New Issue: Palo Alto Networks (PANW) $500 million Convertible Senior Notes

- Bill Feingold & Kent Bailey, CFA

As a kid from Berkeley, Hillside’s co-founder needs to get over certain prejudices when looking at any company with “Palo Alto” in its name.

Ok. We’re good.

The new Palo Alto Networks convertible, on the surface, does a lot more for hedgers than outrights. While revenues are exploding, so are costs. The market thus far has given PANW a generous valuation, clearly focusing on that revenue growth. Where have we heard that before? That valuation gives a lot of comfort to arbs looking to set the new deal up and capture volatility figuring to be north of 40% for some time. This one has the look of a potential home run on the downside given the market cap and the company’s name recognition in cybersecurity.  The deal’s optics, needless to say, aren’t terrific, with just a wisp of a coupon and a premium pushing 40. This issue could be a poster child for why market capitalization should be one of your first considerations in evaluating any deal—even if it’s a much bigger help to the arbs than the outrights.

Still, the accompanying call spread should help support the deal early—and that may be all it takes. Props to PANW for not messing around with the second chance the market’s giving it—the stock, like so many of its kind, has had a nice round trip in recent months.

PANW provides network firewall software and appliances, as well as subscription services for threat detection and prevention to its enterprise customer base.  With recent high-profile data breaches at major corporations such as Target and eBay creating a demand tailwind, Palo Alto's strong revenue growth should continue for the foreseeable future.  Free cash flow is expected to grow apace, with estimates in the $250m range for FY2015.  PANW also settled its patent infringement litigation with Juniper in the past quarter, removing an overhang.  However, with the stock trading at 7.5x 2015 EV/Revenue, it's difficult to get comfortable with valuation.  Steady insider selling over the past 6 months and significant expenses for stock-based compensation are other reasons for caution on the equity.  
Palo Alto discusses potential acquisitions when considering use of proceeds, although nothing is imminent.  With ~$800m in pro forma cash, including the $75m outlay to settle the JNPR litigation, the convert as the only debt, and solid cash flow, PANW will have plenty of flexibility to pursue business development.  The bottom line is that this is the type of convertible deal that makes a lot of sense in this environment:  high growth companies monetizing expensive stock valuations and high volatility to get very attractive terms from a convertible investor base starving for paper.