Shorting Palo Alto Networks, Inc. ($52) - Part 1

I prefer longs to shorts, but these days have been finding more compelling shorts than longs - perhaps that is the function of the market, but, nonetheless:

Palo Alto Networks, Inc. (Short @ 54 with 1-year target of 20)

November 9^th, 2012

Price	$52.00	Sector	Technology	52-week high	$72.61
Volume	648,301	Industry	Software and Programming	52-week low	$51.10

Date	11/9/2012	(FY ends July)	2011	2012	2013E
Price	$52.00	Earnings per Share	-$1.78	-$0.88	$0.18
Shares Outstanding (in mm)	67.890	P/E	#N/A	#N/A	288.89x
Market Cap (in $mm)	3,530.280	P/FCF	184.81x	56.21x	#N/A
Net Debt (in $mm)	-322.640	EBIT (in $mm)	-10.404	3.891	#N/A
TEV (in $mm)	3,207.640	TEV/EBIT	#N/A	824.37	#N/A
		P/S	41.63	20.24	9.17

*Historical data from company prospectus (Oct 17^th, 2012)[i]

Palo Alto Networks, Inc. (PANW) is a newly-public enterprise network security company which is highly overvalued given its highly competitive market, revenue opacity, and excessive insider selling. The market believes PANW’s platform is revolutionary in a growing industry- I believe that the network security business is a highly competitive industry and that PANW has little pricing power. Insiders seem to know this and seem desperate, hence a secondary offering of year’s revenue less than four months after ipo.

• Corporate internet security is a highly competitive market that is not growing as quickly as before and is forced to underprice its largest competitor to gain market share. From PANW’s own prospectus, its market (defined as “Network Security market and Web Security[ii]) is expected to grow from $10B in 2012 to $13.4B in 2016 – that’s only 7.59% per annum vs. 11.6% from 2009 to 2010[iii]. Earlier forecasts of 2012-2016 were more optimistic as well, as the market has been lowering expectations

• Despite a next-generation product, PANW’s gross margins are lower than CHKP, its main competitor. Check Point Software Technologies Ltd., the leader in the firewall and UTM (Unified Threat Management) market, the main focus of PANW, has gross margins of 87.6% vs. 72.3%. At a high level, this means that PANW is underpricing CHKP to gain customers.

• Fundamentally, network security is a tail risk market and is therefore underpriced. Like seat belts, internet security is usually a time-waste/drain unless an actual attack/error happens. It is one of those cases where successes are unknown but failures (breaches) can make headlines (e.g. Google servers attacked[iv])

• Internet firewalls and network security face price competition due to mass availability of free-mium model. Free personal firewalls are a dime-a-dozen (see free Avast, Zonealarm), and so only very complex/large corporations require the added power of PANW and are willing to pay for it.

*To be continued.

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[i] Prospectus pursuant to Rule 424(b)(4), October 17, 2012, page 9

[ii] Prospectus pursuant to Rule 424(b)(4), October 17, 2012, page 2

[iii] http://www.websense.com/assets/white-papers/IDC_Web_Security_Excerpt_Oct2011.pdf

[iv] http://www.nytimes.com/2010/01/13/world/asia/13beijing.html?pagewanted=all

-Stanley