Palo Alto Networks, Inc. (PANW) Earnings Call Transcript & Summary

All right. I think we're all set to go here. I'm Walter Pritchard, software analyst here at Citi. Happy to have with us Nikesh Arora, the CEO of Palo Alto Networks. Nikesh, welcome.

Thanks, Walter.

Great. So I guess what I'd like to start here is just you've been in the role about 2 years and a little over 2 years, I think. And could you just walk us through sort of what you set out to accomplish as you joined? There's been a lot of changes at the company, a lot of them strategic in terms of markets you're focused on and so forth. Could you help us understand sort of where you are along that process of transformation of the company? And then more importantly, kind of how we think about things going forward now that's -- now that we're 2 years in.

Thanks, Walter. And thanks for having me here. And as we talked about 2 years ago in November, I was new to cybersecurity, I didn't understand cybersecurity space, and there was -- this is my first call in the enterprise play after Google. There's some elements in that enterprise. I spend a lot of time talking to customers; talking to you, guys; talking to lots and lots of charters in the space, and studying the cybersecurity industry. And I realize we had a really good firewall business, a phenomenal one, still strong and actually since our firewall -- as well as a bunch of security subscriptions. But we had forays in a bunch of other categories, which I think were right categories because the company is really thinking about cloud security, thinking about remote access, and thinking about some element of a data-oriented, AI-oriented security strategy. But we didn't have enough help today. So we have a bit of catch as you can revenue or billings in there. So the last 2 years, we've spent a lot of time and effort building a cloud security platform, building a data analytics-based approach towards security around Cortex. And I think launched through a combination of organic and inorganic capability, we've shown that we've actually been able to build platforms and become kind of industry best of breed, if you will, in multiple categories. We were in Magic Quadrant far-right corner in firewalls. Today, we think we could be in 5 different such quarters between Prisma Cloud, Prisma Access, Cortex XDR, Cortex XSOAR and firewalls. So in the 2 years, ability to get there. Now look, sort of 2 other thoughts -- that one product of getting the products right and getting to be more of a cybersecurity partner of choice as opposed to firewall vendor, which is like having to see 100 CIOs and CSOs and said, thank you for coming. I really appreciate it. We're seeing you because you're a new CEO of the space. But honestly, our network security team buys firewalls, and they'd be buying firewalls for more than 10 years and did all the features with the firewalls. So this is not going to be a long conversation. Today, when it comes out about cloud security, digital transformation, moving you to a -- away from MPLS and SD-WAN and remote security, now that we're on cybersecurity. So I think we've climbed the sort of -- one of the hurdles of being a multiproduct company with different platforms and being a cybersecurity partner of choice. The second aspect of that is going to be great. You can build products. You can actually go sell them with the sales force across all these categories. And I think our most recent quarter as this [ premier ] has shown that we can take something and go out and build those to $2 billion billings in new categories. About a year ago, I talked with investors and people on The Street, they're like, look, many of the companies have tried it in the past, many cybersecurities stalwarts have tried it, and it's a hard task to get done. We cannot go fix a very strong one product company and actually build a meaningful revenue stream or billing stream in a separate category. And I think much more comfortable now after this past 1 year that we can do it, and we found some model between our core sales team and teams that sell this. This is a lot of work to be done in terms of streamlines and these things, streamlining some of the stuff, product categories and product capabilities, but I feel a lot better today than I did almost 2 years ago [indiscernible].

And how do we think about the sort of transformational or strategic moves that still need to come at a high level? What would you tell us still to sort of think about from that perspective?

Look, I mean, I think if you're an investor of Palo Alto or a prospective investor of Palo Alto, the biggest challenges 2 years ago in this [ guidance ], can you go build an enterprise company and take it forward. Can you actually build a multiproduct business in cybersecurity? So hopefully, we've proven that with me and the team that we can actually -- we are different from other people with [ private ]. And hopefully, we have some trust from our investors that -- we showed a slide in the quarter presentation where we've taken 4x the business plan from every one of our acquired companies. So we have shown that when we go make acquisitions, we actually understand the market, we pick the right players, we pick the winners, and we actually will be able to then, in a short order, integrate them and amplify their business plan. And that's hard to do. 18-month time frame is hard to quote what the business plans are, but we have been able to do that across many of the companies that we acquired, and some of them are still not there yet. We still have to integrate the cloud with industries acquired maybe 4 months ago. So we acquire them, we integrate them in 6 to 9 months to 12 months on the outside. We build on market capability around them, and we go and convince customers that this is the right product to get in Palo Alto Networks. So we should have that credibility. If you look at historically, M&A has always been a part of an enterprise company-scale strategy. Look at Cisco, Salesforce, SAP. Look at the large $100 billion, $200 billion enterprise companies, there's always an element of acquiring product into the company and lighting it up to go to market full force. Now we're very careful. We don't buy customers because they cost a lot more money in terms of multiples, and I don't need more customers. We have the customers. I buy product. I buy product, which is leading edge, best of breed that allows me an on-trade customer, allows me to take the entire portfolio of Palo Alto products and sell it to them or allows my existing customers to get more capability integrating Palo Alto products.

Great. Maybe we could turn to talking a little bit about how sort of COVID is coming as a wrinkle here. You made, I think, a number of comments on the last couple of conference calls. And so mainly looking forward, how you think about how this landscape plays out, both what impact it's had on the threat landscape as well as how customers are interacting with vendors such as yourself.

Yes. So I think, Walter, net-net, COVID is a huge positive for technology and a positive for cybersecurity. If you look across the world, the only thing that's working is [ that ], there's an e-commerce capability or some form of technology that is enabling your life, whether it's your groceries or your food delivery or whatever have you. It's -- the enablement is being created by that. Volumes are going up on all kinds of social media center. So you're seeing that working. The more you enable your business with technology, the more security it needs. So I think it's a net positive for us. And it's a net positive that customers are on the margin, more risk-averse than they were 6 months ago. So they are trying to consolidate towards larger players, and they want consolidation and want simplicity in their IT stack, their security stack. That's a net positive to us, us having more topical products today as people are moving to the cloud, starting cloud security. We laid out [indiscernible] cloud security deals in the market against anyone. So that's useful for us, us having competitor to XDR and XDR with CrowdStrike. It's topical because people are churning off Symantec and McAfee and trying to look for new solutions. So we believe we have the right products. That's helping. So COVID actually is a net-net positive. The only cautiousness I have around the COVID impact is an enterprise sales cycle is 6 months long. So we're still not 6 months into COVID. And a lot of the performance could be a lot of work that have been done prior to COVID. There's a lot of interesting things happened during COVID. And the question is if COVID lasted 12 more months, there has to be some pain that is going on from an economic perspective for many of our customers and we will get a -- that impact was done. There's a lot of positives. There's a bit of negative, and the uncertainty associated are how long COVID last is an even good reason for us to be cautious. If you tell me COVID's gone tomorrow or gone 6 months from now, we can all be more bullish about our expectations.

And you mentioned there displacement of some of the players in the market. To what extent are you seeing customers willing to accelerate those displacement-type decisions versus customers sort of stepping back and saying, I don't have the money or I don't have the sort of wherewithal right now to do big projects where it might involve displacing a big vendor.

I think generally, people are more focused on what needs to get done in their tech stack. So most of the clouds are accelerated. Remember, SD-WAN and Prisma Access is a cost savings for the customer. They can ultimately save 40%. That's always a useful project to get done. If you can help me reduce the cost by 40%, largely will take that and find something else because everybody is watching their P&Ls carefully. So cost-driven projects are still attractive to our customer bases. They are getting stuff done. Surprisingly, during COVID, more -- because customers aren't traveling, they're still sort of focused on getting stuff done. They're actually getting more stuff done in COVID times than they were getting before COVID. Happening to us, happening to everybody else. So I don't think the activity is down. I think on the margin, yes, of course, they're being cautious about big projects that they undertake. And software projects are more preferred over hardware projects because hardware requires taking physical delivery, going to data center and deploying cargo. Software, I can turn Prisma Access on and Mobily for our entire user base without actually having to go touch each box that I'm shipping. So there are some micro trends underneath this which are also helpful in the industry.

Makes sense. I want to go back to the sort of transformation that you've talked about at the company. And I think one area we haven't hit on is on the go-to-market side. And so you brought in a new gentleman as President. I think in the first year that you were CEO, there's a lot of focus about all the changes that happened within sales. Can you talk about sort of where we are today with the sales force, and especially how adept you think they are at selling this product portfolio, which has changed -- or evolved pretty substantially over the last couple of years?

Walter, a point -- nothing tells a story better than numbers, right? We did $1.4 billion in billings, largest quarter company has ever done, in the midst of COVID. We did $928 million of billings of next-generation security, surpassing our estimates of $815 million, which we thought was going to happen in -- as recently as 4 months in. So I'm very excited about the execution that the company -- that the sales teams are being able to pull off, especially in this environment. So I think we found a balance between all the people we brought in, all the changes we made that people are fired up. And I was saying this to one of your investors earlier that the big change has been the quality of our products has gone up drastically or wonderfully in the NGS category that our salespeople are excited about [ to be pitching ]. So we've talked about a customer where last 4 or 5 quarters ago, we sold a $10-plus million firewalls and all that quarters, we sold a $10-plus million Prisma, [ all that quarters ], we sold a $10-plus million of Cortex. Now that wouldn't happen if we didn't have Prisma and Cortex. And that's happened by the same sales team that sold firewalls. So you can see that their previous capacity and capability of just being able to go into a customer base and expand your portfolio, that is the long-term scalability with an enterprise. If you have customer relationships, can you bring capable products that integrate new products and drop them to the same customers and give them better value. If you can, that's a win because it's a way harder acquiring new customer. We must sell into an existing happy customer. Just purely economical. So we have the sales force. We have the relationship. Our NPS scores are high. Our customer success scores, stats scores are high in our customer base. So I think it's the right setup for us to be able to bring great products, to actually bring new products because your reputation is at stake over the quality of the product that you're going to deploy to customers.

Got it. And I want to -- before we continue, I just want to drive viewers' attention to -- on the panel on the left of the conference session, there is a spot to put in questions if anybody wants to submit questions here to the discussion, and then I'll get those through e-mail. So on that point around sales, I agree, you've done, especially in the last 2, 3 quarters, that's really come through. I think you used -- tended to do fiscal year. I think in the past, you had made some moves like put in place these speedboats, for example, that helped to drive some traction on some of the newer products. Are there any major moves that you've made on the sales and marketing side that you'd highlight going into fiscal '21 here? Or is it sort of more at the point where things are evolving from the strategies you've put in place over the last couple of years?

That's a great question, Walter. I think you may have seen that the last 2 quarters, we snuck in an ARR metric for NGS business. Because I think if you step back, you look at it, we have a lot more comfort now that we believe we have the product portfolio. We can sell the new product portfolio. We can do it in an efficient and optimized manner with our core team. So now the question is what's next? The question next is, let's go create more scalability. The more scalability means this will drive more NGS revenue. And more NGS is better for our business. So -- and we'll talk about this separately. You asked me about the margin profile of additional NGS, but we'll talk about it later. So the question, okay, what do you need to continue to be really successful? Next thing you need to continue to be successful in the business, make sure that all of our next-generation security products are being deployed and consumed more like SaaS businesses. So there's a lot of focus this year in making sure that as we sold a lot of NGS, let's make sure it gets deployed. Let's make sure it gets consumed because that consumption allows [ NRR ] to grow in the future meaningfully as well for these products, and there's still a lot of that near term because these things are 2- to 3-year terms. So we have 1 year, 1.5 years to make sure our customers who bought all those products are really happy. It's a very important motion for us because the firewalls, we're going to ship the firewalls. The customer does want other firewalls for years. Right? So there's a little bit of -- and there is -- this one's for deployment in our NGS products versus Mobily products. So a lot of focus on the sales team to sell into customers and make sure they deploy it. That's just high game for us that we have to make sure we do. But there's no major shift in our incentive program that we're doing, actually.

Got it. Got it. And then I guess on that side, you mentioned ARR. Is this that you're conditioning your salespeople more to sell along the lines of ARR and to drive upsell, not necessarily land with large deals? Can you just comment on sort of where you're focusing salespeople from a kind of metric-incentive perspective?

So the salespeople continue to be focused on TCP metrics because that's what our model has been. That's been very successful. It allows us to keep our durations strong and keep our cash flow margins, right? They are one of the categories like Prisma Cloud, which lends themselves to a more shorter lease year or shorter sort of contract duration. That's about 2 years compared to others of about 3 years. That's the only thing that's going on. The focus actually is to make sure that once you sold something to a customer, make sure to deploy it ASAP. And make sure once they're deployed, they're consuming because our Prisma Cloud is slightly different because it's -- we keep adding more modules and we drive more consumption and value. So that's the only minor difference is more product category compared to peers.

Got it. That makes sense. And then, I guess, relative to this transition you had going on in the business, can you talk about -- a lot of these new products are in new categories. How much of it cannibalizes budget that you might have seen on the firewall side? Is there any direct cannibalization of firewall sales? What are you seeing manifest itself in terms of conversations with customers as you're trying to get budget share?

I prefer using the word sort of replacement or transition rather than cannibalization because firewall capacity is needed. If you stop doing it in your data centers, [indiscernible] AWS and GCP either. You still need a firewall inside. So in that case, it cannibalizes a hardware sale, but it compensates the software sale. Do I need a firewall to make sure Walter can dial in from his phone? Yes, of course, you do. Back to the data center. If I choose not to do it in the data center, I put SD-WAN and I put Prisma Access on Walter's laptop, and then I can go make that happen from a smaller office or from a remote product. So that is on the software swap. So yes, we do see -- you're seeing swaps between hardware and software form factors, but I have not seen cannibalization in the space. I'm actually beginning to think long term it's a net positive because you're seeing more consumption of cloud. You'll see more tech enablement of our customers. You're seeing more people deploy more and more remote solutions. So I think there's a net positive to overall spend, and you're seeing that in the numbers.

Got it. Yes. Okay. That makes sense. And then as it relates to these -- there's the number of next-generation security categories that you're in, which of those do you think you're in the strongest competitive position? And then which of these categories do you think you have more work to do, either with the product or with your own sales teams or otherwise, to be in a competitive position that you'd like to be in?

Look, I think Prisma Cloud is extremely strong because we have 1,800 customers from scratch from 2 years ago, and we sell into customers who are typically deploying GCP, AWS, Azure. So we're dealing with the native cloud provider as well as ourselves going on top of that and selling them cloud security. That takes -- that's really good. We see no competitive sort of -- we don't see any clear competitor who can do as many things we can do. We'll see a sliver competitor once in a while in some of those customers. And over time, we think the merge can't be all that complex. So very excited about that. And the way to track that will be the number of customers we would acquire in that space because over time, it seems that consumption for every customer grows. Really excited about Prisma Access. We declared a number of $90 million Prisma Access for CloudGenix this quarter. That compares to Zscaler, which I think is [ $131 million ] 2 quarters ago or something. So we're assuring you that, look, when we put our hearts and minds towards building a better product in the category, we actually can get to such a scale and start looking at what somebody else is doing. Excited about XDR. We think they have great products only 6 months in. So we start to work in being able to be in more competitive situations against us, right? But the key focus is to be in more -- bringing more deals. XDR is a carved space with Cylance, Carbon Black, SentinelOne and us. But 2 years ago, if we asked how was Palo Alto a contender in end point protection, we were not. Two years in, we're 1 of 4 or 5 vendors in XDR. We were the first XDR launched in the world. So we actually defined what XDR was. So really excited about it. It's still early days, but we can do more work in the execution of that product. Excited about Prisma Access, excited about Prisma Cloud. Very excited about the IP security capabilities we're building in our firewalls. We think it's still easy add to our firewall estate of thousands of customers who deploy our firewalls.

And in those 2 areas in Prisma, I guess, specifically, Prisma Cloud and as well as in Cortex, you have incumbents who are in those markets who are sort of trying to hold on to the base that they have or in some cases, selling a product alongside the product that they have been selling on a legacy basis. Who do you look at as the primary competition in those 2 markets? Who is the -- who has the mind share? And who are you focused on the...

On Prisma Cloud, we don't see one competitor. Either customers are just using tools that GCP, AWS and Azure gave them. If we go to multi-cloud, then we'll figure out a way to make it work across multiple clouds because GCP tools don't work in AWS. AWS tools don't work in GCP. So you need something that integrates across those. So you have a customer that integrates themselves or they buy Prisma Cloud, right? That's what we see over there. But there's a sliver of competitors who will do container security or workload security or sell [indiscernible], but there's nobody who does the 7 launches that we have. On Cortex and XDR, as I said, we see CrowdStrike, we see Cylance, Carbon Black, SentinelOne, those guys, but it's early days with [ 12,000 ] customers in 2 quarters, which is great. Part of it's conversion, part of it's existing product, customers part of it, new customers. But we have won deals against all of them. So we feel comfortable that we have competitive product in the space. MITRE viewed it the best ranking a few months ago in that category. So on Prisma Access, it's pretty much easily hardware sales. So people will just buy more 400 firewalls in the data centers to get more and more capacity. And typically, competitively, we'll end up against Zscaler.

Yes. Got it. And then going back to the appliance business. I think when you gave the guidance for the upcoming year, you talked about flat to slightly up product, which I think there's been higher expectations in the past. That number seems pretty achievable just based on it being kind of flattish. But how conservative is that? Obviously, you had some challenges a year ago on that business. And just trying to get a sense as to we have a tougher macro, so it would make sense that number is lower. But it does seem pretty low. Just wanted to understand sort of what you've built into that forecasting scenario around flat to slightly up.

I'm not sure when we'll get there. But honestly, internally, we look at Firewall as a Platform. We look at how many firewalls can I sell irrespective of its form factor. I know the product part gets called out separately in the P&L because it has a revenue profile that is different from ratable revenue profile, and it impacts EPS and margins for the year. But we had a customer call, a customer call who said I'd like to increase my capacity for remote secure work. I had a choice installing new firewalls and deploy them in 15 locations, taking 3 to 4 months, or I had a choice of giving him Prisma Access with cloud-based firewall. I gave him Prisma Access, right? I'd rather give him software solve because software is easier to upgrade. Its total cost of ownership is lower. If I sell you a hardware box, you have to upgrade every year when I launch a new software release. And that's on you. And people get nervous deploying software and spend 1 year upgrading. It's a lot easier if I keep upgrading a software every month in the cloud. They don't have to get involved in order to [indiscernible]. So the software solve is a much more elegant solve, better security, low cost of ownership in the long term. So I think we went through a transition in the industry. Some people don't have the software capability on their side, and some will [indiscernible] to their customers. And some people like us who have the software capability who'd rather sell software capability to our customers. So I'm also telling that I prefer software over hardware firewalls because it's a better quality of revenue and lower cost of ownership for the customer and there security posture. So for all those reasons, I guess -- that's what's happening. Firewalls grew [ 19% ] this quarter. So we're not losing share. We're just shifting from hardware to software, and that's part of our mission.

Got it. Okay. That makes sense. And then I guess the question I've had come in and part of a question I had combining the 2. So you've -- from an M&A perspective, you have done a decent number of deals. I would say none of them have been large deals, maybe bordering on mid- to large. How do you think about the balance sheet limiting the size of the deals you do? And you've used a little bit of stock in those deals. How do you think about something bigger that might involve stock and be more transformational as a deal?