Wednesday, December 4, 2013

Palo Alto Networks is Starting to Look Good Value

Analyzing the network security sector sometimes gives you the feeling that you are researching the only one company, just at different stages in its development. Most companies tend to evolve in a similar fashion, from high-growth start up to mature GDP growth type cash cow.  Check Point   and Cisco's    security division would definitely represent the later stage of this hypothetical company's development. Palo Alto Networks    is at the high-growth end of the spectrum and Fortinet   lies somewhere in the middle.The question is which company has the best risk/reward profile?

Network security rebounds
It's been a varied year for the sector. After a weak first quarter, where companies like Fortinet, Palo Alto and F5 Networks disappointed with results, the last two quarters have been relatively good.

It's hard to pinpoint exactly what happened back then, but sequestration appears to have had an effect on confidence. Furthermore, some unexpected weakness in telco provider spending also hit the market. No matter, the sector has reported some pretty good results since then.

The mature companies
Check Point finally managed to get product sales growing positively again. In addition, its new low-end product range is making inroads in the small and medium size business market. Meanwhile, it continues to generate huge amounts of free-cash flow. By my calculations free-cash flow was $925 million over the last year, representing around 8.6% of its current enterprise value. However, it's only forecast to grow earnings in the mid-single digit range for next few years.  It's attractive if you favor low growth value plays.

Meanwhile, Cisco Systems has revamped its security offering with its acquisition of Sourcefire. Although, Cisco is not a pure-play security company, the way that is able to buy growth by an acquisition is typical of a mature late stage company. Cisco's main strength is the ability to bundle solutions to the other equipment that it sells to Governments and enterprises. Indeed, listening to Palo Alto's management on its conference call, the Sourcefire acquisition actually created a positive opportunity:

We've also seen confusion in the market from the Sourcefire customers about what that deal means... ...We've been able to develop hundreds and hundreds of leads from dissatisfied or confused Sourcefire customers... ... it's been a positive

Fortinet matures, unusually
Fortinet also beat estimates in its last quarter. Revenue came in at $154.7 million, beating the high-end of its guidance range by 1.6%. In common, with Check Point, Fortinet's guidance for the fourth quarter looks a bit conservative. Check Point has averaged 13.7% in fourth quarter sequential revenue growth over the last five years, while this year's guidance implies sequential growth of just 10.4% Meanwhile,despite beating estimates in its third quarter, Fortinet kept its full year revenue and EPS guidance constant. Here is how its full-year guidance has changed this year.

Source: Company presentations

Eagle-eyed readers will note that its free-cash forecasts have been progressively lowered throughout the year. Frankly, this is a cause for concern in an otherwise attractively valued company. Fortinet has had to lower its inventory turns, and therefore use up more cash in holding inventory on its books. It's not a major issue, provided it stabilizes as expected. However, it's something for Foolish investors to look out for. Companies usually start converting more income into cash flow when they mature, not the other way around.

Why Palo Alto Networks is the pick
It seems odd to talk about Palo Alto as the best value in the sector, but on a risk/reward basis the argument stacks up for three reasons.

First, Palo Alto's revenue for the full year is forecast to be around $559 million , a figure noticeably smaller than Check Point's estimate of around $1.4 billion or Cisco's trailing year security revenue of a similar amount. In other words, even if all four of these companies share the market equally, Palo Alto will see the most growth.

Second, Palo Alto is doing a pretty good job of converting revenue into free-cash flow.

source: Company accounts, author's analysis

If Palo Alto converts 22% of its forecast revenues of $559 million and $734 million then investors can expect around $123 million and $161 million in free cash flow in the next two years. That's not bad for a company that has a current enterprise value of $2.83 billion. 

Third, Palo Alto has a favorable geographic mix of revenue. The most recent quarter saw 67% of the company's revenue coming from the Americas, with only 19% from Europe and 14% coming from the Middle East & Africa and Asia-Pacific.  With companies like Cisco and IBM recently warning that emerging market spending was weakening, it's good for Palo Alto to be focused on the Americas.

All told, Palo Alto may not be the cheapest-looking stock in the sector right now, but it looks a good value based on its stage of development. Pure value orientated investors may prefer Check Point, or even a mix of the two.

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