Palo Alto Networks (PANW) is the global enterprise cyber-security leader.

The company is part of the market-beating IW Portfolio since January 2016.

At the time, we believed that Palo Alto Networks was best of breed among the cybersecurity players and we still believe it today.

In this piece, we outline the components of the original long thesis, as well as our main concern in recent quarters, and how that concern is starting to dissipate. We comment on the hiring of Nikesh Arora and the potential of the Palo Alto Networks Application Framework.

We then value the business on a zero-growth basis, and compare its zero-growth earnings yield to Alphabet's (GOOG) (GOOGL).

In The Google Hurdle: Google's Earnings Power As The Opportunity Cost Of Tech, we advanced Alphabet's forward earnings yield as the opportunity cost for tech investments with similar growth prospects. We wrote:

We thus advance Alphabet's earnings power yield, or the ratio of earnings power to enterprise value, as the opportunity cost for tech investments with similar growth prospects (mid- to high-teens CAGR, with returns on capital - ROC - in excess of 20%). We dub it the Google hurdle.

In that piece, we estimated the Google hurdle at 5.5%. Here, we will estimate Palo Alto Network's forward earnings power yield in a similar fashion, compare it to Google's, comment on the growth prospect differences and close with a recommendation.

The original long thesis

The original long thesis was predicated on the coexistence of a reasonable valuation and a set of desirable business attributes:

1. An industry with a large and expanding addressable market ($24+ billion).

2. A company with the right vision and focus: protecting our digital life by preventing successful cyberattacks with an automatic, scalable, easily consumable platform (note the keywords prevention, automatic, scalable, platform).

3. A best-in-class management due with an optimal split of responsibilities:  founder and visionary Nir Zuk focused on technology as CTO, and Mark McLaughlin focused on sales, financials and execution as Chairman and CEO.

4. The best product (a genuine platform build organically from the ground up) and sales & marketing execution (essential to sell sophisticated technologies of difficult appraisal) in the industry.

Nir Zuk, Palo Alto Networks Founder and CTO (source: Neilson Barnard/Getty Images North America)

Our main concern: stock-based compensation

On a non-growth basis, and contrary to the picture painted by GAAP reported financials, Palo Alto Networks is a very profitable business, as we shall show later.

That said, the persistence of exorbitant levels of stock-based compensation has been our main source of concern since 2016. In fiscal year 2017 (ending on 31 July 2017), FCF was $705 million, but stock-based compensation ((SBC)) amounted to a whooping $489 million, or almost 70% of FCF. Had Palo Alto Networks chosen to compensate its management team and workforce entirely in cash, FCF would have been only $216 million. The remaining $489 million of CF would have required an equity raise.

Put another way: in fiscal 2017, of each dollar of reported FCF, 70 cents were raised selling stock and only 30 cents, by operating the business.

To be clear, we are not against stock-based compensation per se. In fact, we rather have managers and employees compensated with a mix of cash and SBC than cash alone, for SBC aligns their interests with those of shareholders.

What we are *emphatically* against is recurrent compensation, cash or otherwise, being presented as a one-off event. The demand for cyber-security professionals is intense to say the least. Lavish compensation is indispensable to attract and retain top cyber-security talent, and SBC is an essential component of that.

Although Palo Alto Networks, as most technological companies with the exception of the largest players, continues to turn a blind eye to the reality of SBC, we are starting to see signs of containment. In the first 9 months of fiscal year 2018, SBC increased by only 5.5% YoY on 28.9% YoY revenue growth. For full fiscal year 2018, we expect SBC to represent about 60% of reported FCF, a decrease of 1000 basis points with respect to the previous year.

As we shall see, the operating leverage resulting from SBC containment is dramatically improving economic profitability.

Exciting developments: the Application Framework and a fitting CEO

Palo Alto Networks started offering network security services in 2007, with a combination of hardware appliances and cloud-delivered SaaS subscriptions.

Between 2012 and 2014, the company extended the reach of its platform to cloud and endpoints, offering consistent security across networks, cloud (through VM-Series and Aperture) and endpoints (through Traps).

Last year, the company announced the Palo Alto Networks Application Framework in what it dubbed "Evolution 3". Think of Apple's (AAPL) ecosystem made of devices (iPhone...), operating systems (iOS), native applications (Apple Music...) and app markets, but for security.

Starting in August, Palo Alto Networks customers can deploy data-collection and enforcing points through the company's HW appliances and platform SW, collect and access data through a native logging service, and exploit that data to fulfill their security goals through Palo Alto Networks, 3rd party and customer apps.

We believe that, with proper execution, the Application Framework can be a game-changer. It can transform the company's offering from one of the premium solutions to THE cyber-security operating system. Smaller cyber security players previously seen as competitors will become partners, and as they structure their business model around the Application Framework to benefit from Palo Alto Networks' customer and data scale, Palo Alto Networks will be in a priority position to perform strategic acquisitions of business already adding value to the platform.

Last year, we were surprised by the lukewarm reception of the Application Framework by Wall Street analysts. But they are starting to come to the realization that FQ3 30%+ revenue and billings growth was driven to great extent by the value proposition of the Application Framework.

And then there is the announcement that Nikesh Arora is becoming Chairman and CEO of Palo Alto Networks effective June 6, with Mark McLaughlin, who has seen the company overcome Fortinet (FTNT), Check Point (CHKP) and Cisco (CSCO) over his tenure to become the largest security player, transitioning to the role of vice chairman of the Board.

Nikesh Arora, former president and COO at SoftBank (SFTBY) and CBO at Google, is seen by many as a superstar tech manager and investor.

 Nikesh Arora, new Chairman and CEO of Palo Alto Networks (source: Fortune)

We think its hiring is significant in at least three ways:

1. It ensures that the Chairman and CEO roles remain under the control of an accomplished and successful business leader.
2. It shows that the Board is committed to the success of the Application Framework and the next wave of cyber security consumption, which Mark and Nikesh articulate around cloud, AI and massive data sets.
3. And most importantly, it represents an enormous vote of confidence from Nikesh, one of the most respected business leaders in the tech world. He must be very bullish on the industry, the company and the team to become CEO of a $18 billion market cap business after having hold major roles at Google and SoftBank.

Valuation

Free cash flow

At the midpoint, management guidance calls for fiscal 2018 revenues of $2,245 million.

For the first 9 months of F2018, reported FCF was $672.5 million. Subtracting $38.2 million related to a one-off upfront cash reimbursement from landlords, that represents a FCF margin of 38.1%. Applying that margin to full year revenues, we estimate annual FCF of $855 million.

Next, we subtract full year SBC expenses which we estimate at $516 million, for ex-SBC FCF of $339 million.

Zero-growth NOPAT

That is our starting point to estimate F2018 zero-growth net operating profit after tax (zero-growth NOPAT), or the unleveraged distributable cash flow that Palo Alto Networks could generate in perpetuity if it decided to stop investments in growth.

Revenue is mostly recurrent, and customer churn very low. About a third of revenue comes from product, which is replaced in cycles of several years. Another third comes from subscriptions, with 90%+ renewal rates. And the last third, from support services, with renewal rates close to 100%. In fact, customer lifetime value often increases dramatically after the initial purchase, likely with only incremental sales and marketing (S&M) effort.

All this suggests that S&M expenditures are more correctly seen as investments than current period expenses.

On the other hand, SW development efforts, accounted for as R&D expenses, go towards maintaining and improving Palo Alto Networks security platform. The benefits of those efforts are again reaped over many years, which suggests that R&D expenditures are more investments than cost of business.

Using a 3 year amortization period for S&M and R&D expenditures, reduces F2018 S&M expenses by $180 million, and R&D expenses, by $55 million. Given the business retention dynamics outlined before, we view the 3 year period as conservative.

Moreover, annual D&A expenses have remain, on average in the last 3 years, some $50 million below capital expenditures. We will use reported D&A as a proxy for maintenance capex.

Before the FQ3 acquisitions of Evident.io, a provider of public cloud services infrastructure protection, and Secdo, an automated endpoint security and incident response player, for a total of $370 million, business acquisitions had only played a small role in Palo Alto Networks expansion. Hence we don't view acquisitions as a necessary cost to maintain current earnings power.

All in all, we adjust ex-SBC FCF upwards by $222 million ($180 million + $55 million + $50 million, after 22% tax), to a total of $562 million.

Adding back $20.0 million of after-tax annual interest expenses, brings our estimation of zero-growth NOPAT to $582 million, or $6.33/share with  91.9 million diluted shares outstanding.

This is a conservative estimation of the hypothetical level of after-tax operating income that the company could sustain in perpetuity if it decided to stop investing in growth. With expected F2018 revenues at $2,245 million, it represents a profit margin of 26%. As advanced before, despite what GAAP raw financials may seem to suggest, Palo Alto Networks is very profitable.

We have estimated zero-growth NOPAT starting from the statement of cash flows rather than operating earnings. Clearly, cash flows are much larger than reported earnings, as the company collects large amounts of cash in advance of service provision (deferred revenue amounts to $2.2 billion as of FQ3).

As a sanity check of the NOPAT figure, if we apply a 25% margin (conservative relative to long-term company guidance, see below) to F2018 revenues, we get after-tax earnings (or FCF) of $561 million, or $6.11/share, not far from our estimation.

Palo Alto Networks Growth And Profitability Model (source: Investor Day 2017)

Distributable cash position

As of FQ3, the balance sheet shows $949 million of cash and cash equivalents, $672 million of short-term investments, $593 million of long term investments and $544 million of convertible senior notes, for a net cash position of $1,670 million.

Of that cash position, only a few dozen millions are required to support day-to-day business operations. Hence distributable cash amounts to about $18/share.

Earnings Power Value

Using a discount rate of 8%, Earnings Power Value ((EPV)), or the value of a stream of zero-growth NOPAT in perpetuity, is $79/share (6.33/0.08). Adding distributable cash, the total value of the zero-growth business to equity-holders is $97/share.

That is about half the current stock price of $200.

Palo Alto Networks and The Google Hurdle

Is a 100% premium to EPV expensive for Palo Alto Networks?

To answer that question, we look at valuation from the perspective of forward earnings yield, and compare that figure of merit to Alphabet's.

At $200/share, Palo Alto Networks trades at $182/share ex-cash. We have estimated F2018 NOPAT of $6.33/share. Assuming 25% growth in F2019, forward NOPAT would be $7.91, for a forward earnings yield of 4.3% (7.91/182), or a forward price-to-earnings power ratio of 23x.

In The Google Hurdle article, we estimated the forward earnings yield of Alphabet (without the Other Bets division) at 5.5%.

We believe those two yields were calculated based on comparable assumptions and are therefore indicative of the relative overvaluation of Palo Alto Networks... on a zero-growth basis.

But how about the value of future growth?

Earnings CAGR is expected to remain in the 20-25% ballpark at Palo Alto Networks, above 15-20% CAGR expectations at Alphabet. While returns on invested capital will likely be somewhat above 20% for both companies.

For Palo Alto Networks, equity value in the balance sheet is $722 million. Adding the last full 3 years of S&M and R&D expenditures to the value of intangible assets increases equity value to $4,288 million. But $1,648 million are cash, cash equivalent and other non operating investments, unrelated to operating income. Subtracting them brings the value of operating assets to $2,640 million.

That puts current returns on capital for Palo Alto Networks at 22% (582/ 2,640), and future ROIC are likely to be larger, as the company keeps leveraging past investments.

So Palo Alto Networks is expected to expand 500 bps faster than Alphabet and with similar returns on capital. Does the faster growth justify the premium valuation, the 4.3% zero-growth earnings yield at Palo Alto Networks vs. 5.5% at Alphabet?

Maybe, although not conclusively. (With ROIC of 20% and a discount rate of 8%, a 5% difference in annual growth rate results in a premium of only 3% difference in value creation).

Takeaways and future coverage

We are in the process of reevaluating the tech components of the IW Portfolio to position it for continuous out-performance. The Google hurdle is an important component of that process and after a significant stock price run-up, Palo Alto Networks was a candidates for divestiture.

However, in light of positive developments including the power of the Application Framework, the vote of confidence from new CEO Nikesh Arora, growth acceleration and encouraging signs of stock-based compensation containment, we have decided to maintain our long position.

In fact, we may add to our long position at stock prices that bring the earnings yield to 4.5%+. 

We recommend investors to maintain or add to their long positions.