A.I. could serve as the next major catalyst for these cybersecurity stocks. Here’s why

Published Sun, Apr 23 20237:12 AM EDT

Deepfakes. Cloned voices. These are some of the growing threats consumers may face as artificial intelligence takes the tech world by storm. While a major headache for customers and businesses alike, the emergence of sophisticated AI attacks could serve as a major boon for cloud companies operating in the cybersecurity space. For many years, cybersecurity cloud companies have harnessed AI and machine learning to stop attacks, monitor suspicious activity and protect businesses. But as generative AI use cases — and the era of chatbots — ramp up after ChatGPT's momentous market debut, many businesses will require better security to fight off more sophisticated threats. This year, many cloud stocks appear to be on the mend from last year's slump as interest rate hikes from the Federal Reserve dented earnings potential and future profits. The sector has also gotten a boost as bond yields have come down from their highs. .IXIC YTD mountain Nasdaq Composite so far this year As investors dip back into the technology sector, cybersecurity stocks across have risen across the board, with the First Trust NASDAQ Cybersecurity ETF (CIBR) up about 7.5% this year. Many of these names are housed in the Nasdaq Composite, up 15.3% year to date. Cybersecurity providers CrowdStrike and Palo Alto Networks are up 25.6% and 38.5%, respectively, year to date. Meanwhile, shares of Microsoft , a security software provider and backer of ChatGPT-maker OpenAI, have gained 19.2%. And those tailwinds could continue. While potentially problematic for businesses, investors and analysts say cloud-computing stocks should benefit from forced cyber upgrades to mitigate new AI-focused threats as society chases innovation. Despite a creeping recession, and fears of dwindling IT budgets, these risks should force companies to prioritize cybersecurity spending, and, in turn, insulate the sector. "Cybersecurity players are going to be an absolute staple in the build out of artificial intelligence," said Sylvia Jablonski, CEO of Defiance ETFs. Recession resilience Despite fears of a looming recession and cuts to IT budgets as companies trim costs, Wall Street views cybersecurity as uniquely positioned to ride out these headwinds, while also capitalizing on AI growth. Even with the run up in shares this year, TD Cowen's Shaul Eyal says many stocks in the industry look reasonable on an enterprise value to revenue valuation. They are also headed toward consistent and healthy growth rates, and they offer solid cash flow generation, he said. "The basket of cloud and cybersecurity stocks offers something for everyone," Eyal said. "If you're a value investor, there's a value play. If you're a growth investor, there's plenty of that within the universe." Many economists and investors are bracing for a slowing macro picture and potential recession, but the sector looks "relatively defensible in uncertain times," with seemingly resilient demand, said Morgan Stanley's Hamza Fodderwala in a recent note to clients. "Since the beginning of the year, the demand environment for security has been much better than feared, with the vast majority of security companies reporting forward year outlooks above consensus/buyside expectations," he wrote, adding that recent survey work suggests IT spending remains a top priority. While most of these stocks have gained to start the year, the analyst sees greater upside in store as these companies focus on margins and show "durable topline growth." He added that slimmer budgets may force companies to shift to fewer vendors, which should benefit "consolidators" Palo Alto Networks and Fortinet . They would be able to "capture more of the security budget in times of greater scrutiny." Finding winners in the space JoAnne Feeney of Advisors Capital Management is placing her bets on Palo Alto Networks, a company with a strong customer base and that is equipped with capabilities to help businesses fighting the new warfront. A transition toward a cyber war in Ukraine could also create tailwinds for the sector, she added. "The threat surface is growing and it's going to grow the more companies start to use generative AI," said the portfolio manager. "The more companies move to the cloud, that increases the vulnerability of companies, so we see cybersecurity as another strong, multi-year growth industry." PANW YTD mountain Palo Alto Networks' stock so far this year Equity research firm Redburn also views Palo Alto Networks as a clear cybersecurity winner, as the proliferation of AI threats creates a "pull-forward" effect in cyber spending for larger businesses. This should heighten the need to invest in companies that have "been first movers" in AI and machine learning, an industry Palo Alto Networks has capitalized on, according to the firm. But who wins over customers may depend on the size of a business. Redburn, for example, views CrowdStrike and Microsoft as superior beneficiaries among small and medium-sized businesses. MSFT YTD mountain Microsoft's 2023 performance "In the small and medium business (SMB) segment, humans are the biggest vector for threat actors; vendors that have curated products at accessible price points will see increased adoption from SMBs as the threat from AI/ML is very relevant," the firm said. Along with its cybersecurity offerings, Microsoft also happens to be a major player in the AI fight among big technology companies. The company announced a new multi-billion investment in ChatGPT-maker OpenAI this year and rolled out AI additions to its Bing search engine . Microsoft faces off against Alphabet , a long-established AI player that recently launched competing chatbot Bard. Elsewhere, RBC Capital Markets views Cloudflare as "one of the best positioned" companies in cybersecurity. In a March note, analyst Matt Hedberg cited OpenAI's move to run some of its network through Cloudflare as a tailwind, adding that other AI providers could potentially follow suit. NET YTD mountain Cloudflare shares this year Cloudflare is also situated to offer security solutions that harness AI capabilities to stop threats from "more intelligent chatbots," he said. To be sure, despite the run-up in shares, longer-term favorable trends and bullish outlook on Wall Street, many of these stocks still trade at a premium to the S & P 500 on a forward price-to-earnings basis over the next twelve months. While well off its PE highs, Palo Alto Networks, for example, trades at 43 times the next 12 month's earnings, compared to a multiple a little above 18 times for the broader S & P 500. The PE for CrowdStrike and Fortinet sit at about 53 and 45 times, respectively. Overall, Wall Street may just be starting to see the magnitude of the tailwinds for the cybersecurity industry, but one thing is certain: "You cannot stop spending on cyber," said TD Cowen's Eyal. "It's a game of cat and mouse." — CNBC's Michael Bloom contributed reporting