PALO ALTO NETWORKS (PANW) BUSFIN 7225: Student Investment Management Summary Fund Manager: Royce West Research Analyst: Meghdeep Mukherjee Palo Alto Networks is a cybersecurity firm that is known for July 15th, 2020 selling security appliances, subscriptions, and support into enterprises, government entities, and service providers. Company Information The company's product portfolio includes appliances, Ticker PANW Sector Technology virtual firewalls, endpoint protection, cloud security, Industry Software - Infrastructure and cybersecurity analytics. The Santa Clara, California, Price as of 7/14/2020 $245.33 firm was established in 2005 and sells its products worldwide.1 Market Cap 23.66B Shares Outstanding (M) 98 Recommendation Investment Thesis Stock Rating Sell Price Target $188.52 We are recommending that investors sell Palo Alto Networks, Implied Upside -23.16% Inc. due to the following reasons: Dividend Yield - • Current stock price is heavily reliant on Palo Alto Key Statistics shifting to offer a broader suite of Cloud-Based Revenue (2019, M) $2,900 Subscription and Support offerings; a tactic Earnings (2019, M) ($82) EPS (2019) ($0.87) the company is still evaluating P/E (06/29/2020) 32.33 Beta (5Y Monthly) 1.2 • Post-merger integration has posed challenges for Performance History Palo Alto’s leadership, which down the line can 52 Week High $255.84 dilute the gains sought by the acquisition 52 Week Low $125.47 1 - Year Return 22.27% • Discounted Cash Flow Analysis suggests Palo Alto’s Contact Information stock price to be overvalued when looking at a ten Meghdeep Mukherjee year forecast horizon [email protected]

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

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 2

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 3

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 .3 With Innovation and customer need in mind, Palo Alto designed their award-winning security featuring the world’s first ML-Powered () 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 () and 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 4

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§or=45

PALO ALTO NETWORKS 5

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 6

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 7

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 8

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 9

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.

Total Sales Net Income EPS P/E Name Ticker Return 1 Yr TTM TTM TTM TTM PALO ALTO NETWORKS, INC. PANW-US (21.03%) 3,263.80 (228.90) (2.36) NEG , 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 , 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

Source: Thompson One, PANW Comps

PALO ALTO NETWORKS 10

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.

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

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

PALO ALTO NETWORKS 11

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.

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

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 () 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-

PALO ALTO NETWORKS 12

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 13

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 14

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, 98 98 98 95 92 91 87 82 basic and diluted 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 15

Appendix III: Discounted Cash Flow Model

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

Appendix IV: Discounted Cash Flow Model Sensitivity 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 16

References 1Morningstar.com - Company Profile PANW

2https://www.sec.gov/Archives/edgar/data/1327567/000132756719000032/panw-7312019x10k.htm

3Paloaltonetworks.com

4https://www.bloomberg.com/quote/SPX:IND

5https://www.tradingview.com/markets/indices/quotes-snp/

6https://eresearch.fidelity.com/eresearch/markets_sectors/sectors/sectors_in_market.jhtml?tab=sdbu siness§or=45

7https://www.statista.com/statistics/235347/global-security-appliance-revenue-market-share-by- vendors/

8https://www.t4.ai/industry/firewall-market-share

9https://www.paloaltonetworks.com/company/press/2020/palo-alto-networks-completes-acquisition- of-cloudgenix

10https://investors.paloaltonetworks.com/investor-relations/news-releases/news-release- details/2020/Palo-Alto-Networks-Reports-Fiscal-Third-Quarter-2020-Financial-Results/

11https://www.zdnet.com/article/palo-alto-networks-shines-in-q3-amid-remote-work-spurs-security- demand/

12https://library-morningstar-com.proxy.lib.ohio-state.edu/v2/quote?id=0P0000WI3J&typeid=ST

13https://eresearch.fidelity.com/eresearch/markets_sectors/sectors/sectors_in_market.jhtml?tab=lear n§or=45

14https://www.wsj.com/market-data/stocks/peyields

15https://www.nytimes.com/2020/03/26/business/economy/coronavirus-relief-bill.html

16https://finance.yahoo.com/news/palo-alto-networks-nyse-panw-154434238.html

17https://research-valueline- com.proxy.lib.ohiostate.edu/Secure/Research/Home#list=recent&sec=company&sym=panw

PALO ALTO NETWORKS 17