Palo Alto Networks Shares Are Too Cheap, Morgan Stanley Says

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Palo Alto Networks

shares have held up a little better than most other software stocks in the recent tech selloff, and for good reason—in an era of “digital transformation,” about the last thing you want to cut from the IT spending budget is software to defend the corporate network from bad guys.

But Morgan Stanley analyst Hamza Fodderwala asserts in a research note Thursday that Palo Alto Networks (ticker: PANW) shares remain “underpriced.” He maintains his Overweight rating and $823 target price on the stock, implying a potential 68% gain from recent levels.

In recent trading, Palo Alto Networks shares were 0.4% higher, at $493.96, while the

Nasdaq Composite
was down 1.2%. The stock is off 11% this year.

Fodderwala’s note focuses one two specific points. 

For starters, he thinks investors are overly concerned about the company’s relatively high stock-based compensation expense. As he concedes, stock-based comp at Palo Alto Networks is about 20% of revenue, well above rivals

Check Point

(CHKP), at about 5%, and

Fortinet

(FTNT), at about 7%. But he also says the higher figure largely reflects M&A activity, when the company issued stock to retain key execs of acquired companies. 

The analyst notes that Palo Alto Networks has free-cash-flow margins above 30%, and more than $2 billion in annualized free cash flow. He thinks the company can buy back stock at an annualized rate of $1 billion to $1.5 billion beyond the July 2022 fiscal year, which should more than offset dilution from stock-based compensation programs going forward.

Fodderwala’s second key point is that Palo Alto Networks is within one to two quarters of reaching profitability under generally accepted accounting principles, with profitability on a trailing-12-month basis as soon as early to mid-2023. Once that happens, he adds, the company would be a “strong contender” for addition to the

S&P 500.
Stocks generally rally when added to the index.

The analyst concludes that with the stock trading at about 20 times expected calendar 2023 free cash flow, and with the top line growing 30%—and given the “durability of securing spend in period of macro uncertainty”—Palo Alto Networks shares offer “one of the most compelling risk-rewards in our software universe.”

Write to Eric J. Savitz at [email protected]