Why Are Hedge Funds Bullish on Palo Alto Networks, Inc. (PANW) Right Now?

We recently compiled a list of the 10 Best Cybersecurity Stocks To Buy According To Hedge Funds. In this article, we are going to take a look at where Palo Alto Networks, Inc. (NASDAQ:PANW) stands against the other cybersecurity stocks.

The growth in internet use has made connectivity ubiquitous across the daily lives of businesses and individuals. It has also opened up more avenues for nefarious individuals or organizations to run financial heists, steal confidential data, or disrupt critical infrastructure and systems. The scale of these activities is staggering as well, with research outlining that as of 2021, cyber criminals caused a stunning $6 trillion in damages - an impact greater than all but the two largest economies in the world.

These threats have led to the growth of a vibrant cybersecurity industry which came into the spotlight of global media coverage in July 2024 after an outage affected an unbelievable 8.5 million computers worldwide. The outage shed light on the intricate nature of the global computing ecosystem as well as the risks that are present if security infrastructure has a single point of failure. While it's too early to speculate on the losses, some estimates from insurer Parametrix show that insured losses could touch as much as $1 billion for Fortune 500 companies. As if this weren't enough, the insurance firm's CEO believes that the global impact could be several times higher. He estimates that the total financial losses could sit at $15 billion while global insured losses could range between $1.5 billion to $3 billion.

Looking at the scale of these losses, it's only natural to ask, what caused the global cyber outage? Well, the problem started when a cybersecurity provider that was the third biggest cybersecurity company in the world, rolled out an upgrade for its Falcon security platform. This caused systems that used the Windows operating system to crash since the software upgrade included a corrupted file that works with the deepest level of a computer called a kernel. The OS showed the infamous blue screen of death, which is the software's response to protect the user from damage to the kernel that can lead to a loss of data. The disruption lasted for quite a while too since all the systems affected by the update have to be manually booted into safe mode to remove the corrupted file before they can normally function.

Coming back to the financial side of the cybersecurity industry, like other sectors, it is also facing disruption through artificial intelligence. Research shows that the AI driven cybersecurity industry was worth $20 billion in 2023. From then until 2027, the sector is expected to grow at a compounded annual growth rate (CAGR) of 25.3% for a final value of $49.2 billion. In other words, the industry is expected to more than double in four years. As for the costs of cybersecurity breaches, they're also expected to grow from 2021 levels in the age of AI. These costs are estimated to sit at $8 trillion by 2023 end and jump to $10.5 trillion by 2025 end. The current era in the finance industry is marked by high interest rates, and they've made their impact on cybersecurity mergers too. In 2023, 363 M&A deals were announced in the cybersecurity industry, for an 18.8% annual drop.

Within these deals, strategic buyers, i.e. those that buy firms that align with their business strategies, accounted for 57.3% of the deals. Despite the lower number of deals, valuations remained robust. Between Q4 2020 and Q4 2023, average EV/Revenue and EV/EBITDA multiples in the cybersecurity M&A sector were 3.3x and 11.6x, which were higher than the broader averages of 2.1x and 10.4x.

Delving deeper, despite the tough business spending and inflation in 2023, cybersecurity stocks did post some returns. These came at a time when broader software as a service (SaaS) stocks were struggling due to corporate uncertainty about future spending plans. The Houlihan Lokey Cybersecurity Index, which tracks the performance of 28 top cybersecurity stocks, increased by 83% year to date by 2023 end and jumped by 28% during the fourth quarter. These returns were accompanied by a revenue growth of 18% and a stronger earnings growth of 29%, showing the benefits of operating in a high margin software industry which allows cybersecurity stocks to eke out more pennies on the dollar when it comes to profit. While the 83% returns of the index themselves mark a strong lead of 58 percentage points over the flagship S&P, this band widens when we further narrow down the top cybersecurity stocks to only include the high growth firms. Their last twelve month returns as of 2023 end were 101% for an even wider band of 76 percentage points.

Shifting towards valuation, like the broader SaaS industry, cybersecurity stocks are primarily evaluated through their enterprise value to revenue. The high growth cybersecurity stocks had a median EV/2024E Revenue ratio was 9.8x. For the medium and low growth stocks, the median ratios were 5.9x and 3.0x. respectively. Crucially, ratios for high and medium growth cybersecurity stocks were significantly higher than the EV/Revenue ratios of acquisition targets that we've shared above. This implies that as far as the current environment for cybersecurity acquisition goes, value seems to be driving at least some deals as businesses find it difficult to raise capital because of high interest rates. As for revenue growth percentage, the median values ranged between 33% for the high growth firms to 4% for the low growth firms.

Our Methodology

To make our list of the best cybersecurity stocks to buy according to hedge funds, we ranked the holdings of multiple cybersecurity ETFs by the number of hedge funds that had bought the shares during Q1 2024 and selected the stocks with the highest number of hedge fund investors.

Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).

A cutting-edge computer lab full of IT experts monitoring the security of multiple systems.

Palo Alto Networks, Inc. (NASDAQ:PANW)

Number of Hedge Fund Investors  in Q1 2024: 78

Palo Alto Networks, Inc. (NASDAQ:PANW) is a diversified cybersecurity company that offers a variety of products and services such as firewalls, malware protection, and cloud security. Like other software stocks, recurring revenue, billings, margins, and free cash flow are key to its hypothesis. Palo Alto Networks, Inc. (NASDAQ:PANW) has also been positioning itself well to capture the current growth in the interest surrounding cybersecurity. It acquired a Secure Access Service Edge (SASE) platform provider in December 2023 to grow its portfolio to also secure employees who might be using unofficial devices to access business networks. Palo Alto Networks, Inc. (NASDAQ:PANW) also expanded its event management platform in May 2024 by allowing businesses to integrate their own machine learning models into the service. The firm has also been performing well on the financial front, with its first quarter seeing a whopping 47% ARR jump to $3.8 billion. Its SASE expansion comes when remote work has gained a permanent foothold across industries, and is delivering stable billings for other cybersecurity stocks such as Fortinet even though their billings as a whole are dropping.

Palo Alto Networks, Inc. (NASDAQ:PANW)'s management commented on its customer relationships during the Q32 2024 earnings call where it outlined:

"We have also had questions from analysts and investors on this topic since we reported our Q2 results in February. I thought I’d share more background on how we got here to provide context and also offer a platformization framework for you to help understand why we’re convinced that we can build a much larger business over the next several years and platformization is key to achieving that. When we embarked on our journey to transform our company, we were keen to create interest and convince our customers that we could solve their problems not just with our next-generation firewalls and the associated subscriptions, but also with a set of best-of-breed products across 20-plus categories organized across three platforms. That strategy was hugely successful and saw us achieving nearly $4 billion in NGS ARR.

The majority of focus of our teams was landing multiple products across our three platforms and our customers. Whether we were able to land at a brand new customer for Palo Alto Networks or we added products from new platforms to our existing customers, we were happy. Landing could range from a single product used in part of the organization to broader usage across the organization. From that lens, if you look at our top 5,000 customers, we have landed two or more of our platforms at about half these customers, and these customers contribute just over 80% of NGS ARR. If you look at it by — this by platform, we have landed 97% of these top 5,000 network security, over 20% of them in Prisma Cloud, and over 40% with Cortex. By all means, our land-the-platform strategy was extremely successful."

Overall PANW ranks 2nd on our list of the best cybersecurity stocks to buy. You can visit 10 Best Cybersecurity Stocks To Buy According To Hedge Funds to see the other cybersecurity stocks that are on hedge funds’ radar. While we acknowledge the potential of PANW as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than PANW but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.

 

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Disclosure: None. This article is originally published at Insider Monkey.