Firewall Leader Set to Expand

On the way to taking the firewall market crown, Palo Alto Networks PANW developed considerable customer switching costs, in our view. We have raised our economic moat rating to narrow from none and are sustaining our positive moat trend rating. Palo Alto is expanding its subscriptions to cover hybrid cloud security concerns with items such as analytics, automated response, and machine learning, which we see as growth catalysts to supplement its strong firewall offerings. We expect the company will gain significant operating leverage in the coming decade as recurring subscription and support revenue streams flow from its expansive customer base. Given our higher top- and bottom-line expectations, we have raised our fair value estimate to $305 per share from $217. We believe this 4-star stock represents an attractive investment opportunity in the cybersecurity market.

Palo Alto became a leading cybersecurity provider with its next-generation firewall appliance, forever altering the requirements of this essential piece of networking security. Its offerings grew to include diversified security subscriptions that attached to firewall appliances, as well as solutions such as protection and automated responses for cloud-based traffic and data, software-as-a-service applications, and endpoints. In our view, cybersecurity will remain a top concern for enterprises and governments as the growing quantity of data and traffic being generated outside of centralized data centers increases the possible attack vectors and drives up security management complexity. We think IT teams are clamoring for security consolidation, and Palo Alto’s security operating platform helps centralize security orchestration and management. We believe the ability to add technologies via subscriptions in the Palo Alto framework can alleviate security complications by providing a more holistic solution, which equates to sustainable demand for the company’s solutions.

We expect a 19% five-year compound annual growth rate for revenue, driven by subscriptions and support outpacing product growth. We believe Palo Alto’s expansion into cybersecurity areas with higher growth trajectories than firewall appliances will increase stand-alone and product-attached subscription revenue. We see substantial greenfield subscription opportunities for cloud-based security, threat analytics and response, and holistic networkwide solutions. We expect Palo Alto’s firewall ecosystem to benefit from entities favoring adding on additional Palo Alto subscriptions per product over managing various cybersecurity vendors. Our growth rate expects internal development efforts to be supplemented with acquisitions, especially in the areas of cloud security, analytics, and machine learning. As Palo Alto sells more nascent security technologies and attaches more subscriptions to its platform, we model subscription and support sales to outpace product revenue and become 67% of revenue in fiscal 2023 versus 61% in fiscal 2018.

We expect gross margins for subscriptions and support to increase toward 75% and gross margins for products to grow to 72% in fiscal 2023 versus 73% and 69%, respectively, in fiscal 2018. We model consolidated gross margins to expand toward 74% in fiscal 2023 versus 72% in fiscal 2018. In our view, Palo Alto will continue increasing its operating expenses at a healthy clip, albeit at a lower year-over-year rate as it reaps the benefits of developing a sizable customer base through previous elevated sales and marketing efforts. As a percentage of revenue, we model sales and marketing to decline below 38% and for research and development to drop to around 15% in fiscal 2023, compared with 47% and 18%, respectively, in fiscal 2018. Based on these effects, we expect operating margins to be around 14% in fiscal 2023 versus negative 5% in fiscal 2018.