Can Fortinet, Cisco and Palo Alto buck the slump in growth stocks?

Corporate spending on cybersecurity is accelerating as more enterprises look to protect their digital projects from an increasing number of threats. Sticky products are the key to success for companies like Cisco, Fortinet and Palo Alto Network.

- Customers that stick around and renew subscriptions are a critical growth driver to cybersecurity stocks

- Rising cybersecurity spending will help Cisco, Fortinet and Palo Alto Networks to boost revenue

- The First Trust Nasdaq Cybersecurity ETF is up 5.8% in the past month

Cybersecurity stocks like Cisco [CSCO], Fortinet [FTNT] and Palo Alto Networks [PANW] have the potential to shine bright despite it being a gloomy time for growth investing.

Amid the volatile macro backdrop, companies still need to invest to meet security demands and protect their operations from an increasing number of threats. Today’s investment narrative may be to focus on profits, but growth still has a place in the conversation, according to Christopher Gannatti, global head of research at WisdomTree.

“If one can look at the specifics of these underlying businesses, it is clear that there is a lot of underlying strength that could be stuck behind a current fog of being presently unprofitable,” Gannatti wrote.

Investors appear to be turning bullish on cybersecurity. On 13 October, Australian Medibank announced it was recovering its system from a data breach. Both Cisco and Fortinet bottomed at a 52-week low that day and Palo Alto Networks came close to falling below its 52-week low set back in May.

Sticky products and subscription growth

One of the advantages of cybersecurity companies is their tendency to operate using a software-as-a-service model. “The key attribute of businesses operating this way lies in how the customers subscribe to a particular service,” wrote Gannatti. They will often have “sticky” products that customers subscribe to and stick with month after month.

Cisco showed signs that its subscription business is growing in Q4 2022, despite supply chain challenges and order backlogs. It reported an 8% year-on-year growth in annualised recurring revenue of $22.9bn for the three months to the end of July.

Fortinet had 122 deals each worth at least $1m annually on its books at the end of Q2 2022, up from 79 at the end of Q2 2021. This is a positive development for the company’s growth prospects because larger enterprises are much more likely to be stickier.

Meanwhile, Palo Alto Networks saw revenue from subscription and support bundles come in at $1.14bn in Q4 2022, up from $879.9m in Q4 2021. Subscriptions accounted for 82% of the revenue mix for the full-fiscal year compared with 79% in 2021 and 75% in 2020. 

Spending will continue to rise

According to Gannatti, companies tend to dedicate between 7% and 10% of their IT budgets to cybersecurity. With IT spending expected to continue to grow in the years to come, he added, cybersecurity spending should increase proportionately.

Palo Alto Networks is in a position to become “the most comprehensive next-gen security platform” that stands to benefit from “ample tailwind for market expansion in the near to long-term,” wrote Cantor analyst Jonathan Ruykhaver in a note to clients. He initiated his coverage of Palo Alto Networks on 21 October with an overweight rating.

Morgan Stanley analyst Hamza Fodderwala lifted his rating for Fortinet from equal weight to overweight earlier this month, saying that the market “materially underestimates Fortinet's secular growth”. Even if the company is able to achieve as little as 5% revenue penetration, this could result in a compound annual growth rate (CAGR) of around 20% over the next five years, Fodderwala added.

An attractive entry point

Gannatti says that the decrease in valuations in cybersecurity stocks compared to a year ago could make current prices an attractive entry point for investors that have a long-term horizon. ETFs can be an ideal way to gain broad exposure to the sector.

Cisco, Fortinet and Palo Alto Networks are in the top 10 holdings of the First Trust Nasdaq Cybersecurity ETF [CIBR], making up 15.44% of the portfolio as of 25 October. Though the fund is down 22.6% year-to-date, it has climbed 5.9% in the past month.

Fortinet and Palo Alto Networks are two of the top 10 holdings in the WisdomTree Cybersecurity ETF [WCBR.L], accounting for 11.2% of the portfolio. The fund is down 33.1% year-to-date, but up 5.3% in the past month.

Cisco, Fortinet and Palo Alto have all gained ground over the past couple of weeks. The Cisco share price is up 10.1% in the past month, while the Fortinet share price has jumped 15.1% and the Palo Alto Networks share price increased by 2.9%.