Palo Alto Network accelerates the shift towards platforms

What happened

On 20 February, Palo Alto Networks Inc unveiled a strategic shift along its latest quarterly results. This shift led the company to cut its FY24 top-line guidance by about 5%, resulting in the stock cratering by nearly 30% the following day. Due to its leading position in the cybersecurity industry, and the potential implications for peers, the entire sector followed, ending the session down 5%.

Impact on our Investment Case

What is this strategic shift all about?

In a nutshell, Palo Alto decided to accelerate the shift from a best-of-breed approach to a platform one, i.e., offering its customers an integrated approach (one software solution to address every threat) rather than having them rely on several products. We had already identified this structural shift in our 2024 outlook, notably citing the company as a fitting example. We considered the change to be a positive catalyst since this approach makes sense both from a technology standpoint (higher efficiency, functional synergies, positive network effect) and from a commercial perspective (one single interlocutor, customer lock-in). Due to its leading position, we still believe that Palo Alto is set to benefit from this trend.

However, what we had not expected, was the way the company chose to accelerate the shift. In one word: subsidies. In more detail, the company will not make its customers pay for the entire value of the software for a certain period of time if they elect to consolidate onto its platform - think "buy 3 but pay 1 for the first X months if you sign with us for several years". This policy would logically be effective in terms of market share gains, and is a clear positive in terms of visibility. However, the short-term impact is clearly negative for billing and revenues. Also the market's reaction is possibly linked to the timing of the announcement, as the company had unveiled a medium-term outlook (now likely obsolete) just two quarters ago, rising the doubt that it may hide a slowdown in some parts of the business.

This goes beyond Palo Alto.

This announcement is a wake-up call for the entire cybersecurity sector, as it spells out loud a trend that remained so far somewhat shadowy. This shift was inevitable, as customers were starting to become weary of dealing with many suppliers in what has become a critical segment. We expect such a strategy to become more apparent in the coming months now that Palo Alto has fired the first shot.

This accelerating transition may result in the segment's consolidation, which we think new-generation players (on which we are positioned, e.g., CrowdStrike) have a chance to dominate. Furthermore, a pricing war cannot be ruled out entirely, and we believe this is the main reason behind the generalized sector weakness yesterday. However, we are not certain that Palo Alto's decision will lead to a direct price war across the sector: most metrics and companies results show that demand remains extremely strong for cybersecurity products, driven by the resurgence of large hacks, the rise of new threats such as AI, the increasing importance of data, and the fact that executives can now be held accountable. In light of such strong momentum, generalized price cuts are unnecessary, and these ongoing favorable trends reinforce our view that Palo Alto's case is company-specific. 

More generally, a consolidation movement would not be a sign of a slowing industry, but rather a structural shift to better address new market dynamics - similar to what happened to the semiconductor industry in the second half of the 2010s.

Our Takeaway

From a strategic perspective, Palo Alto Network's announcement totally makes sense, although the modalities are debatable. We believe consolidation towards platforms was bound to happen, and that this early move will benefit new generation players on which we are positioned.

Our conviction regarding the cybersecurity segment remains intact, although we acknowledge that there could be some short-term turbulence. However, structural drivers remain so strong that the benefits largely outweigh the potential risks. This market move, therefore, represents a buying opportunity.