PALO ALTO NETWORKS (PANW)

Ben Rush, Justin Ferrer, Michael Fitton, James Goldszer, Kooshul Jhaveri, Daniel Lee, Aaron Lewin, Sebi Nakos

Date: April 30^th, 2015

Agenda

Brief Investment Thesis

Company Overview

Recent Company & Industry News

Industry Overview and Dynamics

Competitive Advantages and Risks

Quantitative Analysis (Comps, Research, DCF)

Conclusion/Investment Thesis

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Investment Thesis

WEAK BUY

• Relatively safe play in a very risky field
• Well-diversified customer base and product line
• Extreme growth rates in both revenue and earnings
• Proven business model, anticipation of industry trends, and next-gen emphasis driving future growth
• Unified platform approach has been historically successful in other tech areas (Amazon, VMWare, Salesforce)
• Sell both hardware and software solutions
• Provides security for non-traditional systems like mobile and Mac
• Built products from ground up with next-gen architecture in mind
• Strong analyst sentiment despite less-than-ideal fundamentals
• Consistent buy reiteration and target increase even during strong ttm performance

Portfolio Breakdown

Company Overview

Palo Alto Networks Company Overview

• American network security company
• Market Cap: 12.4 B, Trading Price: 151.02 (4/30/2015)
• Core products: mainly advanced firewalls.
• Content ID, security subscriptions, and centralized management of security
• Virtualized and hardware versions
• Acquired Morta Security for an undisclosed amount in January 2014 and Cyvera for $200 million in April 2014

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Revenue Breakdown

Numerical Data:

PANW 10K FY2014

Geographic Revenue Breakdown

19000 Customers in 130 Countries as of July 31^st, 2014

PANW 10K FY2014

Enterprise Security Platform

• Three Main Elements:
• Next-Generation Firewall
• Application, user, and content visibility and control, protection against network-based cyber threats integrated within the firewall
• Advanced Endpoint Protection (releasing this year)
• Prevents cyber attacks that aim to exploit software vulnerabilities
• Threat Intelligence Cloud
• Central intelligence capabilities as well as automated delivery of preventative measures against cyber attacks.

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PANW 10K FY2014

PANW Patents

• 52 Issued Patents
• 70 Patents Pending in the USA
• Patents Set to Expire between 2017 and 2032
• Because the industry changes so rapidly, expiring patents are most likely not of much use anymore

PANW 10K FY2014

Manufacturing

• Security products are outsourced to various contract manufacturers and original design manufacturers.
• Reduces costs 🡪 reduces manufacturing overhead and inventory
• Allows for quick adjustments to changing customer demand
• Primary manufacturing Partner: Flextronics International, Ltd.
• Assembles products using design specifications, quality assurance programs, and standards established by PANW
• Procures components and assembles products based on PANW demand forecasts
• Does not have long-term manufacturing contracts that guarantee fixed capacity or pricing
• Could increase exposure to supply shortages or price fluctuations related to raw materials.

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PANW 10K FY2014

Customers

• Medium to large enterprises, service providers, and government entities.
• Industries: Education, Energy, Financial Services, Government, Healthcare, Internet/Media, Manufacturing, Public Sector, Telecommunications
• Products to over 19,000 customers worldwide.
• No single customer accounts for more than 10% of total revenue in FY2014.

PANW 10K FY2014

NSS Labs Recommendations on Palo Alto Products

Recent product praise and criticism

• NSS Labs rated PANW’s product PA 3020 as cautious.
• Criticized it for failing to stop certain evasion techniques.
• PANW claims to rate performance at 1 Gbps threat prevention, but NSS rated it at 719 Mbps
• How important is this?
• While NSS Labs does hold a large role in network security research, but they only rated one of PANW’s products as caution.
• There are 3 products in the PA-3000 series.
• The Next Gen series is only one sector.
• NSS recommended 3 products in PANW’s 10,000 Mbps range.
• More likely to be larger clients.

Industry News

• New RSA Breach Readiness Survey Finds Majority Not Prepared
• http://www.securitymagazine.com/articles/86267-new-rsa-breach-readiness-survey-finds-majority-not-prepared

PANW 10K FY2014

Industry Overview and Dynamics

Industry Themes

• Explosion of internet enabled solutions and cloud services
• Increase in services conducted online is expected to stimulate industry expansion
• Online services encourage customers to share personal information
• Private investment in computers and software
• More business spending on computers and software increases need for cyber security
• IT spending projected to grow close to 3% annually for the next 5 years (Gartner)
• Cyclical VC investment in cyber security
• Cyber security is currently a hot space for VC investment, leading to increased competition and M&A activity
• Past “investment peaks” in ‘99, ’07. Currently in the middle of another investment peak (CB insights)
• Mobile security
• Nearly 2.2 billion smartphones and tablets were sold to end users in 201 Focus on Solar Investment Tax Credit and foreign trade policy (Gartner)
• Predicted that early 75% of mobile security breaches will be the result of mobile application misconfiguration (Gartner)

Cyclical Deal Volume

Source: CB Insights

Projected Industry Spending

Source: Gartner

Crime rate and future cyber crime

• Crime rates are decreasing, a trend expected to continue
• Criminals have become more sophisticated as they seek new sources of profit
• Viruses have become more aggressive
• High-profile cyber-attacks targeting retailers, financial institutions, and healthcare providers are expected to stimulate demand for cyber security

Source: Ibis world

Decreasing overall crime rate

Incidence of high profile attacks on Federal Agencies

Source: GAO analysis of US-CERT data for fiscal years 2006-2012

Industry Outlook

• Increased spending to occur in mobile security
• Greater demand from high profile companies
• Greater government regulation
• Gramm-Leach-Bliley Act required financial institutions to increase cyber security practices (many still not fully compliant)
• Stricter government mandates in public utilities industries
• Increased regulation of government contractors
• Shifting future of software services: SaaS model
• In the SaaS model, customers pay for the right to use software installed on a remote serve (subscription based service)
• Companies elease regular and automatic updates, rather than compiling updates to a new version that must be purchased again
• Earnings become more volatile

Source: Deutsche Bank, Renewable Energy World

PORTER’S FIVE FORCES

Competitive Advantages and Risks

Competitive Advantage

• Expansion into mobile
• Recent expansion in partnership with VMware
• Continued rise in BYOD (bring your own device) policies
• Rising attacks on Mac devices
• 2014 saw a sharp uptick in attacks on the Mac OSX operating system and apple mobile devices
• Hardware & Software Integration
• PANW is able to mitigate the risks of the SaaS business model by selling both hardware and software components

Risk Factors

• Significantly increasing net losses: $226.5M in FY2014 down from $29.2M in FY2013 (increase largely due large settlement with Juniper)
• Large reliance on third-party producers and sellers. Short term contracts leave PANW vulnerable to sudden price fluctuations
• Increasing reliance on government contracts exposes PANW to a more competitive and volatile market dependent on ability of companies to achieve potentially changing government standards
• International investment (purchase of Cyvera in 2014 in Israel) leaves profits vulnerable to instability in the region, especially to Hamas-Israel conflict

Quantitative Analysis

PANW has significantly outperformed the S&P 500 over the past 3 months

Source: Yahoo Finance

PANW has significantly outperformed the S&P 500 over the past year

Source: Yahoo Finance

PANW has seen significant decline in trading multiples over the past few years

Source: Bloomberg

PANW Free Cash Flow, Revenue, and EPS trends

Source: Bloomberg

Public Comps

Source: Yahoo Finance/Google Finance/Bloomberg

Analyst Sentiment

Source: Bloomberg

Analyst Sentiment

Source: Bloomberg

Analyst Sentiment

• “PANW is the most credible “newly architected” platform in enterprise security; this translates to an advantage when companies look to “refresh” legacy architecture in their network security – Needham
• “Cyber security is not a top 3 priority in most corporate boardrooms. Mega-breaches are continuing nearly unabated and because of this, management believes security spending is pervasive and will be long-lasting… “platform approach” is the only way enterprises can effectively prevent breaches.” – Piper Jaffray
• “Secret sauce is their unified platform, which should allow additional share gains: History has shown that platforms win (CRM, AMZN, VMW, etc) and ultimately produce outsized gains. We believe PANW is in a unique position, having built their platform from the ground up with next-gen architecture in mind, to gain share vs peers and ultimately become the largest security vendor in the $20B network and endpoint market” – RBC Capital Markets

Source: Bloomberg

Discounted Cash Flow Analysis

Investment Thesis

WEAK BUY

• Relatively safe play in a very risky field
• Well-diversified customer base and product line
• Extreme growth rates in both revenue and earnings
• Proven business model, anticipation of industry trends, and next-gen emphasis driving future growth
• Unified platform approach has been historically successful in other tech areas (Amazon, VMWare, Salesforce)
• Sell both hardware and software solutions
• Provides security for non-traditional systems like mobile and Mac
• Built products from ground up with next-gen architecture in mind
• Strong analyst sentiment despite less-than-ideal fundamentals
• Consistent buy reiteration and target increase even during strong ttm performance