Analysis: PANW FTNT FB

Markets are trading lower today as investors adjust to a slower global growth environment. Helping drive the move is news from the weekend that Democrats do not plan on accepting President Trump's proposal to end the ongoing government shutdown with a deal that would see $5.7 billion of funding for steel barriers on the southern border in exchange for a protection against deportation for some undocumented immigrants for at least three years.

Abroad, there were several disappointing data points supporting the view that global growth is slowing including the release of China's fourth-quarter 2018 GDP growth rate, which came in at 6.4% year-over-year (the lowest since the Great Recession), slowing from the third-quarter rate of 6.5%. China's economy expanded 6.6% in 2018, the weakest pace of growth since 1990. The German Producer Price Index also missed expectations on Monday, increasing 2.7% YoY versus 2.9% YoY expected for the month of December. Additionally, we remind members that the International Monetary Fund (IMF) downwardly revised global growth expectations for 2019 and 2020 to 3.5% and 3.6%, respectively, representing a negative revision of 0.2 and 0.1 percentage points from expectations provided just four months ago, in October.

That said, looking to our portfolio holdings, Palo Alto Networks (PANW) received an upgrade to Buy-equivalent ratings at BMO Capital and UBS, with the former (which simultaneously downgraded shares of competitor Fortinet (FTNT) ) stating, "we think PANW's valuation is attractive relative to its growth potential, as compared to other security software companies, as well as the broader software universe," and the latter calling out that the current discount on shares if unwarranted given that key overhangs (such as fears of a traditional firewall demand slowdown) are dissipating. Importantly, the analysts at BMO also noted, "in addition, we think firewall market share gains in enterprise accounts will increasingly be driven by analytics, and we have greater confidence in PANW's longer-term capabilities in driving value through analytics than competing vendors," adding "we believe the firewall market will grow by 8-10% for the next two years, despite very strong double-digit growth rates over the past several quarters. We believe the current firewall refresh cycle from enterprise customers will continue for the mid-term, as organizations modernize their infrastructure. We note that the last firewall upgrade cycle occurred in the 2014-2015 period, and the average lifespan of a firewall is typically four to five years." These comments are in line with CEO Nikesh Arora's statements during recent analyst meetings that the firewall will be around for longer than many currently believe.

While we have looked to the firewall business for earnings support in the near- to- mid-term, we have also called out that we value Palo Alto for Arora's intense focus on winning the cloud security space. As a result, we are pleased to see that the analysts at BMO state their view that "the modernization of infrastructure is a long-term secular driver for network security spending," while going on to note that "internal segmentation [a factor Arora has called out as being a cause for ongoing demand of third-party security providers such as Palo Alto] is a growing concern for enterprises, especially as they move into more hybrid environments. Therefore, we believe network security spending over the last few quarters has been solid and will remain so for the next few years." As a result, the analysts believe that "cloud security deployments for enterprise customers are accelerating" and that "virtual firewalls will have meaningful growth over the next few years." The last thing we would call out is that in line with our view that the firewall is what supports earnings now but that it is transition to the cloud that will carry future earnings momentum (again, a reason we value Arora's focus in this area), the analysts stated their view that "the growth of SaaS infrastructure is at the expense of on-premise IT infrastructure, and therefore has negative implications for the firewall industry longer term. We believe that cloud access security brokers (CASBs) will experience growth as the SaaS market continues to grow."

All in, we believe the notes serve to support our view that cyber security is a secular trend and our faith in Arora is being awarded as shares initially traded higher on the reports, before being dragged down by broader market dynamics.

Another name we would call out today that came under immense pressure in 2018, but that we chose to stick by coming into 2019 is Facebook (FB) . This morning, analysts at Jefferies reiterated their Buy rating on shares, noting that "contrary to popular belief our data checks do not point to users and advertisers leaving in droves." However, the analysts did note that caution is warranted as, while Instagram is "showing positive drivers of growth," we must keep in mind that "there is still cleanup work left as social fatigue still lingers." Regarding Instagram's momentum, which we have called out previously as a key factor keeping us in the name as growth on this front would help to offset slowing growth on the company's core Facebook platform, the analysts noted that they see "upside to pricing, users, and impressions as Instagram continues to improve its advertising efforts across the entire advertising funnel," adding that data from Kenshoo indicated that advertiser spend on the Instagram platform likely doubled in the fourth quarter of 2018, as compared to fourth quarter of 2017 with Stories leading the way. Additionally, in line with our own view, the analysts also called out that management's decision to focus on video should reward the company longer-term as video advertisers seek out a more engaging way to interact with potential customers, no doubt feeling the pressure as cord cutting continues and view trends shift increasingly toward online mediums.

Given this dynamic of growing Instagram engagement and the continued cord cutting trend, we share the analysts' view that Stories and Video are where further upside will come from as advertisers have no choice but to utilize those mediums that their customers are adopting. Bottom line, the advertisers must go to where the consumers are and when it comes to millennials, a demographic entering the credit intensive years those platforms are Instagram and increasingly, the Facebook Watch tab. All in, while we reiterate that we are not in the clear just yet, what it ultimately comes down to is price, and with shares trading at less than ~20x forward earnings, revenue expected to grow in excess of 16% in coming years (Jefferies forecasts top line growth in excess of 20% in 2019 and 2020) and 2019 expected to mark the last year of a three-year investment cycle, we reaffirm that shares, at current levels, provide for an attractive risk/reward profile.