on the near and LT outlook for this dominant player in the global cybersecurity landscape. The quarterly results were impressive as revenues grew by 29% y/y to reach $1.4B, Q3 billings grew by 40% y/y (or 32% sequentially) to reach $1.8B and net income grew by 38% y/y to reach $193.1M before adjustments. Guidance was equally strong as FY/2022 estimates were increased across the board with total billings increasing to $7.136B (from $7.106B previously), a midpoint in total revenues increasing to $5.491B (from a midpoint of $5.450B previously) and a midpoint of net income/share increasing to $7.445 (from a midpoint of $7.265 previously), before adjustments. Just as importantly, despite an inflationary backdrop, operating margins reached 18.2% which was a nearly 90bps increase y/y, while FCF reached $351.2M this past quarter (25% FCF yield), which was a marked increase of 40% y/y. Longer term, as was mentioned on the call, management stated that the company is on track for FY/2024 targets of $10.0B in billings and $8.0B in revenue.

Given a current geopolitical backdrop in which cybersecurity threats are perceived to be at an all-time high, enterprise spend has accordingly reached multi-year highs and will likely remain at these levels despite the current economic downturn (if anything, we believe the risk for additional enterprise spend is on the upside). Palo Alto Networks continues to be well positioned with key/dominant product offerings for both firewalls and cloud security (among others). We believe that at the present time, investors will prefer companies exhibiting more “value type” characteristics revolving around solid fundamentals such as margin expansion and FCF growth instead of high growth stories but with weak (however promising in future) internal fundamentals.

Given PANW’s -23.5% correction since April 20, the LT story (headlined by a rollout of cloud and firewall product offerings) combined with the valuation and fundamentals make for a compelling entry point at present.


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