This article was originally published on Forbes on Updated Sep 26, 2024, 10:29pm EDTForbesForbes on Updated Sep 26, 2024, 10:29pm EDT

Cybersecurity is becoming increasingly important in the age of AI, as the number and sophistication of threats increase. Combining cybersecurity with AI has a natural affinity as cyberattacks are computer generated, and in turn, computers are uniquely capable of finding computer-generated threats. Utilizing AI to identify threats and for pattern recognition and anomaly detection is not new by any means, but rather what is now rapidly coming to market are platforms enabled with generative AI, to enable threat detection and prevention before attacks occur.

Despite cybersecurity being one of the most promising sectors to reap the benefits from AI, popular stocks have stumbled this year. CrowdStrike had a faulty update that caused global outages with high profile airlines affected. Palo Alto also recorded its largest-ever one-day decline as it cut its outlook; the company is taking a near-term hit as it pivots toward becoming a platform, which will fare better for AI purposes rather than a collection of disparate vendor products.

AI offerings are becoming more prevalent, and the first signs of AI-related growth are arising in the leading names in the industry. Below, I look at the demand environment for leading cybersecurity stocks CrowdStrike, Zscaler, Palo Alto, and Fortinet, and which ones have key metrics hinting toward underlying strength.

AI Opening New Opportunities as Threats Rise

Nearly one year ago, the I/O Fund discussed for its free newsletter readers how cybersecurity was the next industry to be disrupted by AI, not only by improving threat detection and prevention capabilities but also because AI-based attacks were on the rise. AI is aiding enterprises to expedite threat prevention, yet hackers are similarly expediting the end-to-end attack life cycle, and could potentially execute larger and more complicated attacks faster than ever before.

According to McKinsey, 51 percent of organizations believe generative-AI is driving new risks in cybersecurity, down slightly from 53 percent in a similar survey from 2023. However, only 33 percent of organizations are actively working to mitigate AI-related cybersecurity risks, with 16 percent already witnessing a negative consequence or event.

A report from the World Economic Forum predicts that AI could push cyber incidents and data breaches to a new record high in 2024, even after a 72% YoY increase in data breaches in 2023. Palo Alto said it is seeing an “uptick in mega-breaches” with multi-billion dollar impacts, as ransomware public extortion activity has risen more than 50% from 2022. Zscaler also sees ransomware attacks continuing to rise, up 18% YoY, though victims and payloads have gotten increasingly large, with 57% more victims and 144% more payloads.

Zscaler sees ransomware attacks continuing to rise, up 18% YoY, though victims and payloads have gotten increasingly large, with 57% more victims and 144% more payloads

Source: I/O Fund

The new dynamic created by AI in the industry from both a threat and protection standpoint offers a long-term growth runway. As Palo Alto puts it, the year 2024 “will be a phenomenal year in the utilization of AI in cybersecurity,” but it “will pale by comparison to what is yet to come.”

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Palo Alto Networks: 4x Growth to $200M AI ARR

Palo Alto’s management believes AI “continues to generate significant excitement in the market,” and “adoption is proceeding at a rapid pace faster [than] any other new technology.” They see AI not only creating “transformative use cases” enabling new revenue streams and efficiencies, but also enabling cybercriminals to broaden attacks, improve targeting, and scale beyond what can currently be controlled by humans.

Palo Alto is rolling out a comprehensive AI product suite, with the launch of AI Access, AI SPM, and AI Runtime Security in May, combined with its AI-driven SecOps platform Cortex and AI integrations in its Prisma Cloud and SASE offerings. Palo Alto noted in Q4’s earnings call that its AI Access could be deployed to its 5,000+ Prisma Access customers, while nearly 1,000 customers were also interested in AI Access. This is an incredibly strong response given that early access to the solution was launched in July, only one month prior to management’s comment.

In fiscal Q4, Palo Alto disclosed that its AI ARR (AI Access, AI SPM, AI Runtime) had surpassed $200 million to close out the year, for 4x YoY growth. While growth is rapid, AI’s scale is still small, due to the recent timing of launches. However, AI already accounts for nearly 5% of Next-Gen Security (NGS) ARR, and is set to grow its share of NGS ARR as products scale.

Palo Alto is also seeing strong growth in Cortex, with ARR surpassing $900 million in fiscal 2024. Cortex XSIAM delivered north of $500 million in bookings, with customer count rising 4x YoY. Palo Alto has previously noted that XSIAM drives much higher ARR, with customers who adopt XSIAM having >5x ARR compared to those that do not. Continuing to accelerate customer adoption of XSIAM while growing Cortex’s customer base (up nearly 20% YoY to >6,100) can drive strong long-term growth for the fastest-growing product in Palo Alto’s history.

With the strengths arising in AI, Palo Alto is expecting NGS ARR growth to remain robust, though headline growth is decelerating due to the law of large numbers. NGS ARR is guided to increase 34% to 36% YoY in Q1 of fiscal 2025, reaching between $4.33 billion to $4.38 billion. On a dollar basis, that represents YoY growth of $1.13 billion, marginally higher than the $1.12 billion it added from Q1 2023 to Q1 2024, where YoY growth was reported at 53% — essentially, Palo Alto is maintaining the same growth in dollar terms despite operating at a larger scale.

Zscaler: AI Contributing 3 Points to Growth

Zscaler launched its AI Analytics solutions at the end of 2023, and is already seeing strong contributions from these new products, including its Risk360, Business Insights, Unified Vulnerability Management and more. Zscaler’s management believes that “the increasing use of AI is creating new avenues of growth,” and “the rising adoption of Gen AI is exposing new gaps in organizations' security posture.”

Management said that AI Analytics was “seeing strong traction” in Q4, and “contributed nearly 3 points to new and upsell business growth in Q4 and 2 points for the entire fiscal '24,” even with the products being available for just a portion of the year. While Zscaler did not break out AI’s contribution in dollar terms, it noted that it saw record new and upsell business in Q4 and a record $1 billion-plus in quarterly bookings (driven by the new and upsell business), suggesting that the AI Analytics was a strong driver for the quarter under the hood.

Zscaler is also prioritizing data center and AI investments to support this growth in AI Analytics. For fiscal 2025, management said that they expect “data center CapEx to be approximately 3 points higher as a percent of revenue compared to fiscal 2024,” due to investments to upgrade cloud and AI infrastructure. Property and equipment purchases have been accelerating on a quarterly basis to nearly $50 million in Q4, and totaled 7% of revenue for the entirety of FY24, so Zscaler looks to be eyeing a move closer towards the 10% range. As a result of these increased data center investments, free cash flow margin is expected to decline from 27% in FY24 to 23.5% to 24% in FY25.

Zscaler's property and equipment purchases have been accelerating on a quarterly basis to nearly $50 million in Q4, and totaled 7% of revenue for the entirety of FY24

Source: I/O Fund

Additionally, despite closing out its fiscal 2024 with a double beat in Q4, Zscaler’s guide for FY25 was light, pointing to a revenue growth deceleration of ~6 percentage points YoY. Zscaler also left clues that AI Analytics and other new products will continue to see strength in FY25, saying that sales productivity was better than expected, driven by new and upsell business. The trend is set to continue in FY25 and strengthen in the second half of the fiscal year.

Fortinet: AI-Driven Ops Account for 10% of Billings

Fortinet did not break out AI revenue or ARR like Palo Alto has, but management said that in fiscal Q2, “AI-driven SecOps accounted for 10% of total billings,” an increase of 1 point QoQ but flat YoY. Fortinet’s FortiAI solution is currently available in its FortiAnalyzer, FortiSIEM, and FortiSOAR products but will be expanded to more products in the future.

However, AI-driven SecOps’ billings have been lumpy, and are lower in Q2 than they were in Q4. Based on the 10% figure, Q2’s AI-driven SecOps billings were approximately $154 million, up just over 22% QoQ but down more than (17%) from $186 million in Q4. AI-driven SecOps also has not surpassed 10% of total billings in each of the last four quarters.

Fortinet's Q2 AI-driven SecOps billings were approximately $154 million, up just over 22% QoQ but down more than (17%) from $186 million in Q4

Source: I/O Fund

Management guided for billings to be approximately flat to up low single-digits QoQ in Q3, implying that AI-driven SecOps’ contribution will not rise significantly unless SASE or Secured Networking declines significantly, which is unlikely to be the case. As a result, Fortinet may not see its AI-driven products meaningfully contribute to billings growth or drive a newfound acceleration in the metric.

Despite this, Fortinet took steps to broaden its AI security portfolio, acquiring Lacework in Q2. Management expects Lacework’s “organically developed AI-driven cloud-native application protection platform will be combined with the power of Fortinet’s Security Fabric platform, ensuring broad protection across the network, cloud, and endpoint.” The move is expected to add $10 billion to Fortinet’s TAM, per management’s projections.

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CrowdStrike Discusses AI Opportunities Without Disclosing AI Numbers

While peers Palo Alto and Zscaler put forth some early AI revenue and growth numbers, CrowdStrike has not, but management has discussed AI-related opportunities in some detail.

CrowdStrike has not broken out any AI-specific growth numbers or contribution, but arguably has a very strong product suite with its Falcon platform and its new generative AI-powered security analyst Charlotte AI. Management sees a long runway ahead for AI in cybersecurity, with a $225B 2028 AI-native security TAM, explaining that “decreasing TCO and increasing efficiencies through AI and automation are clearly voiced organizational priorities and will be for years to come.”

CrowdStrike believes Charlotte AI holds “an incredible amount of promise,” and has been training this AI security assistant to “be a malware reverse engineer, … to translate threat hunting queries, … to help automate reporting, … [and] to do some incident response use cases,” to improve efficiency and accelerate back-end processes when working in conjunction with humans. Management says that its “best-in-class module adoption” is “supercharged by Charlotte AI [and] makes the Falcon platform sticky for all users.”

Adoption rates for CrowdStrike’s modules remain strong, with adoption of 6+ and 7+ rising 1 point each sequentially to 45% and 29%. Additionally, similar to Palo Alto, CrowdStrike’s ‘hypergrowth’ products (LogScale next-gen SIEM, Cloud and Identity Security) are witnessing strong growth, with ending ARR for the group surpassing $1 billion, up 85% YoY.

Conclusion

Cyberattacks are rising in both number and sophistication. While 2024 has been a bit of a wild ride for the industry, cybersecurity is only growing in importance in the age of AI. The industry’s leading companies are progressing with AI-powered product deployments, seeing long runways ahead despite minimal signs of growth at the moment.

Palo Alto’s AI portfolio is contributing ~$200 million, or 5%, of total ARR, while Zscaler’s products are contributing just 3 points to upsell growth. Fortinet is seeing AI-driven SecOps contribute 10% of billings, though that has been relatively unchanged for four quarters. Meanwhile, CrowdStrike has yet to put a firm number on AI-related growth, though next-gen products are recording rapid growth.

Cybersecurity stocks command a premium to the broad SaaS universe with early signs of AI growth.

Source: YChartsYCharts

Due to their early exposure to AI and revenue streams, cybersecurity stocks command a premium to the broad SaaS universe. Despite its valuation crunch after its incident, CrowdStrike remains the third most-expensive software stock on a top-line basis, with Palo Alto also in the top ten. Fortinet and Zscaler both trade around the 10x forward revenue level, nearly double the median 5.5x multiple for the sector.

Our goal (always) is to perform deep dive research to identify winners, and then to subsequently identify a good entry. I will be direct and say our firm is not a buyer in this market as I believe most tech stocks will trade lower in the next 3-6 months. Yet, it’s never too early to perform research and get our ducks in a row for when the market affords solid entries. Interestingly, despite cybersecurity AI revenue numbers looking low, it’s one of the only software verticals where there is AI revenue. I think investors should pay attention to these early green shoots.

While Wall Street is worried about how much AI is costing, the I/O Fund is busy calculating how big the AI opportunity can get in the next few years and how investors can participate. Learn more about the I/O Fund’s holdings and consistent deep dive research on AI stocks, crypto and more here.here.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

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This article was originally published on Forbes on Mar 7, 2024,08:19pm ESTForbes Forbes on Mar 7, 2024,08:19pm EST

This year has led to a split landscape for cybersecurity stocks, with two of cybersecurity leaders up more than 20% YTD while others are negative YTD. In the past, we’ve discussed the resiliency of the cybersecurity trend being that it’s one of the highest costs that enterprises face at 12% of IT budgets on average. The cost of cybercrime continues to rise, and is estimated to reach $10.3 trillion by 2025 and $13.8 trillion by 2028. AI and automation are playing an increasingly large role in the industry, with 560,000 new pieces of malware detected every day. Software systems cannot keep up with this, and AI is already assisting human teams in identifying which threats require more analysis.

Source: Data by YCharts

Despite the strength of the trend, we are seeing mixed results across cybersecurity leaders. Palo Alto cut its billings and revenue forecast in a shift to a “platformization” approach. Zscaler fell despite beating on the top and bottom line as it pointed to a rather sharp deceleration in calculated billings. In contrast, CrowdStrike rose nearly 11% after it beat estimates with another record in net new ARR, and guided fiscal Q1 marginally ahead of consensus. Adding to CrowdStrike’s strength, Fortinet has rallied double-digits year-to-date despite signaling that growth is slowing, with revenue and billings set to decelerate sharply this year.

However, if we zoom out, it’s quite clear what the strongest cybersecurity stock has been with CrowdStrike’s 1-year returns of 162% well ahead of its peers. The analysis below looks at why some are starting the year exceptionally strong, while others are not in the leading cloud vertical of cybersecurity.

Source: Data by YCharts

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Fortinet: Growth Is Slowing

Although Fortinet reported solid improvement in operating income and EPS for fiscal 2024, revenue growth and billings growth is slowing considerably. Revenue increased 10.2% YoY to $1.42 billion in the quarter, a 570 bp deceleration from 16% growth in Q4. Fortinet had initially guided for billings to decline YoY to $1.63 billion at midpoint, but it handily beat its guide as it reported 8.5% growth with billings of $1.89 billion. This was a 280 bps acceleration from 5.7% billings growth in Q3, but a far cry from the 30% range seen through 2021 and 2022, with growth decelerating swiftly through 2023.

Source: I/O Fund

Q4’s billings were driven by signing 13 deals above >$10M generating $232M in billings (up 177% YoY). However, the Q4 beat was short lived with Q1’s guide pointing to a (5%) YoY decline in billings to $1.43 billion at the midpoint. Growth is expected to be minimal for the full year, with Fortinet pointing to $6.4 billion to $6.6 billion in billings, or growth of 0% to 3%.

This would represent a significant slowdown in billings growth over the past two years, from 33.8% in 2022 to 14.4% in 2023 to the low-single digit range for 2024. Revenue growth is decelerating rather rapidly as a result, with Fortinet’s $5.76 billion guide for the full year pointing to growth in the high single digit range from $5.31 billion in 2023. Consensus estimates were at $5.94 billion for 11.9% growth, but that has since been revised lower to $5.79 billion for 9.1% growth.

Product revenue has declined for two consecutive quarters, in part due to tough comps in late 2022. Management explained that product revenue “will continue to be impacted by project and product digestion in 2024,” though the “selling environment should improve in the second half of 2024 and into 2025.”

Source: I/O Fund

Services revenue growth has slowed to under 25%, the lowest level since early 2022. Given services’ share at nearly 66% of revenue in Q4, a prolonged deceleration would bode negatively for revenue growth moving forward. There were positives emerging in SecOps, which grew 44%, and SSE element of SASE, which management added also witnessed more than 40% growth in the quarter.

Palo Alto: Billings and Revenue Forecasts Cut in Platformization Approach

Palo Alto shares plunged over (28%) after its fiscal Q2 earnings report when management cut its billings and revenue forecast for the full year. We had informed our readers in the analysis “The Strongest Cybersecurity Stocks in Q3” in December following Palo Alto’s weak billings in Q1 that this was “amplifying concerns that revenue and billings growth is decelerating.”

Palo Alto also unveiled a stronger push for “platformization” among its three platforms to drive vendor consolidation, saying that it intends to make “significant additional investments” in this strategy as it will be “a major area of focus for us as we move forward.”

Revenue in fiscal Q2 increased 19% YoY to $1.98 billion, a 1 percentage point deceleration from 20% in Q1. Palo Alto cut its full year revenue guide by $0.2 billion to $7.95 billion to $8.0 billion, for growth of 15% to 16% YoY, and also cut its billings forecast by ~5%. Palo Alto is now seeing billings at $10.1 to $10.2 billion, for growth of 10% to 11% YoY, down from its prior view for $10.7 to $10.8 billion due to impacts in its federal government business. This implies a further deceleration over the next two quarters, potentially to revenue growth in the low teens.

However, next-gen offerings continued to see strong demand and growth: networking security SASE ARR increased more than 50% YoY for the fifth consecutive quarter, while Next-Gen Security (NGS) ARR rose 50% YoY to $3.49 billion. Palo Alto also saw the highest number of deals signed for XSIAM (Extended security intelligence and automation management) in the quarter.

Source: I/O Fund

Palo Alto is taking a more aggressive approach to “platformizing” its offerings as customer LTV increases exponentially per platform added. It sees the near-term headwinds to revenue and billings growth as merely a blip in its long-term target to reach $15 billion in NGS ARR by 2030, up from its guided $3.95 to $4 billion in 2024. Revenue growth is expected to remain pressured through FY24 and begin inflecting higher through the end of FY25 (12 to 18 months), as the headwinds of this approach begin to fade.

Source: Investor Relations

While this exponential increase in customer long-term value alone can support this strategy shift, peer Fortinet also highlighted other positives around this approach: “Consolidation allows security solutions to share data and communicate with each other, reducing complexity, improving security effectiveness, easing the need for skilled labor, and lowering the total cost of ownership. Consolidation drove our SecOps business to 44% growth, with strong growth from EDR, SIEM, email security, and NDR.”

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Zscaler: Calculated Billings to Decline Sequentially

Zscaler beat on the top and bottom line, and marginally boosted its full year revenue and calculated billings forecast. Despite the beat and raise, Zscaler guided for a (7%) sequential decline in calculated billings for Q3, suggesting further deceleration in this key metric to the low-20% range.

Revenue increased 35% YoY to $525 million, a slight deceleration from 40% growth in Q1; Zscaler guided for 28% YoY growth in Q3 to $535 million at midpoint. As a result, Zscaler marginally boosted its full year revenue outlook to $2.118 to $2.122 billion, up approximately 1% from its prior view for $2.09 to $2.10 billion.

Zscaler tightened its billings growth outlook to $2.55 to $2.57 billion, at the upper end of its prior forecast for $2.52 to $2.56 billion. This correlates to 25% to 26% YoY growth. We had said in December following Q1’s release that the fact Zscaler “did not raise its full-year billings outlook as it tends to do” suggested that ‘billings growth will decelerate through the remainder of the fiscal year.” This is currently what is playing out – calculated billings increased 34% in Q1, decelerating to 27% in Q2. Q3’s forecast for a (7%) QoQ decline implies calculated billings of $584 million, or a further deceleration to just 21% growth.

Source: I/O Fund

GAAP profitability remains elusive, unlike peers CrowdStrike and Palo Alto, who have both recorded quarters with GAAP operating and net profitability. Zscaler has been making inroads on the GAAP profitability front, with GAAP operating margin just above (9%) and GAAP net margin at (6.7%) for the past two quarters. However, until Zscaler can meaningfully reduce operating expenses, currently at approximately 87% of revenues, GAAP profitability will continue to remain elusive should growth decelerate.

Interestingly, Zscaler commented that it believes it is “still operating in a challenging macroenvironment and customers continue to scrutinize large deals,” and that its 2024 outlook balances its “business optimism with ongoing macroeconomic uncertainties and sales leadership changes.”

CrowdStrike: Shares Fly With Record Net New ARR, Robust RPO, Margin Strength

CrowdStrike reported a new record for net new ARR in Q4, far surpassing the record it set in the previous quarter, as GAAP margins continued to strengthen. For FY25, CrowdStrike’s guide was marginally above consensus, yet the market is clearly pleased with this continued expansion in operating and net margins. The turnaround on net new ARR is notable, yet the turnaround on GAAP profitability is what is most impressive compared to its cloud peers, especially considering the far majority of cloud stocks are years away from GAAP profitability (if they ever get there). We covered the earnings report in-depth for our premium members here.

Net new ARR accelerated significantly in the quarter to 27% growth, which is a 14-point acceleration from 13% growth in Q3. This is up from 2% growth for net new ARR in the year ago quarter. The turnaround in this particular key metric is notable, especially compared to other cloud stocks whose key metrics are decelerating. ARR increased 34% to $3.44 billion, which was down 1 percent from 35% growth last quarter.

CrowdStrike’s management stated that the company continues “to aggressively invest in our innovation engine and flank the company to achieve its vision of reaching $10 billion in ARR over the next 5 to 7 years.” That would imply about 200% growth in 5-7 years. The growth of deals with total value exceeding $1 million accelerated to “over 30%” this quarter for 250 customers.

Source: I/O Fund

Margins strengthened across the board – driven by four quarters of GAAP gross margin at 75% and GAAP subscription margin at 78%, both up from the prior year. To further illustrate CrowdStrike’s margin expansion, GAAP operating income was $30 million this quarter compared to (-$61.5) million in the year ago quarter. This is up from $3.2 million last quarter. For the full year, CrowdStrike nearly broke even from operations, reporting just a ($2 million) loss from operations, or a (0%) margin, an 800 bp improvement from FY23. CrowdStrike also reported its first full year with GAAP net profitability, reporting a 2.9% net margin, compared to an (8.2%) margin in FY23.

CrowdStrike echoed Zscaler with its macro commentary, saying that it believes the “current macro environment remains stable and consistent with prior quarters,” as it expects “continued deal scrutiny throughout this coming year.” Management added that its fiscal Q1 and FY25 guidance “assumes a consistent, challenging macro backdrop.”

Conclusion

The 1-year performance across cybersecurity leaders is quite variable, ranging from an impressive 161% to a mere 17%. This makes it well worth our time to monitor the metrics driving performance in this sector. Billings growth will be important to continue to track, as some hints of weakness last quarter spilled over into reduced forecasts from Palo Alto and Fortinet. Revenue deceleration will also be a key metric to watch given the decelerations guided from Palo Alto and Fortinet. Most importantly, these key metrics can provide clues as to which companies will be strongest moving into the rest of 2024 and beyond.

If you own Cybersecurity stocks or are looking to own these stocks, consider joining us for our next broad market webinar. Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, manage risk, as well as revealing our various long-term game plans regarding stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

Recommended Reading:

• The Next Market AI Will Disrupt Is Cybersecurity
• The Strongest Cybersecurity Stocks In Q3
• CrowdStrike: On The Brink Of Becoming GAAP Profitable
• The Magnificent 7 Are Falling Like Dominos; Only 3 Remain

This article was originally published on Forbes on Forbes Forbes on Nov 30, 2023,09:40pm EST

Cybersecurity stocks have performed well in 2023, rising about +26.5% YTD, with the security backdrop boosted by an increase in data breaches and ransomware. Quarterly spending has increased approximately +12.7% YoY to ~$37.6 billion through the first half of the year, although commentary from sector leaders Fortinet and Palo Alto raised some concerns about spend optimization, with billings forecasts from the two weaker than expected.

Despite beating on the top and bottom lines, Zscaler provided flat billings guidance while revenue growth is set to slow. CrowdStrike was GAAP profitable from operations for the first time ever as net new ARR reached a record, but billings and ARR growth both decelerated.

Cybersecurity Market Growth Slows in Q2

Zscaler and CrowdStrike reported their October quarters this week with both providing important commentary that the macro environment is tougher than usual. CrowdStrike’s management said that buyers still remain cautious since the “macroenvironment remains challenging with continued increased budget scrutiny.” Zscaler said that while the “global macro environment remains challenging, and customers continue to scrutinize large deals, … customer sentiment seems to be stabilizing.”

Looking back at the cybersecurity market through Q2 offers a bit of color on those broader trends impacting growth this year. The market registered a third straight quarterly deceleration in Q2, per Canalys estimates, as the global market recorded +11.6% YoY growth to $19.0 billion.

This marked a slight deceleration from the +12.5% growth in Q1 to $18.6 billion, and a sharper deceleration from the +15.8% growth rate seen in 2022, as the cybersecurity market topped $71 billion for the year.

Source: CANALYS

Growth in North America remained resilient at +12.6% YoY in Q2, the bellwether of the market considering it accounts for more than half of total spending. Latin America and EMEA growth remained in the double digits, though both decreased approximately 180 to 210 bp sequentially. APAC growth saw the largest slowdown, from +10.7% YoY in Q1 to +8.8% YoY in Q2.

Headwinds Remain in Play in Q3

Budget cuts, consolidation, and optimization are some of the trends at play in the cybersecurity market that are pulling 2023’s growth rates lower. Microsoft CEO Satya Nadella said in January during its fiscal Q2 earnings call that customers were “consolidating on our security stack, in order to reduce risk, complexity and cost.”

CrowdStrike CEO George Kurtz echoed Nadella’s view in the company’s Q1 earnings call in March that customers “want to reduce cost and headcount, reduce the number of point products and agents, reduce complexity and simplify operations.”

Venture capital funding deals and deal value also reflect this challenging environment persisting through Q3. According to Crunchbase, deal count declined just over (-15%) from Q2 to 153. Although deal value was marginally higher at $1.9 billion compared to ~$1.8 billion in Q2, it was about (-30%) lower YoY as large late-stage deals faded. VC funding has totaled just $6.4 billion YTD, on track to mark the lowest level of funding for cybersecurity startups since 2019, which totaled $8.8 billion.

Source: CRUNCHBASE

Despite such cost and complexity concerns, companies are still committed to protecting data and operations. It’s this point that will drive long-term growth of the industry in the face of these near-term headwinds: there will always be more data to protect.

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Fortinet: Q4 Guidance Soft, Billings to Decline YoY

Fortinet declined (-12.4%) following its Q3 earnings report for three key reasons: Q3 revenues marginally missed estimates, Q4 revenue guide was below consensus, and most importantly, Fortinet is projecting a YoY decline in net billings.

Fortinet reported revenues of $1.33 billion in Q3, which missed expectations by just $20 million. For Q4, Fortinet guided revenues $80 million lower at midpoint than the consensus estimate of $1.49 billion.

Q4 billings were projected to be between $1.56 to $1.70 billion, representing a YoY decline of ~(1%) to (9%). Management’s transition to SASE and security operations, and challenging network comps, are some of the factors behind the revenue slowdown with Fortinet seeing “modest” revenue growth for the next few quarters.

Source: I/O FUND

Fortinet’s billings slowdown and the lowered revenue forecast is a concern as 2023 would mark Fortinet’s slowest billings growth since its IPO in 2009. Growth is estimated at just +10.2% YoY at the $6.165 billion midpoint. It’s also a significant slowdown from the +34% and +35% billings growth seen in 2022 and 2021. Management said the growth slowdown in Q3 stemmed from “1 month shorter contract duration and importantly, lackluster appliance demand.”

A slowdown in product revenue growth is likely a driving factor behind the lowered revenue forecast for 2023. Product revenue is forecast to increase only +9% YoY to $1.935 billion – this is well below 2022’s +42% growth, 2021’s +37% growth, and its +23.7% average growth rate since 2009. CEO Ken Xie said that “the Secure Networking market is experiencing slower growth as product demand returns to normal levels following two years of elevated growth.” He added that “building and product revenue fell below our expectation” due to that slowdown in Secure Networking.

Palo Alto: Billings Weaker than Expected, Underlying Metrics Strong

Palo Alto shares fell (-5.4%) following its fiscal Q1 earnings report, but have since gained more than +14% to rise to new highs. The initial negative reaction stemmed from a lowered billings forecast as well as hints that revenue growth is slowing below 20%, but other underlying metrics remained strong.

Palo Alto reported +20% YoY revenue growth to $1.88 billion and +16% YoY billings growth to $2.02 billion, which came in below its prior outlook for $2.05 to $2.08 billion in the October quarter. This miss is amplifying concerns that revenue and billings growth is decelerating — revenue growth was at the lowest level since fiscal Q4 2020, while billings growth was at the lowest level in more than four years and marks a second quarter with growth below +20%.

Source: I/O FUND

For the full year, Palo Alto lowered its billing forecast to $10.7 to $10.8 billion, from a prior view of $10.9 to $11.0 billion. This correlates to YoY growth of +16% to +17%, roughly in line with the recent quarter’s +16% growth rate. Palo Alto cited volatility in contract duration, increased financing demand, and increased demand for deferred billings plans for the lowered forecast. CFO Dipak Golechha said that the company “saw the rising cost of money have an important and incremental impact on customer behavior in [fiscal] Q1.” Similar to Fortinet, Palo Alto saw minimal growth in product revenue, at just +3% YoY, with the majority of revenue growth driven by service revenue, +25% YoY.

Aside from that, Palo Alto had multiple underlying strengths in the report, especially with its next-gen offerings. Next-Gen Security ARR increased +53% YoY to $3.23 billion, and SASE ARR increased +60% YoY. Palo Alto saw very strong growth in multi-module customers, with +155% YoY growth in those adopting 5+ modules, and +59% YoY growth in those adopting 3+. XSIAM’s pipeline exceeded $1 billion, with more than $500 million of that pipeline added in Q1.

Zscaler: Billings Guide Unchanged, Revenue Growth May Slow

Zscaler maintained its billing guide for the full year, although revenue and EPS both came in ahead of expectations in its fiscal Q1. Large customer growth continued to slow, while fiscal Q2’s guide hinted at a possible deceleration in revenue growth.

Zscaler reported $497 million in revenue, +40% YoY, which handily beat expectations and the company’s guidance for +33% YoY growth to $473 million in revenue. While it did post +131% YoY growth in adjusted EPS to $0.67 and a surge in free cash flow, Zscaler remains unprofitable on a GAAP basis.

GAAP operating loss improved 33% YoY to ($46 million), while GAAP operating margin improved 10 percentage points to (9%). At its scale of more than $2 billion in annual revenue, it’s likely the market will want Zscaler to soon shift to operating profitability, which could be tough at the moment given that sales, marketing and R&D accounted for ~98.8% of gross profit in Q1. SBC also remained high at $129.1 million, or ~26% of revenue.

Billings growth remained strong, at +34% YoY to $456.6 million. However, Zscaler did not raise its full-year billings outlook as it tends to do, even if only by a few million; its outlook remained unchanged at +24% to +26% YoY growth, or $2.52 to $2.56 billion. That outlook suggests that billings growth will decelerate through the remainder of the fiscal year.

Fiscal Q2’s revenue guide also hinted at some early signs of revenue deceleration, with the $506 million guide pointing to YoY growth of approximately +30.5%. Fiscal 2024’s guide calls for +29.5% YoY growth at midpoint to $2.095 billion, again indicating that revenue growth in fiscal Q3 and Q4 is likely to slow to the mid to high-20% range.

Source: I/O FUND

Growth in large customers of over $1M in ARR has slowed significantly by 21 points over the past year, from 55% growth down to 34%. Growth in $100K+ ARR customers has also slowed from 37% to 22%.

Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.Learn more hereLearn more here.

CrowdStrike: Net New ARR Rises to Record, But Billings Decelerate

CrowdStrike beat on the top and bottom lines and guided fiscal Q4 marginally above consensus. The report in itself was fairly strong, as net new ARR rose to a record and CrowdStrike recorded its first-ever quarter with positive operating income. However, ARR growth and billings growth both decelerated, similar to peers who are also seeing decelerating billings. Management added that “buyers are still cautious” as the “macroenvironment remains challenging with continued increased budget scrutiny.”

Source: I/O FUND

Net new ARR rebounded to a record $223.1 million, +12.6% YoY, a strong recovery from Q1 and setting the stage for another possible record to close out FY24. With this rebound in net new ARR, CrowdStrike’s ARR topped $3 billion for the first time, reaching $3.15 billion in fiscal Q3. CrowdStrike emphasized that it is the “fastest and only pure play cybersecurity software vendor in history” to surpass the $3 billion ARR milestone.

However, ARR growth is still decelerating, as is billings growth. ARR growth in fiscal Q3 was +34.6% YoY, a slight deceleration from Q2’s +36.9% YoY growth rate and a sharper deceleration from the +55% YoY growth rate from fiscal Q3 last year. What’s important is that CrowdStrike soon shows ARR bottoming and stabilizing, instead of decelerating further into the +20% range or even the high teens.

Source: I/O FUND

Billings also decelerated, matching what we’ve seen so far with CrowdStrike’s peers. Billings were calculated to have fallen (-2%) QoQ and +9% YoY to $821.5M for Q3, a significant slowdown from the +13% QoQ and +22% YoY growth rate recorded in the prior quarter. You can read more about billings and ARR in our CrowdStrike’s Q3 earnings recaphere.

Source: I/O FUND

Pictured Above: I/O Fund calculations for CrowdStrike’s billings growth/decline

CrowdStrike also recorded its first quarter to generate operating income, albeit at a razor-thin 0.4% operating margin. However, this shift to a positive margin benefited the bottom-line, allowing net margin to expand ~225 bp QoQ to ~3.4%. This marked CrowdStrike’s third straight quarter of GAAP profitability, with sequential growth in each of the three quarters. We had previously mentioned that while CrowdStrike had begun to post GAAP profitability, it was preferable that the company be GAAP profitable from operations rather than interest income – now, the next task is for CrowdStrike to show further growth in operating income.

Conclusion

Aside from Fortinet, the remaining cybersecurity stocks covered here have all rallied to new highs following earnings, despite each report having some weaknesses. Cybersecurity stocks are investor favorites due to an ever-growing need for cybersecurity solutions among enterprises and high cash flow generation metrics – all of the four reported free cash flow margins higher than 30%. Billings growth remains an important metric to track, given the decelerations seen this quarter and hints at more deceleration ahead. Yet, these key metrics are providing clues as to which companies will be strongest moving into 2024.

Damien Robbins, Equity Analyst at the I/O Fund, contributed to this article.

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This article was originally published on Forbes on Forbes Forbes on Sep 29, 2023,12:05am EDT

Cybersecurity is one of the highest costs that enterprises face at 12% of IT budgets on average, and this cost is rapidly rising. While a company can lay off staff or reduce marketing and R&D expenses during a period of lower growth, enterprises cannot compromise on cybersecurity. The rise in the number of attacks and the increased sophistication of attacks means this expense will continue to grow, yet AI and automation can help.

According to Cybercrime Magazine, if cybercrime were a country, it would be the world’s third-largest economy, second to the United States and China. The costs that enterprises dedicate to cybersecurity are expected to increase from $8 trillion to $10.5 trillion by 2025. Statista agrees with Cybercrime Magazine’s estimates, stating the cost of cybercrime will reach $10.3 trillion by 2025 and $13.8 trillion by 2028.

At the I/O Fund, we are positioning for AI and automation to play an important role in this critical, no-compromise industry. There are 560,000 new pieces of malware detected every day, and software systems cannot keep up with this. AI is already assisting human teams in identifying which threats require more analysis, and in the near-term, this will meaningfully lower cybersecurity costs. There is also a shortage of cybersecurity talent, with a 2022 survey stating 59% of companies have a shortage in this department and may not be able to effectively handle a cybersecurity attack.

Below, we look at how AI is set to disrupt cybersecurity next and what is being said on the topic.

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How AI Can Improve Incident Response and Threat Detection

Combining cybersecurity with AI has a natural affinity as cyberattacks are computer generated, and in turn, computers are uniquely capable of finding computer-generated threats. Automation reduces the number of false positives. Instead of getting every piece of telemetry that requires the security team to investigate, AI-assisted endpoint detection and response solutions eliminates the noise so that the security team is only responding to those that have the potential to be critical.

Fundamentally, cybersecurity is a data problem. Cybersecurity platforms ingest, correlate, and query petabytes of structured and unstructured data from disparate external and internal sources in real-time. Cybersecurity platforms then build rich context and deliver greater visibility by constructing a dynamic representation of data across an organization.As a result, AI-driven cybersecurity platforms are often highly accurate in triggering a response.

The number of endpoints in a corporate network are exponentially growing with 27 billion endpoints expected to be connected by 2025. There have been staggering studies done that show 68% of enterprises have experienced a compromised endpoint. Compromised credentials across desktops, laptops, and mobile devices are often the hardest points of access to secure. Algorithms can detect new malware on endpoints based on the attributes of known malware. Unauthorized access, data breaches and cyber threats from endpoints will also help to drive demand for edge-based, decentralized AI cybersecurity solutions.

The network security market is a large contributor to cybersecurity spend. Machine learning algorithms help systems to learn by experience, which helps to identify malware in encrypted traffic and find insider threats. Machine learning algorithms do not need to decrypt, rather can spot the malicious patterns and find threats hidden with encryption.

Cloud security is the fastest growing segment within cybersecurity. AI/ML can help to identify suspicious cloud app logins, detect location-based anomalies, and quickly identify threats through IP reputation analysis. Threat prevention is possible through ingesting cloud telemetry with AI systems, foregoing the need for expert rule engineering. Attack path simulation is also made possible with AI, to help simulate the path an attacker would take to reduce coverage gaps. Egress web traffic can be monitored without the need to configure virtual machines by focusing on limiting egress based on source, identity, destination and request types. Machine learning models can also detect new API threats based on large training data sets. These are a few examples of how AI/ML is improving cloud security.

Chat-GPT heightens security risks as generative AI is capable of writing malicious code or acting as a sidekick to the human hacker writing malicious code. To level the playing field, the best defense will also be self-learning, generative AI tools. The downloads for Chat-GPT have plateaued considerably among consumers. Meanwhile, the use of Chat-GPT among hackers is rising on an exponential curve. This helps illustrate why the adoption curve for AI may be healthier among enterprises (rather than consumers) in the medium-term.

According to Mackenzie Jackson, a developer advocate with GitGuardian, Chat-GPT is likely to give rise to a greater number of hackers. This new generation is called “AI Hackers” because previously they could not hack on their own, but are now able to hack with generative AI as their sidekick.

Source: RAPID7: BAIN & COMPANY

Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.Learn more hereLearn more here.

What the C-Suite is Saying About AI & Cybersecurity

McKinsey released a recent report where 53 percent of organizations believe generative-AI is driving new risks in cybersecurity. Not only can AI help enterprises expedite threat detection, but hackers can also expedite the end-to-end attack life cycle. In another survey, 38 percent of enterprises stated they are mitigating AI-related cybersecurity risks compared to 32 percent who are mitigating inaccuracies, indicating cybersecurity is the top risk that is AI-related at this time.

According to Forbes, 56% of enterprises ranked governance, security and auditability issues as their highest-priority concern with AI/ML spend. This survey was completed in 2021, and it’s likely this number is higher today.

What Public Company CEOs are Saying

Microsoft has one of the largest cybersecurity businesses in the world at $20 billion. This is larger than six best-of-breed companies combined. The company has been working for years on new automation features called CoPilot, which was released to the public this month. Although it’s being marketed for Windows, Office 365 and the browsers Bing and Edge, yet will also become an AI companion for it’s cybersecurity business. Per the CEO in the most recent earnings call: “our Security Copilot, the first product to apply this next generation of AI to SecOps will be available to customers via paid early access program this fall.”

Source: BETH KINDIG'S TWITTER

Palo Alto Networks is a company that has outsized returns this year of up to 78% following the most recent earnings call. It’s currently trading at 66% gains YTD. The CEO stated in the most recent earnings call: “I think what's important to understand is that over the last five years, cybersecurity TAM has continued to rise. It has grown at approximately 14%, and it has grown twice the pace at which the IT market has grown […] and possibly now with the sort of arrival of AI as a mainstream opportunity, every one of us is trying to make sure we grab that with both hands. So, we will continue to see the pace of technology spend go sort of up or forward.”

Source: YCHARTS

Cloudflare is a stock that is up 35% YTD and is edging out the Nasdaq-100 this year, which is no small feat given the rally Big Tech has seen. The CEO recently stated that his company is seeing an uptick in business on their R2 product: “And by our estimates, Cloudflare is the most commonly used cloud provider across the leading AI startups. They're using R2 to help arbitrage the lowest GPU cost to train their models.”

Conclusion:

Using AI to identify threats and for pattern recognition and anomaly detection is not new by any means. Rather what is rapidly coming to market are platforms enabled with generative AI and automation that is self-learning, so that a threat is detected before it occurs rather than after the cyberattack. Rather than threat detection, the ultimate goal is threat prevention.

AI will not entirely replace security professionals anytime soon, but it can contribute to efficiency by automating threat detection, analyzing data sets, and by continuously learning to identify anomalies and new attacks before they occur. By offering agentless solutions, theoretically, fewer human agents will be needed. For new technologies, the adoption curve can be challenging (go ask virtual reality enthusiasts how that’s going). But for industries where AI can offer a value proposition that can predictably lower costs at a reasonable price, a market will form. We think one of the next markets to be disrupted by AI will be cybersecurity.

If you own cybersecurity stocks, or are looking to own cybersecurity stocks, we encourage you to attend our weekly premium webinars, held every Thursday at 5:00 pm EST. Next week, we will discuss a cybersecurity stock we recently entered and one that we are eyeing closely – what our targets are, where we plan to buy, as well as where we plan to take gains.

I/O Fund Equity analyst, Royston Roche, contributed to this analysis.

Recommended Reading:

• Cloudflare Stock Misses On Cash Flow In Q1
• Microsoft – AI Will Help Drive $100 Billion In Revenue By 2027
• CrowdStrike Stock: Cloud Darling Reports Weak Sequential Key Metrics
• Cybersecurity Continues To Lead Cloud Stocks