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Palo Alto Networks (Nasdaq: PANW) delivered solid quarterly results, with both revenue and profit exceeding expectations.However, during the earnings call, management dropped a bombshell, announcing that it was undergoing a complete shift in strategy that would focus more on Become a platform participant and focus more on the field of artificial intelligence. In this article, I analyze the company’s second-quarter results and explore whether the company’s plans to shift its focus to platform players will cause its stock price to drop nearly 30% following the announcement.I Previously reported on PANW In March 2023, I gave it a “hold” rating.
Palo Alto Networks Q2 Overview
In terms of results alone, Palo Alto Networks had an impressive second quarter.Revenue was US$1.98 billion, up 19.33% year-on-year, better than analysts The increase is expected to be $3.55 million. Non-GAAP diluted earnings per share were $1.46, an increase of 39% year-over-year, easily exceeding analysts’ expectations of $0.16. Non-GAAP operating profit margin grew strongly, with an annual increase of 5.80% to 29%. Residual performance obligations (RPO) also grew strongly, rising 22% year over year to $10.8 billion.
However, this guidance is lighter than expected for reasons I will highlight in the next section. The company now expects total revenue in FY24 to be between $1010 and $10.2 billion, down from its previous guidance of $1070 to $10.8 billion. FY24 revenue is now expected to be between $7.95 billion and $8.0 billion, down from the previous estimate range of $8.15 to $8.2 billion. Finally, FY24 adjusted earnings per share are now expected to be in a range of $5.45 to $5.55, with the median estimate of $5.50, down from the prior estimate of $5.52.
Changing strategy and becoming a platform player is the right move, no matter how sudden
Although the guidance fell short of expectations, it was not the main reason why the company’s stock price fell by nearly 30% after the earnings release. In my opinion, the factors driving the stock lower were the catalysts that led to lower-than-expected guidance. The catalyst was management’s plan to suddenly shift the company’s strategy and focus more on “platformization.” In short, the company now plans to focus more on selling all-in-one bundled cybersecurity software packages to customers, rather than relying on individual packages.
Additionally, the way management plans to execute this strategy is by offering customers the opportunity to lock in long-term deals without having to pay package fees for a period of time. More specifically, customers can now get an all-in-one bundle of PANW products, and payment for the bundle will be deferred for a defined period of time. In other words, customers can use PANW’s bundle for free for a period of time, after which payments will kick in. The company expects revenue and billings to face headwinds over the next 12 to 18 months due to its transformation into a platform player.
On the face of it, a sudden shift to a completely new strategy mid-year might seem absurd. However, it’s definitely the right move for the company in the long run. PANW continues to be best-in-class across multiple verticals. The company continues to expand market share across product segments. For example, in the second quarter, more than 30% of the company’s new SASE customers were new to Palo Alto Networks itself. In addition, the company’s second-quarter ARR increased by 50% for the fifth consecutive quarter. In addition, the company achieved its highest “new ACV” growth in five quarters in the Prisma Cloud segment in the second quarter. Finally, at Cortex, the company set a record for the most deals signed in a single season thanks to XSIAM, with over $90 million in bookings.
The above achievements do show that the company’s products are winning over customers. Therefore, I believe now is the perfect time for the company to consider bundling its products as a product and marketing them to customers. Additionally, such a strategy should also help companies retain customers over the long term, which from a customer’s perspective means uniformity and consistency in their cyber defenses compared to a multi-vendor approach.
Finally, while the move may seem sudden, it’s not entirely so. Over the past six months, the company has begun experimenting with a platform strategy. So, in my opinion, I don’t think this was a spur-of-the-moment move by the company. The results of the trial must be positive enough to convince management that now is the right time for transformation.
AI investment comes at a good time for the company
As part of the strategic shift, PANW also announced that it will invest significantly to enhance its “Artificial intelligence leadership. “ The timing is once again right, given that investment in AI continues to grow and demand for AI products shows no signs of abating. According to KnuthGlobal spending on artificial intelligence software is expected to grow from US$124 billion in 2022 to US$297 billion in 2027, with a compound annual growth rate of 19.1%. According to the same report, GenAI software spending is expected to increase from 8% in 2023 to 35% in 2027.
Because of this growth, PANW does see three areas of opportunity presented by AI to be able to capitalize on: AI-driven phishing, protecting against threats to AI deployments on the cloud, and monitoring AI. driven network traffic. Over the next five years, the company expects these areas to contain opportunities of $13 billion to $17 billion, prompting them to increase investment in artificial intelligence products.
When considering the predictions of the Gartner report, management’s expectations for AI-driven opportunities do not appear to be entirely unrealistic. But the timing of these investments in AI-related cyber defenses is important.Given what we’ve seen from earnings NVIDIA reportDemand for artificial intelligence continues to surge, with supply becoming the only limit for companies. This supply constraint may slow the deployment of AI solutions in the short term. This makes PANW a good time to invest more in building AI products so that the company can be ready to capitalize once restrictions subside.
So this shift in focus on dominating the field of artificial intelligence doesn’t look sudden at all to me. On the contrary, it is a wise decision.
Valuation
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forward price to earnings ratio method |
|
|
price target |
$294.00 |
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Estimated forward price-to-earnings multiple |
45.4 times |
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Estimated earnings per share for fiscal year 2024 |
$5.50 |
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expected price-to-earnings ratio |
2.55 |
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Profit growth in FY25 |
17.8% |
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Estimated FY25 EPS |
$6.48 |
Source: The Company’s second quarter fiscal 2024 press release, LSEG Workspace (formerly Refinitiv) and author’s calculations
PANW currently trades at a forward price-to-earnings ratio of 45.4 times, which is expensive but in line with its historical multiples, according to data from LSEG Workspace (formerly Refinitiv). Additionally, peers such as Zscaler and CrowdStrike currently trade at forward P/E ratios of 80x.
While billings and revenue are facing headwinds due to this change in strategy, management doesn’t expect any pressure on earnings. In the long run, I think the platforming strategy should pay off for PANW as it leads in many verticals. Therefore, in my calculations, I assume a forward P/E of 45.4x.
The company currently expects fiscal ’24 diluted non-GAAP earnings per share to be in the range of $5.45 to $5.55. I’m assuming the midpoint of this guide for my calculations is $5.50. According to LSEG Workspace (formerly Refinitiv), the company currently trades at a forward PEG multiple of 2.55x. Given that management doesn’t see any headwinds to the bottom line (which I think is a reasonable assumption, as the company continues to win deals in its verticals despite the shift in strategy), I assumed this multiple in my calculations.
A forward PEG ratio of 2.55x and a forward price-to-earnings ratio of 45.4x imply earnings growth of 17.8%. At this growth rate, FY25 earnings per share are expected to be $6.48. A forward P/E of 45.4x and EPS of $6.48 would result in a price target of $294, implying roughly 10% upside from current levels.
Given the limited upside, I think new investors would be better off waiting for better entry levels. That being said, the cybersecurity industry currently has many structural tailwinds, especially given geopolitical tensions. Given that the stock fell nearly 30% after the earnings release, I wouldn’t be surprised if there was some buying activity in the short term. However, from a valuation perspective, I think it’s better to keep this stock on your watch list rather than buy at these levels, especially over the long term.
risk factors
While convinced that the timing is right for the company to pivot to becoming a platform player and focus on gaining leadership in artificial intelligence, the strategy does come with risks. My main concern is execution risk. While I have no doubt that senior executives like PANW will successfully transform, the nature and extent of that “success” remains extremely uncertain. The company expects revenue and billings to face headwinds over the next 12-18 months. Therefore, getting this strategy right remains critical.
Additionally, PANW experienced cuts in U.S. federal government spending last quarter. Management sees the headwinds from this incident affecting the third and fourth quarters as a concern. Additionally, during the earnings call, CEO Nikesh Arora did emphasize that the issue was more specific to PANW rather than a reflection of the industry as a whole, which again is a risk factor for investors to consider.
concluding thoughts
PANW shocked the market by announcing it was undertaking a mid-year strategic shift that would position the company as a major platform player and leader in artificial intelligence. While investors found this sudden shift difficult to digest, when viewed from an overall perspective, the move appears to be anything but sudden.
PANW continues to be a leader across various industry verticals, as evidenced by its continued success in securing contracts quarter after quarter. So it makes a lot of sense for the company to figure out what can drive the next phase of growth. Differentiating through platforming and focusing on AI products makes a lot of sense, especially in the current environment. Additionally, the company announced a strategic shift after the trial period, so the company isn’t taking a blind risk.
Over the long term, PANW remains well-positioned to capitalize on changing trends in the technology sector. Therefore, investors should take advantage of any pullback in their stocks, especially one due to near-term uncertainty.
