Palo Alto Networks (PANW) Management Presents at Barclays Global Technology, Media and Telecommunications Conference (Transcript)

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About: Palo Alto Networks (PANW)
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Earning Call Audio

Palo Alto Networks (NYSE:PANW) Barclays Global Technology, Media and Telecommunications Conference December 5, 2018 1:00 PM ET

Executives

Kathy Bonanno - CFO

Analysts

Saket Kalia - Barclays

Saket Kalia

Good morning, everyone. Welcome to Barclays TMT Conference. My name is Saket Kalia. I cover U.S. software here at Barclays. Very happy to have with us Kathy Bonanno, Chief Financial Officer of Palo Alto Networks. We also have Amber Ossman, Investor Relations here in the audience.

We’ve got about 25 minutes together. We’re going to spend the first 15 or 20 minutes, maybe kind of 15 minutes going through some fireside chat. And let’s make this interactive. We’ve got a mic going around, so feel free to pipe in with some questions. So with that, Kathy, thanks a ton for being with us today.

Kathy Bonanno

Very happy to be here. Thanks for inviting us.

Saket Kalia

No, absolutely. It wouldn’t be a conference without you. So, Kathy, just last week, Palo Alto reported what we thought was a really solid quarter of growth and market expansion. But just to make sure that we’re all in the same page, could you recap some of the highlights from this past quarter that you were particularly proud of.

Kathy Bonanno

Yes. We had a really great quarter and our first quarter of fiscal 2019. We had revenue growth of 30%. We had billings growth of 27%. We saw growth across all of our geographies, 29% growth in the Americas, 35% growth in both EMEA and APAC. So we had a really nice quarter, good performance across the product portfolio. So we were really pleased with Q1. A nice start to the fiscal year.

Saket Kalia

Absolutely, I agree. So before we dig into the business, we’ve got tons of questions on the business. Let’s just talk about some of the changes at Palo Alto Networks, most notably Nikesh Arora’s first six months as CEO and more recently Amit Singh’s appointment as President. Really high-level open ended question, but how has the business changed, if at all, with some of those changes?

Kathy Bonanno

Yes. I think Nikesh coming in as our new CEO has approached the transition into the role the way probably most CEOs approach this new journey and that’s trying to first learn the business and understand the business. And so he spent a lot of time with customers, partners and employees really diving into the details of the business and trying to pinpoint what the direction of the company is, what are the strengths, where do we need additional focus or emphasis and resources.

So he’s trying to figure all of that out in his first few months with the company. And so he spent really a lot of energy diving into the business, spending a lot of time internally with our product teams and our sales teams and then externally meeting with a lot of different customers of various sizes and around the globe. We’ve had an Ignite event in EMEA that he’s attended.

And so we’ve really had the opportunity to give him a great Palo Alto Networks’ one-on-one, two-on-one and we’re probably working up to graduate level courses now. So he’s really been immersed in the company. And I think what’s been terrific is that if I as CFO and having been with the company for four and a half years, if I wrote down on a piece of paper, “Okay, these are the really strong areas of the company and these are the areas where I think we can do better.” He’s coming up with a similar list.

So I don’t think I would say that anything’s really pivoting or changing significantly. What I would say is he’s bringing a lot of terrific discipline and focus to the areas where we need it frankly. So he talks, for example, about our cloud security offerings and the potential that we have in that space. And we really think that we have a lot of potential to grow in that space and to become a real leader in cloud security as companies start their journey to moving more workloads into the cloud.

And what he’s done is to establish these speedboats which really are just greater focus and emphasis on our R&D development and our go-to-market initiatives around the cloud opportunity. And so what we’ve done is we’ve brought together the teams that were already working on both developing cloud R&D products and security products and also working on – we’ve had a small overlay sales organization working on selling the cloud product because it’s newer to our company.

And so our general sales force needs a little bit of assistance in terms of selling. And so we’ve had this cloud overlay team. So bringing the leaders of those teams and those resources together, they’re physically sitting together, they’re developing business plans. And Nikesh is saying, “Look, you’re accountable for this. You’re accountable for the success of this. You have decision making authority. We have high level leadership focused on this.”

And so it’s giving us a lot of momentum and energy around driving those parts of our business faster. And that’s the kind of change that I would say that he’s bringing to the company rather than wholesale, let’s flip everything upside down and be a completely different company now. He’s coming in, finding our strengths, real strength in network securities, don’t break that at all, keep that going, keep that machine going and let’s augment and build upon the good start that we’ve gotten in some of these newer areas and make those even better.

Saket Kalia

That’s great. That’s a very thoughtful approach in my view from what he was trying --

Kathy Bonanno

Yes, I would agree.

Saket Kalia

Let’s dig into the business. Before we even talk about some of the specific areas for the product or subscription, I’ve to say that one of the things that I found particularly encouraging is the acceleration that we’ve seen in the number of customer additions in the last year. Now clearly customer adds is an imperfect metric for a variety of reasons. But the question is, academically how do you think about Palo Alto’s ability to continue to add new customers? And how meaningful is the metric internally if that makes sense?

Kathy Bonanno

Yes. We’ve been adding between 2,500 and 3,000 customers a quarter for the past several quarters. It’s been about a year and a half since we started adding that many customers every quarter. And obviously we’re very pleased with our ability to continue to acquire new customers. We still think that we have a lot of room to expand our market share and that’s both acquiring new customers and expansion within our existing customer base.

So we’re not a 100% penetrated in every customer that we have. So that’s a huge opportunity for us in addition to just acquiring new customers quarter-after-quarter. Still a lot of customers out there for us to go get, so we’re very focused on that obviously. And particularly in EMEA and APAC where we’re smaller, still plenty of room for us in those regions to acquire new customers.

But then our motion has always been, you land, you acquire the customer and then you expand. And we’ve continued to show our ability to expand our lifetime value once we acquire a customer and that metric has been growing in this most recent quarter our lifetime value of our top 25 customers increased 45% year-over-year. And we’ve continued to see that quarter-after-quarter nice growth in lifetime value as well.

Saket Kalia

Absolutely.

Kathy Bonanno

That’s the combo, definitely.

Saket Kalia

Sure. So let’s shift over to some of those other product line items starting with product revenue. Nice acceleration that we’ve seen in the last couple of quarters. One of the things that I personally confuse in the past is this notion that the market for product revenue is similar to the growth profile to overall network security. Why is that wrong in your mind and how do you think about it? Does that make sense?

Kathy Bonanno

Yes. Well, we do look at product growth separately from overall network security growth. Network security includes a lot of things, including the subscriptions – for our company the subscriptions that attach to the firewall, we have four of them and that’s a very significant business for us as well as support, right. So it’s not always just the renewal of support driving the growth in the business or the subscription sales but the profit sales as well. So you have to kind of think about those three things separately.

If we look at our product growth, we’ve been growing very nicely over the last several years or if you look at industry product growth, then it’s a much smaller number. Then you see an overall network security growth. So sometimes network security growth is maybe expansion of subscription sales or expansion of support sales but not necessarily being the same kind of product growth. But we really have been growing all elements of our business very nicely.

Saket Kalia

Absolutely.

Kathy Bonanno

Does that answer your question?

Saket Kalia

It does. Very helpful. I think the other notion that we all have frankly is this idea of a refresh cycle, whether it’s a refresh cycle on the overall firewall market, whether it’s a refresh cycle specifically for Palo Alto’s customers? Open-ended question, but how do you think about that as a driver?

Kathy Bonanno

Yes. People talk to us about these buying cycles in the industry and for Palo Alto Networks we’ve been able to grow really consistently over time. We did have a period of time in fiscal 2017 where we had some productivity issues with our sales organization. But aside from that, that was driven by some organizational changes that we made and we rectified that. And aside from that period of time we’ve really been able to grow our product revenue very nicely for long periods of time, regardless of whatever buying cycle has been out there that people talk about.

We really see the opportunity to us in terms of market share as being very significant to continue to grow. And when people talk about refresh, they’re really talking about products because that’s what gets refreshed, right. Your firewalls get old after five years perhaps and so you want to get the latest technology and your capital budget is there available for you to renew that or refresh your product after five years, right. So it’s really kind of a product question.

And so we’ve been growing product revenue very, very nicely for some period of time, regardless of whether there’s been a buying cycle or not. If I look at the year-over-year growth in the industry of product revenue, you can definitely see a peak in terms of fiscal or 2015 calendar year. But aside from that, I don’t really see our current rate of growth in the industry suggesting some big bubble or some big cycle.

So we have a lot of market share opportunity in front of us in terms of industry growth and industry capacity. And so we think we have a lot of runway to continue to grow. On top of that we can talk about our own internal product refresh opportunity and while it’s an important opportunity for us, the cohorts right now that we would be refreshing are relatively small compared to the customer cohort size as we’ve continued to grow as a company.

So five years ago we had acquired about 5,000 customers a year and when you compare that to today where we’re acquiring 2,500 to 3,000 a quarter, the magnitude in terms of opportunity to us, the new customer acquisition and the ability to expand lifetime value within our existing customer base is a much bigger opportunity than refreshing a cohort from five years ago. But that opportunity is important and it continues to grow year-after-year-after-year into our future. So we think that we have a lot of opportunity to continue to grow product.

Saket Kalia

Absolutely. So we’ve got about 12 or 13 minutes left. I want to make sure I open it up to the audience before we pivot over to subscription. So maybe one of the questions that I wanted to follow up on, Kathy, was going back to last week’s call, one of the questions that I got was around the services billings business which is subscription plus maintenance I guess.

And it looked like services billings was perhaps a little bit more seasonal, the quarter-over-quarter that is, then we maybe see in the past especially kind of given the acceleration in product. Is there anything to really consider there whether it’s seasonality or mix or frankly expectations, right, in terms of comps because that of course can affect how we all model? How did you think about the services billings business kind of coming out of this last quarter?

Kathy Bonanno

Yes. We didn’t report on services billings explicitly but if you just take product revenue as a proxy for product billings, which is an appropriate thing to do, you can see that our services billings grew about 25% year-over-year. I think that’s a really strong number.

In terms of the quarter-over-quarter compare, if you look at Q1 quarter-over-quarter performance I think we’ve gotten some comments that maybe it’s a little light relative to what we thought last Q1 in terms of quarter-over-quarter performance.

But the thing I would point out to people is that the Q4 compare is different as well. We had a much stronger quarter-over-quarter performance in Q4 of '18 relative to Q4 of '17. So I think that explains the difference. 25% year-over-year services billings growth is pretty strong and 27% year-over-year in total billings growth, I’ll take that.

Saket Kalia

All day long, agreed.

Kathy Bonanno

Yes.

Saket Kalia

So within the services billings part of the business, it’s really the unattached subscription piece that is growing clearly the fastest, right, and just remind everybody, this is the piece of the business that is not attached to the sale of an appliance. And so the question is, I think at the end of '18, and Amber keep me honest, I think we said that it grew north of 60%, right, maybe sort of north of 270 million in kind of run rate sort of billings. The question is how do you rank order the products inside that unattached business in terms of size, maturity, however you look at it?

Kathy Bonanno

Sure. So the nonattached products as you rightly explained are about $274 million annual billings run rate as of our Q4 '18, which was the last time we reported that metric. We report on that semiannually in Q2s and Q4s. So nice size business growing at over 68 – growing at about 68% year-over-year at that time that we last reported it. So really strong growth within the nonattached subscriptions that we offer. There are nine of them now.

So we have Traps which has been around for about five years – four and a half years and our VM-Series which are the largest most mature, if you will, even though they’ve only been around for four or five years. VM-Series I think has been around about six years. Most mature in that category of nonattached offerings. And so they make up the bulk of that $274 million run rate today. But all of them are growing very nicely and we’re very excited about some of the newer cloud offerings as well as Traps because we’ve just acquired a company called Secdo which provides EDR capability and we’re integrating that into Traps.

And we’re expanding the technology, the EDR technology so it’s not just available on endpoint but it’s available on throughout our entire platform. We’re calling it [XER] [ph] at the moment. I don’t know if that name will stick. But we’re going to be offering that through the application framework in early 2019. So really excited about all of these products and we’re placing a lot of emphasis obviously on making sure that we execute and that we have our operational strategy in place so that we can really seize the opportunity available to us.

Saket Kalia

Sure. Maybe the latest addition to the unattached piece of the business are the Evident.io and the RedLock acquisitions and there’s just so much to talk about there, but one of things I really want to hit on because it’s a question that I’m sure you get and we all have, right, is we have the new CEO at Palo Alto. We’ve increased the size of the convertible bond. Can you remind us what management’s view is on sort of M&A philosophy going forward?

Kathy Bonanno

Yes, you bet. So I want to just touch on the convert for a moment. We did $1.5 billion convertible debt offering just a few months back and it’s been about six months now. And as a reminder, we had an outstanding convertible debt that we issued five years ago now almost. It matures in July of 2019. And that was a $575 million convert. And so when people ask me, “Well, why did you do a much bigger convert? You did 1.5 billion compared to 575 million. That must mean that you’re gearing up for some massive M&A, right?”

Well, the reality is if you look at our debt-to-EBITDA profile, we’ve grown significantly as a company. And so our debt to EBITDA ratio is actually lower today than it was five years ago when we issued the initial convert, the 2019 that’s maturing in July. And so if you just think about capital structure and the amount of debt versus equity that you have, it’s a relatively low cost way of raising capital and our debt-to-EBITDA ratio is very manageable and we think very appropriate for a company of our size.

We did the original convert and we have done some M&A over the years, but it hasn’t been anything earth-shattering or extraordinary. What we have done and what Nikesh has continued to talk about doing is if these acquisitions are on our roadmap, if they make sense in terms of our overall security strategy, if we can integrate the technology into our platform and make our offerings better and do so more appropriately through an acquisition rather than trying to build it ourselves or partner with somebody, so we always look at all of those options obviously.

If the best choice is M&A in terms of accelerating roadmap and what we can bring to bear, we also want to make sure that it’s a market of size. That it’s not just a little fiddly market or opportunity that we would address that we believe that we can be a significant player in that space, that we can be number one or two. And that we think that the combination of the new companies plus Palo Alto Networks brings some sort of benefit. So that bringing it into Palo Alto Networks makes the company and the combination better somehow. And so that’s the way that we are thinking through M&A.

Nikesh was very explicit about that on our recent earnings call. I think that he tried to be very explicit and address head-on this concern about M&A and has tried to I think be very practical in how he describes his approach to M&A. It’s really not much different from the strategy that we’ve had all along.

Saket Kalia

Yes, absolutely. I’m glad you put a finer point on that. So we’ve got about five minutes left. I want to pivot to margins and such. Before we do that, any questions out here in the audience?

Kathy Bonanno

There’s going to be a test later.

Saket Kalia

So, Kathy, let’s talk about margins because we’ve all focused so much on billings and product and subscription and such and M&A, there is still very much for margins story here and I want to make sure we shed some light on it. The question is, can you remind us what you said historically about margin expansion before any M&A, right, because we still are digesting Evident and RedLock, so meaning for organic margin expansion. And related to that, can you just remind us what we’re sort of layering in for M&A costs in this next quarter that you’ve guided to?

Kathy Bonanno

Yes, sure. So margin expansion, we have historically talked more explicitly and given guidance for a longer period of time. Never really given operating margin guidance per se. We are currently giving guidance for one quarter at a time and providing revenue and EPS guidance. So we’ve got revenue and EPS guidance out there for Q2 and you can kind of back in to what you think operating margin guidance reflects from that guidance that we’ve provided.

In Q1, we expanded operating margin by about 150 basis points, including M&A. So if you strip it out and look at it organically, it’s better than 150 basis points year-over-year growth. And so for the first half of this year, our guidance reflects continued operating margin expansion in the company. And we have talked – we have a framework out there, financial framework that we had talked about historically that looks at our progression as a company over time and how we will – our view on how much opportunity we have to continue to expand operating margins.

And what we’ve said is that over the long term of the company, we’ve sort of partitioned the company into like a high growth phase and a growth phase and long term and that’s the financial framework construct and that’s how we’ve communicated what we think we can do over the long term in terms of margin expansion. And we said that we believe that operating margins should be greater than 70% in the long term for the company. Right now, we’re about 20% operating margins on a non-GAAP basis, right?

Saket Kalia

Sure.

Kathy Bonanno

So that’s kind of the goalpost where we are today and then what we’ve said about long term where we think we should be. And so we definitely believe that we have more opportunity to expand operating margins over time. We have talked about obviously wanting to focus on organic operating margin expansion and holding ourselves accountable for that, because when you do M&A obviously you bring in new costs that you can’t necessarily forecast at the time that you’re making these statements.

Saket Kalia

Of course.

Kathy Bonanno

So we’ve talked in our modeling points this most recent quarter about $10 million to $15 million of incremental expense associated with RedLock and Evident and Secdo acquisitions that we’ve done recently on our operating expense profile.

But I will say that we’ve been able to get a lot of leverage out of the business over time and just over the past two years if you just look at operating expenses as a percentage of revenue, and I’m sort of discounting gross margins for a minute only because we’ve had a relaunch, a massive relaunch of all of our products and that has had an impact on gross margins.

So if you just look at operating expense as a percentage of revenue, over the last two years we’ve improved that metric by 440 basis points on that compared to two years ago. So a lot of leverage that we’ve gotten out of the business and our operating margins are in nice shape competitively.

Saket Kalia

Absolutely.

Kathy Bonanno

We feel good about where we are.

Saket Kalia

We’ve got a question up here.

Question-and-Answer Session

Q -Unidentified Analyst

How does stock-based comp sort of play into expense leverage over time?

Kathy Bonanno

Yes. Stock-based comp is another area where we’ve seen a lot of improvement over the last couple of years. So I think – Amber, can correct me but I think it’s of the order of the same magnitude around 400 basis points improvement in our stock-based compensation expense as a percentage of revenue. So we’ve gotten a lot of leverage in that metric as well.

And the way that we think about stock-based compensation expense is when you’re starting out as a company and Palo Alto Networks is a relatively young company. When you start out as a company, you’re offering more stock-based compensation than you are cash compensation because the new company is generally cash strapped, right. And so you want to preserve your cash. And over time that stock-based compensation expense comes down and your actual salary cash expense goes up. And we’ve been making really good progress in that over the years.

And our goal – we realize that maybe three years ago, we’ve been very high and on the high side relative to our competition in terms of that metric. And so we’ve made a real concerted effort to bring that metric down over time. And we want to be competitive. We want to hire the best people. We don’t want to not be able to attract great talent. Stock-based compensation is an important tool. But we definitely know that we need to be competitive with the industry on that metric.

Saket Kalia

Absolutely. With that perfect timing, we’ll end on that. Kathy, Amber, thank you so much for making the time. I really appreciate it.

Kathy Bonanno

Thank you. It’s great to be here. I really appreciate it.

Saket Kalia

Thanks so much, Kathy.