PALO ALTO NETWORKS (PANW)

Summary

Palo Alto Networks is a cybersecurity firm that is known for

selling security appliances, subscriptions, and support

into enterprises, government entities, and service providers.

The company's product portfolio includes firewall appliances,

virtual firewalls, endpoint protection, cloud security,

and cybersecurity analytics. The Santa Clara, California,

firm was established in 2005 and sells its products worldwide.1

Investment Thesis

We are recommending that investors sell Palo Alto Networks,

Inc. due to the following reasons:

• Current stock price is heavily reliant on Palo Alto

shifting to offer a broader suite of Cloud-Based

Subscription and Support offerings; a tactic

the company is still evaluating

• Post-merger integration has posed challenges for

Palo Alto’s leadership, which down the line can

dilute the gains sought by the acquisition

• Discounted Cash Flow Analysis suggests Palo Alto’s

stock price to be overvalued when looking at a ten

year forecast horizon

Risks

Risks to investing in Palo Alto Networks, Inc. include:

• Future demand trends for pure-play

cybersecurity solutions

• M&A activity within the cybersecurity

industry, shifting the competitive layout

• Change in demand due to COVID-19, leading

customers to rethink spending priorities

BUSFIN 7225: Student Investment Management

Fund Manager: Royce West

Research Analyst: Meghdeep Mukherjee

July 15th, 2020

Revenue (2019, M) $2,900

Earnings (2019, M) ($82)

EPS (2019) ($0.87)

P/E (06/29/2020) 32.33

Beta (5Y Monthly) 1.2

Key Statistics

Meghdeep Mukherjee

mukherjee.150@osu.edu

Contact Information

Ticker PANW

Sector Technology

Industry Software - Infrastructure

Price as of 7/14/2020 $245.33

Market Cap 23.66B

Shares Outstanding (M) 98

Company Information

Stock Rating Sell

Price Target $188.52

Implied Upside -23.16%

Dividend Yield -

Recommendation

52 Week High $255.84

52 Week Low $125.47

1 - Year Return 22.27%

Performance History

PALO ALTO NETWORKS 2

Company Overview………………………………………………………………………………………………………………………………..3

Business Segments…………………………………………………………………………………………………………………….3

Products……………………………………………………………………………………………………………………….4

Subscription & Support.……………………………………………………………………………………………....5

Market Landscape…………………………………………………………………………………………………………………….…………..5

Sector Landscape……………………………………………………………………………………………………….……..........5

Competitive Strategy and Market Factors………………………………………………………………………..……….6

Strategy Shift.…………………………………………………………………………………………………………………….……..6

Recent Stock News ……………………………………………………………………………………………………….……………….……..7

Investment Thesis.…………………………………………………………………………………………………………………………………8

Fundamental Drivers.…………………………………………………………………………………………………….………….8

Economic and Sector Conditions.…………………………………………………………………………………….………..9

Financial Forecasts……………………………………………………………………………………………………………..…..10

Valuation and Price Target.………………………………………………………………………………………………………………….11

Risks.……………………………………………………………………………………………………………………………………………………12

Industry Risks.…………………………………………………………………………………………………………………………12

Company-Specific Risks.………………………………………………………………………………………………………….13

Conclusion.………………………………………………………………………………………………………………………………………….13

Appendices.…………………………………………………………………………………………………………………………………………14

Appendix I: Palo Alto Networks, Inc. Product Mix Forecast……………………………………………………..14

Appendix II: Palo Alto Networks, Inc. Income Statement…………………………………………………………15

Appendix III: Discounted Cash Flow Model………………………………………………………………………………16

Appendix IV: Discounted Cash Flow Model Sensitivity…………………………………………………………….17

References…………………………………………………………………………………………………………………………………………..18

PALO ALTO NETWORKS 3

Company Overview

Palo Alto Networks, Inc. is a cybersecurity vendor that sells security appliances, subscriptions, and

support into enterprises, government entities, and service providers. 1 By definition, Palo Alto would be

classified as cyclical company. Having a Beta is 1.2 skews them towards the more volatile side; with

performance trends following the overall economy. Although, most of their product offerings would

not fit into the “discretionary” category, some services and products offered by Palo Alto would follow

macroeconomic changes. More times than not, customers would consider several of their products to

be non-essential in times of financial distress.

Established in 2005, Palo Alto Networks is headquartered in Salta Clara, California. Supporting their

worldwide customer base is a team of 8,049 employees. Palo Alto breaks down their business into the

following geographic territories: Americas, EMEA (Europe, Middle East, and Africa), and APAC (Asia-

Pacific). Being a relatively new company, Palo Alto Networks has established itself as a dominant player

in the Software – Infrastructure industry within the Information Technology sector.2

Business Segments

Palo Alto separates their business into 2 main sections: Product and Subscription. Product Revenue is

derived primarily from sales of appliances (including software licenses). Revenue is recognized at the

time of hardware shipment or delivery of software license.2 Subscription and Support Revenue is

derived from sales of subscription and support offerings. These contracts last anywhere from 1-5 years.

Revenue is recognized over time as the services are performed. 2 As a percentage of total revenue, Palo

Alto expects this line to vary from quarter to quarter and increase over the long term as new

subscriptions are introduced, existing subscriptions are renewed, and their installed end-customer base

expands.2 For the 2019 fiscal year, Subscription and Support ($1,803MM) made up 62% of the business

with Products ($1,096MM) at 38% respectively. The dominance of the Subscription product line is

expected as these offerings are more customizable and typically offer a wide suite of options.

Source: Palo Alto Networks 2019 10-K Data; Excel created

PALO ALTO NETWORKS 4

Product

Although Palo Alto aggregates their offerings into 2 segments when reporting financials, their business

can be broken down into the following product categories:

Secure the Enterprise (Strata) The main product offering in this category is Palo Alto’s famous Firewall; known for its dominance in preventing attacks with industry-leading intelligent network security.3 With Innovation and customer need in mind, Palo Alto designed their award-winning security featuring the world’s first ML-Powered (Machine Learning) NGFW (Next Generation Firewall).3 Over 85% of the fortune 100 rely on Palo Alto Networks, whose firewalls have been reinventing the industry for nearly 15 years.3

Complementing this product is a suite of security management and subscription offerings that deliver customers a simplified and highly effective network-wide security experience.3 Secure the Cloud (Prisma)

With Cloud utilization being a focal point for many companies, Palo Alto was able to cultivate a product line for this market. Prisma Cloud, the trademarked name for this segment delivers complete security across the development lifecycle of any cloud, enabling customers to develop native applications with confidence and trust.3 Most commonly used to support AWS (Amazon Web Services) and Microsoft Azure applications, Prisma’s comprehensive cloud security serves to provide customers full transparency, vulnerability risk monitoring, and advanced protection that other cloud offerings lack. Secure the Future (Cortex) Data mining and predictive modeling is the present and future for corporations that desire to use advanced analytics to accompany their decision-making process. Similarly, Palo Alto’s Cortex products offer the industry’s most comprehensive suite for security operations; empowering enterprises with the best-in-class detection, investigation, automation, and response capabilities without the need of human interference.3 With 50x reduction in alert volume, 8x faster investigations, and 95% automated response Cortex is a superior product that checks many boxes for a large customer base.

Source: https://www.paloaltonetworks.com/

PALO ALTO NETWORKS 5

Subscription and Support

All products produced by Palo Alto Networks offers (see page 4) an accompanying support package.

From Threat Prevention Subscriptions to DNS (Domain Name System) Security Subscriptions and

everything in between, all these ancillary add-ons can be bought on a per-user, per-endpoint, or

capacity-based basis as deemed fit by the consumer.2 If customers experience product malfunctions,

Palo Alto expedites replacement parts for any defective hardware with the use of a third-party logistics

provider that manages their worldwide deployment.2

Customer support is also a critical part of Palo Alto Networks’ value proposition. Their authorized

Support Center (“ASC”) deliver level-one and level-two support, while level-three support is available

24 hours a day, seven days a week through regional support centers that are located worldwide.2

Additionally, Palo Alto offers annual subscription-based Service Account Management (“SAM”) which

provides support for customers with custom tailored products.2 This service includes both hardware

and software maintenance which can be purchased for a one-year or longer term at the time of sale

and typically renew for successive one-year or longer periods.2

Market Landscape

Sector Landscape

The COVID-19 pandemic has had tremendous the impact on the stock market. Year-to-date the S&P

500 is down -0.23%.4 Concurrently, over the same time period, the Information Technology sector is up

+18.01%.5 Taking the state of the pandemic and the overall health of the economy into consideration,

the current perspective is that the market is in a recession. However, if this sentiment holds true, the

Information Technology sector is not performing in line with expectations of the current stage in the

business cycle. Historically, the Information Technology sector has consistently underperformed in the

late and recession stages with positive returns occurring in the early and middle stages on the business

cycle.6 Today’s environment not a reflection of history as the Information Technology sector has been

the primary catalyst in driving market returns.

Source: https://eresearch.fidelity.com/eresearch/markets_sectors/sectors/sectors_in_market.jhtml?tab=learn&sector=45

PALO ALTO NETWORKS 6

Competitive Strategy and Market Factors

Palo Alto Networks has been able to assert its dominance in the Security Appliance market, coming in

second terms of market share (13.4%, Q4 2019), only behind CISCO (15.8%, Q4, 2019).7 This sustained

competitive advantage has been achieved through their ability to engineer a superior firewall product

with industry leading performance and machine learning components that can proactively identify

threats and provide end-customers corrective measures to prevent data theft. Additionally, Palo Alto’s

robust product support offering has helped elevate their brand and has kept consumer satisfaction high

over the years. The company is well positioned to continue their growth as the trends being utilized in

this industry is already embedded in Palo Alto’s existing product line.

Source: https://www.statista.com/statistics/235347/global-security-appliance-revenue-market-share-by-vendors/

With the firewall market projected to growth on average of 12% per year through 2023, success in this

space will be determined not on physical hardware firewalls, but more so on software-defined

firewalls.8 Given the impact COVID has had on companies, the investment in data security is a priority

for all parties that have shifted to a work-from-home dynamic. Companies are investing more in data

security upfront to avoid breach litigations in the future. This shift in work environment has forced

cybersecurity firms like Palo Alto to have a greater presence in the cloud space. Since more end-

customers are deploying their systems to the public and hybrid clouds, increased spending in Network

security and the firewall market will follow.8

Strategy Shift

Palo Alto Networks has recognized that future success is dependent of their ability to bolster the Cloud

product offering. To achieve this goal, Palo Alto completed the acquisition of CloudGenix back in April

of this year.9 As the industry continues to undergo network and security transformations, this move will

allow Palo Alto to integrate CloudGenix’s platform into their best-in-class SASE (Security Access Service

Edge) offering.9 Specifically, with ClouldGenix’s cloud-managed SD-WAN (Software-defined Wide Area

Network) solutions, Palo Alto can expedite the onboarding of remote branches and retail stores into

their existing Prisma product line; allowing for a more seamless and efficient transfer from SD-WAN to

SASE for their existing customer base. 9 Although post-merger integration has been a challenge for Palo

Alto in the past, this acquisition, if handled correctly, will make Palo Alto Networks a formidable force

for quite a long time.

PALO ALTO NETWORKS 7

Recent Stock News

The illustration below from Palo Alto Network’s 2019 annual report depicts the five-year return of Palo

Alto compared to the NYSE Composite Index and the NYSE Area Tech 100 Index. Palo Alto has

outperformed both indices over this time period as their consistent top-line growth has fueled investor

confidence. The 2018 and 2019 calendar year was favorable to Palo Alto due to the optimism that

surrounded the overall economy; driving much of the stock market returns.

Source: 2019 Palo Alto Networks Annual Report

On May 21, 2020 Palo Alto Networks released their fiscal third quarter results. Quarter three revenue

grew twenty percent year-over-year ($869.4MM versus 726.6MM).10 Billings (revenue plus the change

in deferred revenue12) increased twenty-four percent ($1B) year-over-year, along with deferred

revenue, which grew twenty-eight percent ($3.4B) year-over-year.10 Net losses for the third quarter

2020 was 74.8MM, which amounts to be $0.77 per diluted share as compared to a net loss of $20.2MM

or $0.21 per diluted share for the third quarter of 2019.10 Surpassing quarter estimates can be

attributed to remote working models that are being carried out by companies to promote social

distancing measures and stop the spread of the coronavirus. Palo Alto Networks CEO Nikesh Arora

states: “The world will likely be in a state of transition over the next 12 to 18 months due to COVID-19

pandemic”.11 He goes on to state how this environment will prompt key trends to accelerate, including

a rapid shift to the cloud and focus around AI/ML and automation to drive cybersecurity outcomes.11

For fiscal fourth quarter, Palo Alto Networks upped their guidance. The company is projecting a non-

GAAP earnings between $1.37 to $1.40 with revenue expectations falling anywhere between $915 and

$925 million.10 If these projections are accurate, Palo Alto would surpass expectations as analysts are

looking for a non-GAAP earnings of $1.31 with a revenue of $916.8 million.11 For the fiscal year 2020,

Palo Alto Networks is projecting revenue estimates to be between $3.37 billion and $3.38 billion with a

non-GAAP earnings per share coming in somewhere between $4.78 and $4.81.10

PALO ALTO NETWORKS 8

Investment Thesis

Fundamental Drivers

There are three main drivers that will determine Palo Alto Network’s outlook moving forward, few of

which are all speculations at this point. First, sixty-two percent of Palo Alto’s 2019 revenue was driven

by their Subscription Product line. A large part of their future performance is contingent on the

continued success of this product offering. Second, with market conditions and demand constantly

changing, Palo Alto’s Next Generation Firewall performance and specifications will have to meet the

requirements of their broad customer base. Lastly, with COVID-19 pandemic still plaguing the

economy, the demand for Cloud-Based Services will drive much of Palo Alto’s future performance as

more and more companies will make a push to have robust network security measures to keep

confidential data safe. The current outlook for Palo Alto Networks looks uncertain, and should be

reflected in the stock price. Conversely, investors are betting that Palo Alto’s strong top-line growth will

be enough to sustain their momentum, which is artificially inflating the current stock price.

Subscription Product Line

Over the last four years, Palo Alto’s Subscription and Support product line has made up roughly fifty-six

percent of revenue. Given how COVID-19 has impacted the economy, the demand for cybersecurity

protection will continue to stay top of mind for the next couple of months/years. As enterprises look

bolster up their remote security measures to accommodate the shelter-in-place guidelines, Palo Alto

Networks has a prime opportunity to capitalize on these market conditions. Furthermore, as these

subscriptions generally last anywhere from one to five years, a steady cash flows stream can be

expected from this product line. On the contrary, given the intense level of competition in this sector,

Palo Alto will have to effectively find ways to promote their Subscriptions over their competitors as the

companies producing similar products will try and capture market share. The Subscription and Support

line has provided great returns in the past for Palo Alto, and given their current product offering,

revenue growth for this line does not seem to be slowing down anytime soon.

Next Generation Firewall

Over the years, Palo Alto Networks has found ways to stay ahead of the curve from an innovation

standpoint. Most recently, they released the world’s first ML-Powered (Machine Learning) NGFW

(Next Generation Firewall).3 As product differentiation is key in this sector, Palo Alto Networks thus far

has been able to strike a good balance between innovation and performance. However, even with the

utilization of cutting-edge technology, Firewall sales make up only forty-four percent of their total

revenue. The future growth of this product line will be largely dependent of how well the overall

economy does. As entities find ways to combat COVID-19, the need or desire to upgrade existing

firewall systems may not be a priority for most companies. This effect can already be seen when

looking at the year-over-year product growth. For fiscal quarter three, compared to the previous year,

Product revenue was up one percent while Subscription and Support grew more than thirty-one

percent.12 Even with Research and Development in the heart of their decision making process, Palo Alto

Networks will have its fair share of challenges maintaining historical growth rates for the Product

business segment given the toll COVID-19 has taken on the global economy.

PALO ALTO NETWORKS 9

Demand for Cloud-Based Services

Palo Alto Networks is relatively new in the Cloud Service space, but like their competition they have

realized the tremendous upside this market possesses. This is a space where Palo Alto has invested

significant amount of capital via the acquisition (CloudGenix) channel in hopes to be a prominent player

for the imminent future. As threat-prevention is a key focus for many companies today, Palo Alto has

high growth potential with room for improved margins in this niche segment.12 As companies deal with

more data traffic coming from various entry points (remote work locations), the need for consolidated

security management is on the rise.12 This plays well into one of Palo Alto Network’s core competency;

centralized security management.12 One factor that is key to the growth of this segment is post-merger

integration. How well Palo Alto Networks can utilize the synergies from CloudGenix, will come down to

their ability to synchronize the operations of both entities. Overall, this product line has the

opportunity for sustained growth, but will largely be dependent of the success of their current and

future acquisitions in this division.

Economic and Sector Conditions

The Information Technology sector has been able to sustain positive returns throughout the COVID-19

pandemic. However, there may be a sense of overvaluation in the sector. Typically, during the last 2

phases of the business cycle (Late and Recession), where the economy moderates or contracts, Info

Tech underperforms. Nevertheless, this year, the Information Technology sector is seeing valuations

being close to an all-time high compared to the S&P 500. The current P/E multiple for Info Tech is

37.4813 versus 27.9514 for the S&P 500. The concern arises when the current Information Technology

P/E multiple is compared to the median for the sector (37.48 and 18.9 respectively). The large delta

between the two figures raises the flag for a potential correction. This leaves the short-term outlook for

the sector to be somewhat unclear as markets try navigate through the COVID-19 pandemic.

A positive for the Information Technology sector has been the shelter-in-place order. As companies

switch to working remote, industries such as data security, cloud initiatives, and virtual meeting

applications to name a few have seen a spike in cash infusion. The current secular trends are in favor of

the Information Technology sector, and the long term future outlook seems to be on pace to break

historical expectations.

Sector Valuation Absolute Basis High Low Median Current

P/E 28.8 12.5 18.9 26.4

P/B 8.1 2.8 4.5 8.1

P/S 5.3 1.9 3.2 5.2

P/EBITDA 18.3 7.9 12.1 16.9

Source: Assignment 2 SIM Class, Summer 2020 (Data as of May, 2020)

PALO ALTO NETWORKS 10

Financial Forecasts

Over the last 12 months, Palo Alto Networks has seen roughly a twenty-two percent increase in its

stock price. Comparing their performance to the Information Technology sector and the S&P 500

(36.72% and 8.84% respectively), Palo Alto outperformed the S&P 500 as whole, but lagged well behind

the Information Technology sector during this period. Much of their 2020 performance can be

attributed to the state of the pandemic, as investors favored Info Tech to carry the market through the

first half of the year. Shelter-in-place orders further drove up Palo Alto’s price as investors grew

optimistic around companies that played in the data security space. Fiscal quarter three revenue grew

twenty percent year-over-year, with the quarter four estimates forecasted to beat analyst expectations

($1.41 EPS versus expectation of $1.31 EPS).

Source: Yahoo Finance: historical monthly data pull

Although Palo Alto Networks has experienced modest gains this year, their performance has been

average compared to the competition. Palo Alto Networks’ returns have been similar to companies like

CISCO and Norton LifeLock. However, when looking Net Income, Palo Alto Networks rank the lowest

amongst their competitors. Taking Palo Alto’s performance relative to its peers, it’s clear that their

stock price is based more on speculation versus actual results.

Source: Thompson One, PANW Comps

Name Ticker

Total

Return 1 Yr

Sales

TTM

Net Income

TTM

EPS

TTM

P/E

TTM

PALO ALTO NETWORKS, INC. PANW-US (21.03%) 3,263.80 (228.90) (2.36) NEG

FORTINET, INC. FTNT-O 20.48% 2,260.50 371.70 2.11 62.03

NORTONLIFELOCK INC. NLOK-O (18.70%) 2,490.00 3,887.00 6.05 3.33

CISCO SYSTEMS, INC. CSCO-O (21.39%) 50,575.00 10,784.00 2.72 16.89

CYBERARK SOFTWARE LTD. CYBR-O (28.13%) 444.79 51.77 1.33 78.84

PALO ALTO NETWORKS 11

Our projected income statement for Palo Alto Networks is shown in Appendix II. Our future outlook is

based on the Subscription and Support segment driving majority of the sales volume with margins

coming in slightly higher than the Product segment.

We expect Product revenues to decline 3% for 2020, grow 10% and 14% respectively for 2021 and

2022. In the Subscription and Support segment, we are forecasting a 28% growth for 2020, 20% growth

for 2021, and a 21% percent growth for 2022. The expectation around gross margin for both of these

segments are moderately conservative with Product gross margin improving to 75% from 71%, and

Subscription and Support gross margin climbing to 77% from 73%. However, even with strong growth

and improved gross margins, our belief is that operating margins will be in the -1% to -3% range over

the next three years.

Valuation and Price Target

Starting with the Discounted Cash Flow Model (DCF), we utilized the Income Statement found in

Appendix II to bake in the effects of Subscription and Support revenues outpacing Product revenues for

the foreseeable future. Taking into account the current state of the pandemic, we are projecting that

2022 will be the first year Palo Alto Networks can capitalize on their investment in Cloud-based

subscriptions to drive more recurring revenue, with the assumption that longer contract terms will be

reached with end-customers. Based on these factors, we expect 2022 and 2023 revenue growth to

reach 18%, followed by a marginal drop in growth rate between 2024 to 2028, and the final terminal

growth rate of 6% being achieved by 2029. Additionally, we assumed operating income will increase to

7% by 2021 and level off for the years that follow. Taking all these factors into account, and using a

10.25% discount rate, the DCF Model projects Palo Alto Network’s equity value to be $17.2 billion.

Using a basis of 98 million shares outstanding, the implied equity value/share of Palo Alto is currently

$175.52. Comparing this to their current share price of $245.33, the DCF Model suggests an

overvaluation of the current stock price by 28.5%.

Another method explored to gauge Palo Alto’s valuation was the Comparisons Model (COMPS). We

stacked up Palo Alto with its closest 4 competitors: Fortinet (FTNT-O), Norton LifeLock (NLOK-O), CISCO

Systems (CSCO-O), and Cyberark Software (CYBR-O). Comparing these 5 companies, it is evident that

Palo Alto is under the average for both P/E, P/S, and P/B, but significantly over average on EV/EBITDA.

Source: Thompson One, PANW Comps

Applying these ratios to Palo Alto, the range of share prices that can be derived falls anywhere from

$147.50 (based on a target EV/EBITDA multiple of 43.23) to $281.25 (based on a P/B target multiple of

Name Ticker P/E P/S P/B EV/EBITDA

PALO ALTO NETWORKS, INC. PANW-US NEG 7.12 25.46 71.90

FORTINET, INC. FTNT-O 62.03 9.38 30.67 43.40

NORTONLIFELOCK INC. NLOK-O 3.33 4.77 1,077.15 13.45

CISCO SYSTEMS, INC. CSCO-O 16.89 3.83 5.03 10.75

CYBERARK SOFTWARE LTD. CYBR-O 78.84 9.10 5.03 49.11

Average 40.27 6.84 228.67 37.72

PALO ALTO NETWORKS 12

30.1). To get a better pulse on Palo Alto’s valuation, we combined the DCF Model with the market

multiples to create a weighted model. Here, the DCF was assigned a 70% weighting, both the P/E and

EV/EBITDA were assigned a 10%, and the remaining 10% was split evenly between P/S and P/B. Using

the combination of the DCF Model and the Weighted price multiples, we priced Palo Alto Network’s

stock at $188.52. The valuation metrics, price targets, and weightings are outlined in the table below.

Risks

Industry Risks

The COVID-19 pandemic is the biggest risk that every industry and company is dealing with right now.

With new cases per day still climbing to record highs, the future outlook for not only the Information

Technology sector but the economy as a whole is uncertain. Even with the two trillion-dollar aid

package put out by the government15, the list of companies going bankrupt keeps on getting longer.

The volatility that can been seen in the market is an accurate representation of how uncertain investors

are on the future outlook of the economy. Although the Information Technology sector has done well

this year, one thing these market conditions have taught us, is that historical trends are not necessarily

a predictor for future results.

In addition to the overall uncertainty that exists in the market, the cybersecurity industry is constantly

changing because of ever-evolving threats.12 As more companies move data over to Cloud

environments relying on SaaS (Software as a Service) applications, the demand for pure-play

cybersecurity solutions will go down.12 Specifically, entities choosing to go down the SaaS route, can

rely on security through the means of insurance provided by SaaS vendors.12 If the popularity of

application based security rises, the barriers of entry into this marketplace is reduced, essentially

leading to an increase in the number of startups that will crowd this industry.

Lastly, with competition being fierce in the cybersecurity market, the product offerings available to

consumers are quite similar. Additionally, every company that operates in this space is chasing the

same business model; to create a consolidated security platform. At the end of the day, if all these

solutions are comparable, then the only differentiator will be price. A price driven market is a win for

consumers, but comes at a cost to the producers. Over time, M&As would dominate the market, as

smaller scale companies would get bought out by prominent players. In today’s environment, products

are priced based on how much capital is being invested in research and development initiatives to

further innovation. If larger players start under-cutting new entrants or smaller producers, not only will

there be limited vendors playing in this space, but the room for product differentiation would be non-

Valuation Metric Weight Price Target

DCF 70% $175.52

P/E Ratio 10% $245.08

P/S Ratio 5% $237.93

P/B Ratio 5% $289.99

EV/EBITDA 10% $147.50

Final Target Price: $188.52

PALO ALTO NETWORKS 13

existent. The end result would be a contest to offer the lowest price rather than competing on product

specifications.

Company-Specific Risks

Palo Alto Networks has some debt position issues that could be a problem down the line. As of

December 2019, the company has a net cash position of 1.37B. (2.8B total cash and ST Investments - LT

debt of 1.43). Their total liability is roughly 5B; 2B of which is due within a year, and 3B due at a later

point.16 All of this amounts to Palo Alto carrying about 1.7B more liability (3.3B – 5B = - 1.7B) than cash

+ receivables.16 Although not overly concerning, Palo Alto Networks should consider the right balance

of cash and debt as they look for potential ways to bolster their balance sheet. Additionally, there are

concerns around Palo Alto’s ability to reduce spending as a percentage of revenue while maintaining

growth.12 Historically, Palo Alto has generously rewarded employees with stock options, and diverting

from this route could have a negative impact on retention and morale.

As acquisitions can serve as catalyst for growth, they can also hinder operations. Palo Alto Networks is

a prominent player in the M&A space, with CloudGenix being the 10th acquisition Palo Alto have made

over the last 3 years. Unfortunately, post-merger integration has presented many challenges for them

as an organization.17 If the proper synergies cannot be extracted from the target companies, these

M&A transactions can end up having a negative CBA (Cost Benefit Analysis). Palo Alto should prioritize

efforts around mitigating these integration issues, as failed mergers can have negative repercussions

on future growth.

Conclusion

Sell Palo Alto Networks, Inc. (NYSE: PANW) with a target price of $188.52 and an implied upside of

-23.16%.

Palo Alto Networks is currently extremely overvalued and much of their stock price is based on

speculation associated to the current state of the economy and the shelter-in-place guidelines.

However, with companies frantically finding ways to cut back on spending, the products offered by Palo

Alto Networks may not be deemed as essential in these times of financial distress. The reality is that

most if not all corporations have existing firewalls and data security measures in place. COVID-19 will

definitely increase Subscription and Support billings for Palo Alto, but this assumption has already been

factored into this share price and therefore has limited upside if it does come to fruition.

PALO ALTO NETWORKS 14

Appendices

Appendix I: Palo Alto Networks, Inc. Product Mix Forecast

PALO ALTO NETWORKS

Segment FY FY FY FY FY FY FY FY

Millions 2022E 2021E 2020E 2019 2018 2017 2016 2015

Revenue

Product 1,335 1,171 1,064 1,096 880 709 671 493

Subscription and support 3,357 2,774 2,312 1,803 1,394 1,047 708 435

Total 4,691 3,945 3,376 2,900 2,274 1,755 1,379 928

Consensus 4,671 3,956 3,379

Guidance 4.10-4.12

Gross Margin

Product 1,001 878 798 780 607 507 495 362

Subscription and support 2,585 2,136 1,780 1,311 1,021 772 513 315

Total 3,586 3,014 2,578 2,091 1,629 1,279 1,009 677

Sales Growth YoY

Product 14.0% 10.0% -2.9% 24.6% 24.2% 5.6% 36.1%

Subscription and support 21.0% 20.0% 28.2% 29.4% 33.2% 47.9% 62.5%

Total 18.9% 16.8% 16.4% 27.5% 29.5% 27.3% 48.5%

Gross Margin

Product 75.0% 75.0% 75.0% 71.2% 69.0% 71.6% 73.9% 73.4%

Chg YoY 0.0% 0.0% 5.4% 3.1% -3.5% -3.1% 0.6%

Subcription and support 77.0% 77.0% 77.0% 72.7% 73.3% 73.7% 72.5% 72.3%

Chg YoY 0.0% 0.0% 5.9% -0.8% -0.6% 1.7% 0.2%

Total 76.4% 76.4% 76.4% 72.1% 71.6% 72.9% 73.2% 72.9%

Chg YoY 0.0% 0.0% 5.9% 0.7% -1.7% -0.4% 0.4%

PALO ALTO NETWORKS 15

Appendix II: Palo Alto Networks, Inc. Income Statement

PALO ALTO NETWORKS

FY FY FY FY FY FY FY FY

Millions 2022E 2021E 2020E 2019 2018 2017 2016 2015

Revenue:

Product 1,335 1,171 1,064 1,096 880 709 671 493

Subscription and support 3,357 2,774 2,312 1,803 1,394 1,047 708 435

Total revenue 4,691 3,945 3,376 2,900 2,274 1,755 1,379 928

Cost of Revenue

Product 334 293 266 316 272 201 175 131

Subscription and support 772 638 532 493 373 275 195 120

Total Cost of Revenue 1,106 931 798 808 645 476 370 252

Total Gross Profit 3,586 3,014 2,578 2,091 1,629 1,279 1,009 677

Operating expenses:

Research and Development 1,034 870 675 540 401 347 284 186

Sales and Marketing 2,149 1,807 1,689 1,344 1,074 899 776 523

General and Administrative 469 395 409 262 258 198 138 102

Total Operating Costs 3,652 3,071 2,773 2,145 1,733 1,445 1,199 810

Operating Income (Loss) (67) (57) (194) (54) (104) (166) (190) (134)

Interest expense 94 100 101 (84) (30) (25) (23) (22)

Other income, net 113 71 61 63 29 10 8 0.2

Income (Loss) before income taxes (48) (86) (235) (75) (105) (180) (205) (156)

Provision for income taxes 5 8 23 7 17 23 20 9

Net Income (Loss) (52) (94) (258) (82) (122) (203) (226) (165)

Net Profit (Loss) per share, basic and diluted (0.54) (0.96) (2.63) (0.87) (1.33) (2.24) (2.59) (2.02)

Consensus (0.52) (0.93) (2.60)

Guidance 4.78-4.81

Weighted-average shares used to compute net loss per share,

basic and diluted98 98 98 95 92 91 87 82

D&A 469 395 338 154 96 60 43 29

% of Sales 10.00% 10.00% 10.00% 5.3% 4.2% 3.4% 3.1% 3.1%

CapEx (PPE) 422 355 304 296 273 211 117 63

% of Sales 9.00% 9.00% 9.00% 10.2% 12.0% 12.0% 8.5% 6.8%

Accounts Receivable, net of allowance for doubtful accounts 942 792 678 582 467 432 349 212

% of Sales 20.09% 20.09% 20.09% 20.1% 20.5% 24.6% 25.3% 22.9%

Accounts payable 422 355 287 73 49 36 30 13

% of Sales 9.00% 9.00% 8.50% 2.5% 2.2% 2.0% 2.2% 1.4%

Change in WC (83) (46) 118

Revenue Growth

Revenue of Product 14.0% 10.0% -2.9% 24.6% 24.2% 5.6% 36.1%

Revenues Subscription and support 21.0% 20.0% 28.2% 29.4% 33.2% 47.9% 62.5%

Total Revenues 18.9% 16.8% 16.4% 27.5% 29.5% 27.3% 48.5%

Expenses as % of Sales

R&D 22.1% 22.1% 20.0% 18.6% 17.6% 19.8% 20.6% 20.0%

Sales and Marketing 45.8% 45.8% 50.0% 46.4% 47.2% 51.2% 56.3% 56.3%

General and Administrative 10.0% 10.0% 12.1% 9.0% 11.3% 11.3% 10.0% 10.9%

Operating Income/Loss -1.4% -1.4% -5.8% -1.9% -4.6% -9.4% -13.8% -14.4%

Interest expense 2.0% 2.5% 3.0% -2.9% -1.3% -1.4% -1.7% -2.4%

Other income (expense) 2.4% 1.8% 1.8% 2.2% 1.3% 0.6% 0.6% 0.02%

Federal Statutory Rate 21.0% 21.0% 21.0% 21.0% 26.8% 35.0% 35.0% 35.0%

Tax Rate -9.8% -9.8% -9.8% -9.8% -16.0% -12.7% -9.9% -6.0%

PALO ALTO NETWORKS 16

Appendix III: Discounted Cash Flow Model

Appendix IV: Discounted Cash Flow Model Sensitivity

PALO ALTO NETWORKS

Analyst: Meghdeep Mukherjee Terminal Discount Rate = 10.25%

Date: 06/09/2020 Terminal FCF Growth = 6.0%

Year 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E 2028E 2029E 2030E

Revenue 3,376 3,945 4,691 5,545 6,349 7,270 8,142 8,957 9,673 10,254 10,869

% Growth 16.8% 18.9% 18.2% 14.5% 14.5% 12.0% 10.0% 8.0% 6.0% 6.0%

Operating Income (194) (57) (67) 388 444 509 651 717 774 820 870

Operating Margin -5.8% -1.4% -1.4% 7.0% 7.0% 7.0% 8.0% 8.0% 8.0% 8.0% 8.0%

Interest and Other (41) (29) 19 161 184 211 236 260 281 297 315

Interest % of Sales -1.2% -0.7% 0.4% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9%

Taxes 23 8 5 115 132 151 186 205 221 235 249

Tax Rate -9.8% -9.8% -9.8% 21.0% 21.0% 21.0% 21.0% 21.0% 21.0% 21.0% 21.0%

Net Income (258) (94) (52) 434 497 569 1,074 1,181 1,276 1,352 1,433

% Growth -63.5% -44.2% -926.3% 14.5% 14.5% 88.9% 10.0% 8.0% 6.0% 6.0%

Add Depreciation/Amort 338 395 469 555 635 727 814 896 967 1,025 1,087

% of Sales 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%

Plus/(minus) Changes WC 118 (46) (83) (55) (63) (73) (81) (90) (97) (103) (109)

% of Sales 3.5% -1.2% -1.8% -1.0% -1.0% -1.0% -1.0% -1.0% -1.0% -1.0% -1.0%

Subtract Cap Ex 304 355 422 499 571 654 733 806 871 923 978

Capex % of sales 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0%

Free Cash Flow (106) (101) (88) 434 497 569 1,074 1,181 1,276 1,352 1,433

% Growth -5.1% -12.4% -591.0% 14.5% 14.5% 88.9% 10.0% 8.0% 6.0% 6.0%

NPV of Cash Flows 3,726 22%

NPV of terminal value 13,475 78% Terminal Value 35,753

Projected Equity Value 17,201 100%

Free Cash Flow Yield -0.44% Free Cash Yield 4.01%

Current P/E (93.2) (255.4) (458.1) Terminal P/E 24.9

Projected P/E (66.7) (182.7) (327.7)

Current EV/EBITDA 155.6 66.0 55.3 Terminal EV/EBITDA 17.4

Projected EV/EBITDA 107.8 45.7 38.3

Shares Outstanding 98

Current Price 245.33$

Implied equity value/share 175.52$

Upside/(Downside) to DCF -28.5%

Debt 1,430

Cash 3,203

Cash/share 32.68

Terminal Growth Rate of 6%

OPTIMISTIC PESSIMISTIC

BASE

Discount Rate 8.80% 9.00% 9.50% 10.00% 10.25% 10.50% 11.00% 11.50% 12.00%

Terminal Value 54,268 50,650 43,415 37,988 35,753 33,767 30,390 27,627 25,325

NPV of Cash Flows 4,098 4,044 3,913 3,787 3,726 3,666 3,549 3,437 3,329

NPV of terminal value 23,348 21,395 17,518 14,646 13,475 12,441 10,703 9,302 8,154

Projected Equity Value 27,447 25,440 21,432 18,433 17,201 16,107 14,252 12,740 11,483

Current Price 245.33$ 245.33$ 245.33$ 245.33$ 245.33$ 245.33$ 245.33$ 245.33$ 245.33$

Implied equity value/share 280.07$ 259.59$ 218.69$ 188.09$ 175.52$ 164.36$ 145.43$ 130.00$ 117.18$

Upside/(Downside) to DCF 14.2% 5.8% -10.9% -23.3% -28.5% -33.0% -40.7% -47.0% -52.2%

Terminal P/E 37.86 35.33 30.29 26.50 24.94 23.56 21.20 19.27 17.67

PALO ALTO NETWORKS 17

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