Following Palo Alto Networks’ (PANW) solid F1Q results, we recommend investors to buy shares. Given the improving outlook, the transition from a single product to a multi-product platform company, compelling valuation, and improving execution, we would be buying shares opportunistically. Palo Alto Networks is using its install base to become a leader in adjacent markets and this should bode well for revenue growth.

Palo Alto Networks reported F1Q21 results that were ahead of estimates and provided guidance that beat consensus estimates. PANW reported revenue of $946 million versus the consensus estimate of $922 million. EPS was $1.62 versus the consensus estimate of $1.33. EPS beat was driven by higher than expected revenue, gross margin, and lower than anticipated opex. The following chart illustrates the company’s results versus our expectations.

The company beat estimates on every metric it guided. The following chart illustrates the highlights of F1Q21 results versus guidance.

Source: Company presentation

Guidance ahead of estimates

The company provided F2Q21 revenue guidance in the range of $1.17-1.19 billion, which was above the prior consensus of $971 million. PANW guided EPS in the range of $1.42-1.44, which is again above the previous consensus estimate of $1.35.

CEO Nikesh Arora noted that “This continued strength during the pandemic makes me cautiously optimistic about the prospects of the business. While we expect the winter will try all of our collective resolves with COVID, the worst-case scenarios are unlikely to unfold, and we expect our customers to continue to invest in technology. I also feel that the strategic bets we made a few years ago are right for our customers in the current environment. Against that backdrop, I feel comfortable raising guidance for the full fiscal year.”

Regarding guidance for F2021, “at the midpoint guide, we expect total billings growth of 19%, up 300 basis points from our prior guidance. Total revenue growth of 20% to 21%, up 300 basis points from our prior guide. Next-Generation Security ARR to be approximately $1.15 billion, up 77% year-over-year.” “Subject to close, this includes a benefit from Expanse of approximately 100 basis points of billings growth, 50 basis points of revenue growth, and $73 million in ARR. We will absorb Expanse’s operating expenses within the framework of our guide.”. The following charts illustrate guidance for F2Q21 and FY2021.

Source: Company Presentation

Details into the Firewall as a platform business

Palo Alto networks, listening to investors’ plea for more information on its legacy firewalls business, offered a breakdown of the network security business as well as the AI & Cloud business. The network security business consists of firewalls, Prisma Access (SASE), CloudGenix (SD-WAN), and attached subscriptions such as WildFire, IoT, DLP, etc. The network security business revenue is expected to grow 14% in FY21, with gross margin growing 50bps Y/Y to 77.3%. The software subscription mix will drive the gross margins. The network security business is transitioning to a ratable revenue model, with the company reporting 71% of revenue in 1Q21 as ratable. The following chart illustrates the key takeaways for the network security business.

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Source: Company presentation

Details into the AI & Cloud business

Palo Alto Networks AI & Cloud business consists of Prisma Cloud, Cortex XDR & XSOAR, Crypsis, and the virtual firewalls VM-series software products. It also includes the recently purchased Expanse product, which is not yet in the model, since the acquisition did not close. The following chart illustrates the products and services within the Cloud & AI segment of Palo Alto Networks.

Source: Company presentation

According to the company, Cloud & AI is one of the fastest-growing ARR businesses in the tech industry. Palo Alto Networks expects the ARR of the Cloud & AI business to grow 89% Y/Y to $735 million, and the revenue to grow 90% Y/Y to $605 million. Palo Alto expects to invest aggressively to grow the business because it believes the TAM is enormous ($100 billion), and it has a first-mover advantage in several segments of this business. The following chart illustrates the key takeaways of the Cloud & AI business.

Source: Company presentation

Details about Expanse Acquisition

Palo Alto Networks announced its intention of acquiring Expanse for about $800 million on November 11th. The deal is expected to close in F2Q21 (the current quarter). Expanse is used to monitor and manage the attack surface and counts several fortune 500 companies and the US military departments as its customers. The average ARR per customer is around $650K, and the acquisition is expected to strengthen the Cortex product offering. Previously the company acquired Demisto to launch its SOAR (Security Orchestration, Automation and Response) platform. The Expanse acquisition will solidify PANW’s SOAR platform and yet again solves a big customer pain point. Interestingly, the company believes its acquisition price on a growth adjusted basis is favorable compared to other acquisitions made by the tech companies.

Source: Company presentation

The following chart illustrates the impact of the acquisition on the business model.

Source: Company presentation

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Continues to invest in emerging growth areas to drive growth

Palo Alto uses its cash on its balance sheet to invest in emerging growth areas such as SOAR, Micro-segmentation, Container Security, SD-WAN, and IoT. Over the last two years, the company spent more than $2.7 billion acquiring companies such as Demisto, CloudGenix, Zingbox, Redlock, Twistlock, etc. In almost each of the new segments, Palo Alto Networks managed to leapfrog the competition in terms of capabilities. The company uses its install base of over 71,000 customers to upsell and cross-sell many of these newer products. The following chart illustrates the acquisitions the company made over the last several quarters.

Source: Company presentation

CEO Nikesh Arora noted that “But if you look at the $2.7 billion of acquisitions we have done since 2019, they contribute approximately 15% of our forecasted FY ’21 billings. Very large enterprise companies have been built by successful M&A strategies. Good M&A strategies need to ensure that the products are easy to integrate; they are products customers want and that we at Palo Alto Networks can significantly change their trajectory. We believe that our ability to acquire, integrate, and leverage our go-to-market for acquisitions is a strategic competitive advantage, and we expect to continue to be opportunistic to increase our long-term growth strategy.”. All the above-mentioned investments are deployed in the cloud and are sold on a subscription basis. The acquisitions are expected to generate more than $750 million in billings during F2021.

What excites us about Palo Alto Networks

Palo Alto’s firewalls are considered the best in the industry, and the company has the leading market share in the industry. PANW has about 71,000 customers, and many enterprises will continue to deploy firewalls on-prem, at least in the near term. However, the growth rate for the firewalls that are deployed on-prem will be lackluster at best. However, the company has unbundled the software from the hardware and will sell the virtual firewalls in the cloud and the on-prem private cloud. These virtual firewalls, along with other pieces of software, will drive the growth for the company. Palo Alto is using its install base to entice its existing customers to buy its cloud services products. We expect this strategy to work, given that much of the competition, such as Checkpoint (CHKP), Cisco (CSCO), and Fortinet (FTNT), has no clear plan of action. New technologies and newer architectures are upending the Security market. Except for Palo Alto Networks, the legacy firewall incumbents are not innovating fast enough to capture newer markets. Hence new players such as Zscaler (ZS), Okta (OKTA), CyberArk (CYBR) are gaining ground at the expense of legacy providers.

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When valuing PANW, we use EV/Sales as the primary valuation metric. Given that many of the companies in the peer group are currently in transition to SaaS/Subscription revenue model or not sufficiently profitable, EV/Sales makes the comparisons meaningful. Also, in a takeout scenario, one of the primary metrics used to evaluate takeout prices remains EV/Sales, as it is easier to compare with historical multiples. PANW is currently trading at 5.4x EV/C2022 sales, well below the peer group average of 9.0x, despite growing inline with the peer group. PANW is forecasted to grow at 18%, versus the security peer group at around 18%. Zscaler ( ZS), one of the PANW chief rivals, is forecasted to grow at 28%, significantly faster than PANW, yet, it is trading at 20.5x. ZScaler’s multiple is 400% higher. Similarly, it competes with CrowdStrike, whose multiple is 400% higher. What is even worse is that Checkpoint (CHKP), which has not innovated in a long time and is growing much slower at 3%, has a higher multiple than PANW. The following chart illustrates the valuation of the security peer group.

Source: Author based on Thomson Reuters data

Risks to owning Palo Alto Networks

Please see our previous write-up on SA with regards to the risks involved with buying Palo Alto Network shares.

Patient investors will be rewarded

Given the shares are undervalued, and the outlook is improving, we recommend investors to accumulate shares opportunistically. As we had written previously, PANW is due for a catchup trade. Given the transition to subscriptions, we expect the multiple to expand, driving the stock higher. We expect the last remaining hold-outs will turn positive on the company and will move the stock higher. Net-net, we believe the investor community is underappreciating the PANW transition story, and we expect the story to get better from here. Patient investors will be rewarded in our view.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.