This month, we’ve been looking more closely at the impact AI will have on cybersecurity. We covered CrowdStrike twice recently before earnings here and also after earnings plus a refresher on the product here. On the Essentials side, we highlighted a few companies’ key metrics. On the free side, we published an overview of why the cybersecurity industry will be the next to be disrupted by AI.
Today, we are looking at Palo Alto Networks’ financials, and will follow-up soon with more analysis on Palo Alto’s platform. What we like about PANW is that it gives you the best of both worlds – it has the potential to accelerate in revenue growth from its platform approachits platform approach to cybersecurity and has an enviable bottom line. The value proposition for the platform approach is similar to Microsoft’s value proposition, which is that a platform consolidates many vendors under one umbrella. As AI begins to automate tasks and transform cybersecurity, Palo Alto Networks stands to benefit as a one-stop-shop. Although nearly every cybersecurity company is attempting to acquire startups to become a platform, Palo Alto Networks has a five-year head start.
In the free editorial we published, we highlight that 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 is expected to increase from $8 trillion to $10.5 trillion by 2025. At 12% of IT budgets, what we want to find is the companies that will drive down these costs for enterprises.
Financials:
Palo Alto Networks is GAAP profitable with expanding margins. This has helped PANW outperform against its peers in 2023.
Revenue and EPS:
- Palo Alto’s revenue in the recent quarter ending July grew 26% year-over-year to $1.95 billion. Management guidance in the quarter is in the range of $1.82 billion to $1.85 billion, for growth of 17.4% at the midpoint. This is slightly below consensus of 18%.
- Management is targeting 17% to 19% in revenue and billings growth over the next three fiscal years.
Source: Seeking Alpha
- Palo Alto’s adjusted EPS grew by 80% YoY to $1.44 in the recent quarter, beating estimates by 12.03%.
- Adjusted EPS is expected to grow 40.3% YoY to $1.16 in the next quarter.
Source: Company IR/Seeking Alpha
Margins
Palo Alto is GAAP profitable, which sets it apart from other cloud stocks. Per management: “We are now firmly GAAP profitable with GAAP net income of over $200 million in the quarter.”
The margin expansion below is quite impressive.
- In the most recent quarter, the gross margin expanded 590 basis points YoY to 74.1%.
- The adjusted gross margin increased by 410 basis points YoY to 77.3% and was primarily helped by a higher software mix. The normalization of supply chain costs also helped to improve margins (PANW has hardware exposure) and there were lower costs associated with combining customer service support efforts across the platform. The company also uses generative AI to lower customer service costs.
- The operating margin was 12.98% in the recent quarter compared to 0.99% in the same period last year.
- The adjusted operating margin improved by 760 basis points YoY to 28.4% in the recent quarter. The company’s current business mix and focus on efficiency initiatives have helped to improve margins significantly. The efficiency initiatives include resource utilization and streamlining the sales force.
- The net margin of 12% compares to 0% in the year ago quarter. The company was also able to deliver more profits by focusing on helping their largest customers to upgrade.
- The adjusted net margin of 25% compares to 16% in the year ago quarter.
Looking ahead, management expects adjusted operating margins in the range of 25% for fiscal year 2024, and in the range of 28.5% in fiscal year 2026, with a long-term opportunity to reach the low to mid-30 percentile.
Free Cash Flow:
- Operating cash flow margin of 21% for cash flow of $414 million. Notably, the cash flow margin has been unusually high in previous quarters at 79% margin due to lumpy collections. It was particularly high in fiscal Q1 of last year, ending in October. We are making this note for the upcoming earnings season should cash flow be high again.
- Adjusted free cash flow of 20% for $387.8 million.
The company has managed to generate consistent adjusted free cash flow margins in the past three years, with 32.6% in FY21, 33.3% in FY22, and 38.8% in FY23. The management guide for FY ending July 2024 is a FCF margin of 37.5%. Dipak Golechha, CFO of the company, stated: “This higher operating profitability, strong bookings growth and interest income form the baseline for our free cash flow at higher levels, as we achieved 39% adjusted free cash flow margins in fiscal year 2023.”
Management also stated they are confident of maintaining a baseline of 37% adjusted FCF over the next three years. Some of this longer-term visibility is helped by deferred payments, which were up 400% over a three-year period in Q4.
The company has cash and investments of $5.4 billion. The company repaid 2023 convertible notes of $1.7 billion in cash in the recent quarter. The next repayment is due in 2025 for $2.0 billion and the company plans to settle this in cash.
Key Metrics:
Remaining Performance Obligation (RPO) grew by 30% YoY in the recent quarter to $10.6 billion. Management expects 25% RPO growth annually through FY26.
This statement was quite bullish: “Additionally, we see about two-thirds of our revenue in fiscal year '26, driven by current RPO entering the year highlighting the increase in predictability of our revenue profile.” Not only does this lay a nice foundation for future beats on revenue, but the market tends to reward predictability while it penalizes uncertainty. This really is one of the most bullish things a management team can say.
It’s been discussed on the earnings call that management believes RPO is a better metric than Bookings since it is not impacted by billing terms, such as customers preferring deferred payments in the current environment. This is a common discussion on earnings calls across the board, at the moment. RPO represents the booked business the company expects to recognize as revenue in future periods, and cannot be canceled. The market tends to reward companies that have RPO growth that is higher than revenue growth as it can be a leading indicator as to the health of future revenue growth percentages.
Source: Company IR
Palo Alto’s billings grew by 18% YoY to $3.2 billion. Billings growth is showing a deceleration, although the market was forgiving with strong price action following the earnings report as the company is up against tough comps. Billings grew 44% in the year ago quarter, and so the 18% reported this quarter was better than feared.
Management guidance for billings is in the range of $2.05 billion to $2.08 billion, representing a YoY growth of 18% at the mid-point for the next quarter. They also expect billings to grow in the range of 17% to 19% for the next three years. The guidance impressed analysts. RBC Capital analyst mentioned in a research note, “The company's Q4 results were generally fine as some metrics were better and some were mixed, but the real highlight was the better-than-expected outlook for billings in FY24 and billings growth through FY26.” , but the real highlight was the better-than-expected outlook for billings in FY24 and billings growth through FY26.”
Source: Company IR
Next-Generation Security (NGS) ARR grew by 56% YoY to $2.96 billion in the recent quarter. For FY24 management expects NGS ARR in the range of $3.95 billion to $4.0 billion, an increase of 34% to 36%.
Source: Company IR
Conclusion:
We will dive deeper into Palo Alto’s products and competitive positioning soon. As of now, the chart is not looking like a buy. Although we do not have plans to buy at the moment, we want to be prepared to buy if the chart affords us a good entry, and thus are doing our due diligence now.
Palo Alto’s financials are nearly flawless given the many stumbles its peers have reported this past year. When you combine the unusual performance with an incoming trend like AI-powered threat prevention that can block attacks as they happen and also transform security operations, it’s only prudent for us to put this stock in our pipeline.
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Royston Roche, equity analyst for the I/O Fund, contributed to this analysis
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