PANW - Palo Alto Networks: Microsoft Putting The Heat On Cybersecurity Players

2023-07-13 09:25:23 ET

Summary

• The global cybersecurity market is expected to grow at a rate of 14% per year through 2030, increasing from $170 billion to over $420 billion.
• Microsoft is increasingly becoming a major player in the cybersecurity market, putting pressure on smaller, less profitable companies in the sector.
• Palo Alto Networks, Zscaler, CrowdStrike, and Cloudflare are all cybersecurity-focused companies that have shown significant growth, but are facing increasing competition from tech giants like Microsoft.

Article Thesis

Cybersecurity is a vast and fast-growing market that is highly important for the functioning of the global economy. This market opportunity is attracting deep-pocketed players such as Microsoft Corporation ( MSFT ), which, in turn, pressures other cybersecurity players that don't have the established sales networks and channels Microsoft has access to, while smaller, less profitable players in this space also can't invest as much in growth ventures compared to Microsoft with its massive cash flows and immense war chest.

Cybersecurity: A Huge, Important, And Fast-Growing Market

The world is becoming ever more dependent on digital technologies, for entertainment, businesses, and commerce, but digitalization is also increasingly important for governments and administrations. With digitalization becoming ever more important, cyber threats become ever more important as well and pose increasing risks. Not surprisingly, this means that the global cybersecurity market is pretty large, and it continues to grow as more and more things are digitalized or dependent on computing, while more and more cyber threats, from all kinds of actors (criminals, terrorist organizations, intelligence agencies, and so on) emerge.

Forecasts see the global cybersecurity market growing at a rate of 14% per year through 2030, which will make the market explode from a forecasted $170 billion this year to more than $420 billion at the end of the decade. The combination of a strong market growth rate and an already pretty large market size makes the cybersecurity market highly attractive, of course. Not surprisingly, there's a large number of companies that are active in this space, and the number continues to grow every year, as new startups are entering the space while existing tech companies build out their own cybersecurity ventures in order to get a share of this fast-growing market.

Cybersecurity Pureplays

There are some companies that are either entirely cybersecurity-focused or that have significant cybersecurity exposure. This includes Palo Alto Networks, Inc. ( PANW ), Zscaler, Inc. ( ZS ), CrowdStrike Holdings, Inc. ( CRWD ), and Cloudflare, Inc. ( NET ). Looking at their fundamentals, we see the following:

All four companies have shown compelling business growth over the last five years, growing as much as 880% in this time span in the case of CrowdStrike. Even the slowest-growing among these companies, Palo Alto Networks, has easily more than doubled its sales over a five-year time span, which is highly compelling from a fundamental perspective.

At the same time, however, these companies can't be described as established or overly large tech players (yet), as we can see in the following chart showing their sales in absolute terms and their margins:

With more than $6 billion in annual sales, Palo Alto Networks is the largest by far, which also explains why its relative growth rate is the weakest among these companies -- growing at a fast rate becomes harder as a company's absolute size increases. But even Palo Alto Networks is only slightly profitable, operating with an EBITDA margin of just 9% -- tech giants such as Alphabet ( GOOG )( GOOGL ) or Microsoft have EBITDA margins in the 30% to 50% range. And with its rather meager EBITDA margin of 9%, Palo Alto Networks is still way more profitable than the competition, which are generating no profits at all.

These pureplays are thus somewhat typical growth investments with fast business growth but with no profitability. During the peak of the pandemic, when money was very cheap, the market loved these types of companies. But as interest rates rose and money became more expensive, the market has become less interested in these companies over time:

While PANW stock has held up very well, the others are trading 50% to 70% below their COVID highs, which resulted in massive share price losses for shareholders. It is, I believe, not a surprise to see the most profitable of these companies -- PANW -- suffer the least from the end of the "cheap money" times, while the faster-growing but less profitable competitors suffered a lot from the end of the growth stock hype during the pandemic.

Microsoft As An Increasingly Influential Player

As noted above, the cybersecurity market is highly attractive. Microsoft, which is not operating with a cybersecurity focus, is interested in becoming a more important player in this space, it seems. This, in turn, is pressuring the shares of the pureplays shown above. After all, competing with a company like Microsoft is not an easy task: Microsoft has existing sales channels across the globe, Microsoft is a trusted big player that has established business connections with a vast amount of businesses and corporations, and Microsoft has the resources to invest heavily for growth if it wishes to do so, e.g. by adding engineers or by growing via tuck-in acquisitions. Microsoft's war chest of several dozen billion dollars allows the company to become a major force in all markets it seeks to enter, while competitors that don't have similarly deep pockets can't invest at a similar scale.

Microsoft has recently been adding new features to its cybersecurity portfolio, such as a new Secure Service Edge offering . Cybersecurity pureplays reacted negatively to this development during the middle of this week, as we can see in the following chart:

Palo Alto Networks, Zscaler, CrowdStrike, and Cloudflare all dropped by 5% to 9% on Wednesday, while the board market performed way better. This is, I believe, not a random occurrence, but rather the result of investor worries when it comes to increasing competition from Microsoft in the enterprise cybersecurity market. While the cybersecurity pureplays aren't as expensive as they used to be, they are still expensive. This, in turn, means that a lot of growth is baked into their share prices today -- when competition is growing and they are under threat of losing market share, the growth outlook could come under pressure. For a company that is priced for rapid growth, this naturally is a bad development, which explains the significant selling pressure that these stocks have experienced.

Which Is The Best Cybersecurity Investment?

The cybersecurity market is growing quickly, but that alone does not mean that the sector is a buy. After all, it is not guaranteed which players will ultimately win out, and valuations have to be considered as well. There are many cases where equity returns have been unattractive when investors bought shares of companies that are active in growth markets but that traded at a too-high valuation at the time of the investment -- think of Cisco ( CSCO ) during the dotcom bubble, for example.

Palo Alto Networks, Zscaler, CrowdStrike, and Cloudflare all look expensive at first sight, trading for 54x (Palo Alto Networks) to 190x (Cloudflare) this year's expected net profits. And those numbers are using the non-GAAP earnings per share estimates for the current year -- on a GAAP basis, they are even more expensive.

Palo Alto Networks, while still expensive in absolute terms, is the least expensive among these four. At the same time, it is the largest in terms of revenue generation, giving it size and scale advantages versus the competition. PANW is also the only profitable company on an EBITDA basis, and it is showing the least amount of dilution compared to its peers:

All four companies have experienced a substantial share count increase, but it has been least pronounced at Palo Alto Networks, meaning a larger portion of its business growth has turned into per-share growth. There is no guarantee that this will hold true in the future, too, of course. But still, if I had to choose one of these four for investment, Palo Alto Networks would be my favorite. The company's recent quarterly results were pretty strong with a 24% revenue growth rate, and PANW has an excellent track record when it comes to outperforming expectations: The company has beaten estimates on both lines for a highly impressive 13 quarters in a row. Earnings revisions look excellent , with PANW receiving 39 EPS upward revisions over the last three months, with zero downward revisions over the same time frame -- Seeking Alpha's Quant algorithm gives PANW an A- grade for that. Likewise, PANW also receives A/A- grades for profitability, momentum, and growth -- although the valuation grade is far from great, at D- .

Of course, investors that want more broad-based exposure to the cybersecurity industry can also opt for industry ETFs such as the ETFMG Prime Cyber Security ETF ( HACK ) or the First Trust NASDAQ Cybersecurity ETF ( CIBR ). With $1.5 billion and $5.0 billion of assets under management, these are major ETFs, and their expense ratios of 0.6% (in both cases) are not overly high. Investors that buy these ETFs should consider, however, that this means that they will purchase stakes in highly expensive and/or unprofitable businesses, which adds risks. Buying or owning shares of a company like Microsoft is another option, of course, although this is not a cybersecurity pure-play. Due to the AI hype that Microsoft has experienced so far this year, its shares have become rather pricey as well, however -- waiting for a better buying opportunity could pay off, although MSFT still is a lot cheaper compared to the cybersecurity pureplays shown above, as its shares are valued at 35x net profits.

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