In this Weekly Insights we provide thoughts on Palo Alto Networks' earnings and the outlook for cybersecurity, software valuations, and the macro backdrop. 

CONTENTS

Cybersecurity earnings    

• Palo Alto Networks provides a glimpse into cybersecurity earnings season

• Trough multiples on accelerating earnings makes cybersecurity our top investment theme

Macro Backdrop  

• Software on sale - buy the dip?

• Interest rates, inflation, and Jackson Hole Meeting expectations 

CYBERSECURITY EARNINGS 

Palo Alto Networks: impressive growth at scale 

Palo Alto Networks (PANW), a leading cybersecurity platform, reported earnings yesterday after the close. Expectations were not very high going into the report, with tough comps, macro concerns, and extended sales cycles highlighted by several analysts. The company, however, was able to deliver outstanding results consistent with history, despite the tough macro backdrop. Particularly impressive was the billings growth of 44% and the F23 Revenue guidance of 25%. Highlights: 

• F4Q22 revenue growth of 27% with billings growth of 44% (on a tough comp of +34.4% in F4Q21). NGS ARR +60% (~$1.89bn) 
• F23 Guidance for 25% revenue growth ($6.85-6.9bn) with NGS ARR 37-40% and FCF margin 33.5-34.5% (vs. 33.3% in F22)

On the , the company noted that F4Q22 had several large deals that were pulled forward, but there is a level of conservatism built into the guidance. Nevertheless, these results are very impressive especially as Palo Alto is able to deliver 2x the pace of the addressable market growth despite the increasingly large revenue base.

We continue to be impressed with Palo Alto NGS (Next Gen Security) portfolio. The company successfully pivoted from on-prem network firewalls to comprehensive cloud security portfolio that includes NGS solutions (Prisma SASE, Prisma Cloud and Cortex).  NGS offerings now make up 38% of total billings and we believe will be the primary growth driver going forward. For more detail visit our Cybersecurity Primer- Case Study #3.

Despite top-line growth acceleration, Palo Alto's valuation has pulled back meaningfully from the high end of the range (>10x EV/NTM revenues) to below 8x, in-line with the broader interest rate driven sell-off in software stocks (see next section). We continue to believe that within the spectrum of enterprise spend, cybersecurity budgets will be the last area to be cut. The favorable market dynamics, combined with through multiples, make cybersecurity our top investment theme.

For the rest of our cybersecurity coverage universe, one key point to watch is that both Cloudflare (NET) and Palo Alto Networks (PANW) highlighted the value of a platform offering and commensurate cross selling opportunities. It will be interesting to see how will some of the more narrowly focused peers such as Crowdstrike (CRWD), Sentinel One (S), Zscaler (ZS) perform in this backdrop.

MACRO BACKDROP 

Software on sale - buy the dip?

Software valuations are now trading meaningfully below the 5Y trailing average of 10x and max of 17.4x NTM Revenues. While there is some macro driven risk to earnings, there are many subsectors such as cybersecurity, cloud infrastructure, where earnings are still accelerating, providing a unique investment opportunity. 

In our opinion, the set up for software stocks in 2H22 is significantly better than 1H22. We believe that it is now evident that the Fed does not have the ability to raise interest rates significantly above 3%, without causing a deep recession. Consequently, for modeling purposes, using 10Y 3-3.5% is a solid base case assumption, and we can now go back to trading on company fundamentals.

The most significant challenge facing investors is to distinguish between companies with business model challenges and companies experiencing stock price declines due to interest rate concerns or tough comps. Below are some guidelines:

• Beware of value traps. EV/Revenue is a good starting point, but it is not a good way to value software companies due to very wide range of growth and profitability profiles. A company trading at 7x EV/Revenue is not always cheaper than a company trading at 20x. Assessing the durability of growth is key. 
• Balance sheet strength and profitability are paramount. Software companies are asset light and are well positioned to weather economic down-cycles. But it is important to avoid the ones that are not appropriately capitalized and need to raise equity at depressed valuations. Cash burn and cash on the balance sheet are key metrics to look at.
• Survival of the fittest. While generally new entrants with good products can grow faster, downturns favor established leaders (e.g. Zoom (ZM) vs. Microsoft (MSFT), Tesla (TSLA) vs. Lucid (LCID)). Capital availability generally tightens and talent shifts back to the lower risk opportunities. It is important to find the balance between innovation, and already established business models and market position.  

From Palo Alto F4Q22 conf. call: ...the company is noting "return by employees who had left for seemingly greener pastures. Over 70% of former employees 

expressed a desire to come back; 50% are returning from start-ups and the next largest percentage coming from peer companies."  

In summary, downturns are a time to add risk, and invest in companies whose share prices have meaningfully pulled back. But it is important to pick the companies that are able to play offence, gain market share, and can come out stronger from the downturn.  

The Fed and interest rates

The highly anticipated Jackson Hole meeting will take place on Friday, where the Federal Reserve Chair, Jerome Powell will speak about the economic outlook and the Fed's willingness to increase rates. 

We expect to hear more of the same e.g. fighting inflation is a priority etc. etc. But now that the Fed has more data on the economy's reaction to increasing rates (e.g. slowing housing market, consumer discretionary spending etc), we believe that the positioning has shifted more towards avoiding a deep recession rather than a very aggressive inflation fight.  

For the market, if a deep recession is not the base case scenario, many opportunities look attractive especially with the steep valuation pull backs discussed in the prior section. While we dont think investors should be chasing rallies, as inflation remains a key risk (see our prior Weekly Insights), we are aggressive buyers of dips.  

For more research visit out website spear-invest.com.

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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