Oracle's a Buy, Dump Palo Alto, Fortinet, Says Credit Suisse

Credit Suisse's Brad Zelnick today rejects the conventional wisdom of buying cloud computing stocks, instead arguing the key to software makers is something "more abstract," namely, the difference between "aggregation" and "disaggregation" of adjacent markets.

In that vein, Zelnick votes Oracle (ORCL) one of the best software buys, along with VMware (VMW), ServiceNow (NOW), and Hortonworks (HDP), all of whose shares he assigns Outperform ratings.

By contrast, Zelnick thinks there is under-appreciated risk in shares of security vendors Palo Alto Networks (PANW) and Fortinet (FTNT), and he assigns them Underperform ratings.

"We consider the world more abstractly than simply cloud vs. non-cloud," writes Zelnick, "and look for investment opportunities through our aggregation framework."

Simply stated, aggregation occurs when a market participant can parlay its strength in a given market into capturing adjacent market opportunities; disaggregation represents the inverse phenomenon. We consider several examples herein and highlight ORCL as our favorite aggregation pick, while Underperform-rated FTNT and PANW are disaggregation ideas we argue investors should avoid.

Zelnick points out that things like cloud are "paradigm shifts" that have happened many times over the decades, and so this one might just switch back to de-centralized computing again:

As for paradigm shifts, we suggest investors remain calm and evaluate fundamentals with an open mind. If one believes the next major paradigm shift is a return to decentralized computing, from Cloud to Edge computing, then perhaps many seemingly legacy on-premise technology companies aren't so irrelevant. Perhaps inside its nearly 500 Whole Foods locations, Amazon will deploy edge data centers for increased proximity to AWS customers. We believe history generally repeats itself and we therefore approach our universe with that perspective in mind.

At the same time, Zelnick notes that in stock picking, "As always, it comes down to valuation," and he assigns Neutral ratings to Check Point Software Technology (CHKP), Akamai Technologies (AKAM), Red Hat (RHT), and CA (CA).

It helps to remember Billy Joel, he writes:

And to the famous Billy Joel lyric, "darling I don't know why I go to extremes," things are rarely as good or bad as they might seem. This is why valuation is critical to our stock selection. Even for secularly challenged companies, there might very well be a price at which investment makes sense, and likewise, for the cleanest of growth stories, a price where it does not. We employ an academic approach to DCF analysis to drive our target prices.

Regarding Oracle, to which he assigns a $60 price target, Zelnick advises investors to bear in mind the genius of founder and CTO Larry Ellison, and also Oracle's history of consolidating the industry:

While the success of any company rarely comes down to any one thing, one decision, or even one person, we attribute much of Oracle's durability to the tenacious winning spirit, vision, and ingenuity of founder Larry Ellison. Along with every enterprise technology hype cycle over its 40-year history, pundits have prognosticated Oracle's demise, only to be proven wrong. Oracle has consistently defied the conventional wisdom dictating that technology companies have their term limits. Common to Oracle's strategy over time has been a drive to maximize share of customer wallet. We believe the cloud is no different in this regard when compared with prior success in consolidating the industry years ago through M&A as well as engineered systems and core database innovation. In our analysis, there is a margin of safety whereby the company can lose some lower end unit share in its respective markets and still drive significant dollar share gains through aggregation.

He notes his target price is 20 times calendar 2018 expected earnings, "vs. 21.9x for MSFT and SAP at 19.2x."

Regarding Palo Alto, "despite being one of the most disruptive innovators in the security industry, we believe investors are overly optimistic in Palo Alto Networks' ability to sustain over 2x market growth rates," writes Zelnick. "We truly believe this is a great company with great management, but not a great stock at current level."

The stock is expensive, he writes, when considering stock-based compensation: "While seemingly inexpensive on FCF multiples, adjusting for stock comp expense and long- term deferred revenues tells a completely different story. If we instead consider simple P/E (CY2018), PANW trades at ~40x vs. CHKP at ~20x and FTNT at ~35x."

Oracle shares today are up 36 cents, or 0.7%, at $50.98, while Palo Alto is up 33 cents at $147, and Fortinet is down 35 cents, or 0.8%, at $37.95.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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