Seeking Alpha

Palo Alto Networks, Inc. (PANW) Management Presents at Deutsche Bank Technology Conference (Transcript)

|
About: Palo Alto Networks, Inc. (PANW)
by: SA Transcripts
Subscribers Only
Earning Call Audio

Palo Alto Networks, Inc. (NYSE:PANW) Deutsche Bank Technology Conference Call September 11, 2019 11:40 AM ET

Company Participants

Kathy Bonanno - EVP and Chief Financial Officer

Conference Call Participants

Karl Keirstead - Deutsche Bank AG

Karl Keirstead

All right. Well, good morning, everybody. This is at least my start to day two. Kathy, welcome.

Kathy Bonanno

Thank you.

Karl Keirstead

And David as well is here. Kathy Bonanno is the CFO of Palo Alto Networks. I think a lot of you saw her or listened to her, and her executive team gave, what I thought was, a fantastic Analyst Day last week. So thanks for all that detail, that breadth you offered. I thought it was one of the best analyst days, frankly, I have ever attended.

Kathy Bonanno

Thank you for that.

Karl Keirstead

Yes.

Kathy Bonanno

We work hard.

Question-and-Answer Session

Q - Karl Keirstead

Good. Well, maybe let's dive in because there were some takes from that event that I wanted to ask you about and maybe you could elaborate on. But I think one of the bigger takes for me and investors was the detail you provided about the disaggregation between what you called next-gen billings and kind of non-next-gen or core, let's say.

So maybe you could talk a little bit about that, because I think your guidance suggested next-gen billings growth of like 55%, 60% over the next three years. And given that you gave total billings target, you could back into “core billings” of I think it worked out to be 10%, 12%, something like that. So maybe you could take a minute and broad-strokes talk about what's happening in each one of these two buckets so then we can dive into each separately, if that's okay.

Kathy Bonanno

Yes. Sure. Thanks. And it's not easy to talk about them in completely different categories, right.

Karl Keirstead

Okay. Yes.

Kathy Bonanno

Because we do think that network security, which is our core has been served for a long time using hardware. That type of security, that in-line security that protects all traffic, all users, all applications, that has traditionally been our firewall’s core strength, right.

And we introduced the next-gen firewall as well so that – we still have next-gen firewall security. But the reality is that the form-factor is shifting. And so it's not just a hardware form-factor that we offer any longer.

We also offer virtual firewall and have for some time. And we also offer Prisma Access, which is essentially firewall security delivered as a service from the cloud. And so what we see, if you go look at Gartner or other industry firms that forecast where the industry is going into the future, you'll see that hardware security is sort of – the growth is projected to decline over time.

But what we believe is that what will happen is that the form factors will shift to more of the software form-factor. So that security – that in-line security is still very, very important for companies. And it's not going away and it’s not diminishing the need for that, but the form factors will shift.

And so we're seeing significant growth in our Prisma Access product as well as our VM-Series products. And so that category of network security as a whole, we believe we’ll continue to take share. We believe that we have a real competitive advantage in terms of being able to offer the three different form factors that we offer.

And so in many instances we're driving our customers to consider the software form factors rather than the hardware form factors. So that category as a whole, we think we'll be growing at about 20%. But like I said, that hardware form-factor, we think will decline and we think it's a prudent forecast.

And what we see on the other hand is that Prisma Cloud, for example, our Cortex products, which consist of the Traps product that we've held for some time, Cortex XDR which has the EDR capacity that we offer across the entire network as well as Demisto, which is a behavioral analytics company. All of those products all growing very, very rapidly as well.

So when you combine all of that, you see a mix shift away from the product towards more of a software, and then we have all of those next-gen security products growing very, very rapidly. And it winds up with us projecting out the next three years a 20% growth rate.

Karl Keirstead

Within those the next-gen bucket, Kathy, you mentioned Cortex, Prisma Cloud, Demisto, et cetera, is there one or two that sort of you're relying that are might be a little bit larger that you're relying on driving the bulk of that extraordinary 50% plus growth?

Kathy Bonanno

Yes. We did see really strong growth in the Q4 results really across the Board. The categories that we think are going to be very, very large if you look at where workloads are moving into the cloud, we certainly have high hopes for both Prisma Access as well as Prisma Cloud. Those have been growing very nicely for us. But moving into the world of machine learning and behavioral analytics, we also have a lot of confidence in our abilities to continue to grow the Cortex side of the category as well.

Karl Keirstead

Okay. And from a sales standpoint, when you go through this shift where the form-factor is changing from very appliance-centric to software form factors, to what extent does that require you, Nikesh and the team to alter sales structure, sales comp because sometimes those can require different skills, different motivations. Can you talk through that and maybe put it in the context of Dave's recent departure, whether that was related at all to these shifts that you've been describing?

Kathy Bonanno

Yes. Dave's departure was not related to the shift. Dave has decided to go do something else to move on in his career. He's been with the Company a while and that's all fine and good and we have a really strong bench and we've got that sales organization really nicely covered with someone named Rick Congdon, who we promoted into the Americas division, who’s has been with the Company a long time, and he is beloved by the sales organization, really a strong motivator.

So we're feeling really good about all of our sales leadership. And Amit, who's the new President of the Company has been with the Company nine months or so now and he is really very engaged and working very closely with the sales organization. So we're feeling good about that.

In terms of our selling motion and how it's changing, we have talked a lot about the speedboat concept, which is a way in which we're putting a lot of emphasis and focus on not just the product plans, but also the go-to-market motions for the newer products that we're selling.

And when Nikesh came on board, I think what he saw was that we had some strength and we had managed to build some really great products, but we really weren't putting our full force into pushing and driving success in those particular areas.

And so he started this speedboat concept, which I think we've really seen the proof that is working in Q4. We saw 180% year-over-year growth in the next-gen security category, and now we're really looking at growing that part of our business to very nice numbers into the future, looking three years out to $1.8 billion, right.

And so the speedboats are designed to put a core team together to build out the strength of all of our go-to-market motions to get them reference customers, to prove the motion, and then we transition that over time into the core sales force to get greater leverage and greater distribution capacity across our entire 3,000 persons strong selling organization in the company.

And so we've seen really great success in Q4 and we're starting to transition more and more of the products that we've been selling into the core, and we believe that will give us a lot of leverage going forward.

Karl Keirstead

Okay. And just further to the go-to-market shifts, does it require any change to channel structure or economics, because the channel is obviously super-sophisticated, big partners like Westcon et cetera, but to oversimplify, they are generally used to selling boxes, appliances, the channel can sometimes be hardware focused. So as Palo Alto shifts towards software form factors on the core, does it change at all the channel go-to-market and economics?

Kathy Bonanno

Yes. We're not really anticipating any change in the channels strategy. We have great channel partners. We think that who wins in the market that's a very competitive environment in and off itself. And companies that are going to be able to help with the move to the cloud and help with bigger architectural decisions because security doesn't become any less complex with companies moving their workloads into the cloud or having mobile devices that they need to protect and everything connected to the Internet just makes it more complex. So those companies that can really provide help and assistance to their customers will probably be the ones that are more successful.

Karl Keirstead

Yes. It certainly changes the competitive set for Palo Alto Networks, doesn't it? Because as you shift the mix away from the “core firewall appliances” to cloud security and more security analytics, the rivals that you come up against are different.

And what struck me from the presentation last week is under the prior management team, you would often on earnings calls hear displacements of Cisco and displacements of Checkpoint. But I'm not even sure over the course of two or three hours, I heard the word Cisco or Checkpoint or Fortinet, it was all kind of next-gen rival. So is that a fair observation that the competitive set is shifting as your mix shifts?

Kathy Bonanno

Yes. Obviously we're – with the newer areas of our business, we have newer competitors.

Karl Keirstead

Yes.

Kathy Bonanno

And oftentimes we're competing against small point product players rather than the bigger network players, right. And so I think that the fact that you heard a little bit of our competitiveness coming out in these newer areas is a reflection of the fact that people understand our success in the network side of the business and we've proven ourselves. We're now the largest network security company in the industry. And so our abilities there, I think are proven and everybody is very familiar with the competition.

Karl Keirstead

You don't need to hammer away at Cisco anymore.

Kathy Bonanno

We don't need to hammer away. Yes. But I think demonstrating that we're having real success against some of these newer competitors is what you saw reflected in our Analyst Day.

Karl Keirstead

Okay. The one that stood out and it might be on investor minds given last night is Zscaler.

Kathy Bonanno

Yes.

Karl Keirstead

So it sounds like you and Nikesh and the team were certainly quite proud of – I believe, you characterized it as a Fortune 50 retail displacement of Zscaler. Can you talk a little bit about Prisma Access and Zscaler, not to get too technical, but do you feel like they're approaching feature parity? Like what are some of the differences as both companies might be at the table in front of customers that customers would evaluate the two alternatives against each other?

Kathy Bonanno

Yes. I think it's a fundamental difference in what customers need, and our view is that what customers need continues to be the full breadth of network security that we've offered for their branch offices as well as their mobile users. And it's not as simplistic as just saying you need a proxy, right.

Karl Keirstead

Yes.

Kathy Bonanno

And so what we're doing is competing on the basis of the strength of our offering. And we believe that once customers understand the dynamic and what we can offer with Prisma Access and with our virtual firewalls, that's a much more compelling story for customers in terms of providing the full breadth of network security, plus there's the integration arguments if you have or in the future considering Palo Alto Networks in your own data centers protecting your own infrastructure with our firewalls or virtual machines.

It's much easier to deploy Prisma Access into your branch offices or mobile users because all of those policies just transfer very easily and it's not yet another point product that is giving you a different set of information that you'll have to figure out and implement, and the policies can just apply across your network. And so that helps us to succeed as well.

Karl Keirstead

Even qualitatively are you able to give any color on the frequency which you – RFP against Zscaler or maybe that's unfair because perhaps what is driving the success of Prisma Access is that you're selling it into an installed base of Palo Alto customers. And it's possible that those might be sole sourced and Zscaler might not even be seeing some of them, but anything that you can offer on the frequency with which you're bumping up against them?

Kathy Bonanno

Yes. I think in fact one of the observations that Nikesh has made since joining the company is that because we weren't putting the full weight of our sales organization against these newer products, we weren't even in a lot of deals. We weren't even showing up for these types of deals. And what we've learned is that in many cases, our success just depends on showing up and being able to get invited into those deals.

And so with our focus with the speedboat, the speedboat concept that we've developed and with the new overlay sales organization that we've hired in order to really drive and push Prisma Access and other areas of our portfolio that are newer, the Prisma and Cortex lines, we're showing up in a lot more deals and we're winning.

Karl Keirstead

Yes. Got it. So let's talk – maybe switch from the next-gen cloud security stuff back to the core for a minute.

Kathy Bonanno

Yes, you can.

Karl Keirstead

And just so we're all on the same page, Kathy, when on the billing's projections, you ex-out the next-gen billings and back into what the core must be, which as I mentioned earlier implies about a 10%, 12% growth for the next three years.

Kathy Bonanno

Yes.

Karl Keirstead

What's in that bucket that would include core firewall appliances plus I presume attached subscriptions?

Kathy Bonanno

That's correct.

Karl Keirstead

Correct. And does it also include software form factors of those firewall appliances? So it would include. Okay. So just to be clear, maybe what's in that non-next-gen bucket would be helpful?

Kathy Bonanno

Yes. So within the non-next-gen bucket is the core firewalls and their attached subscriptions and support.

Karl Keirstead

Got it. Okay.

Kathy Bonanno

And one thing to keep in mind, I'm just looking at our business is support as a separate SKU as a line item that we track is only a concept in that hardware world. As you move into software, support is just bundled into that product price, and so it's not tracked as a separate line.

Karl Keirstead

So if we can somehow breakout that 10%, 12% non-next-gen to get comfortable. So as you said, there is two elements to it. There is appliance sales and there's attached subscriptions. I think given prior disclosures, we can probably take a crack at that mix because you have actually given us numbers in the past.

Kathy Bonanno

Yes.

Karl Keirstead

But maybe you could talk a little bit about to get to that 10%, 12% maybe don't want to be too precise. But generally speaking, what are you thinking in terms of growth of the core appliance versus growth of the attached subscription even if just directionally if you want to go into that much detail.

Kathy Bonanno

Yes. It's not a significant change from what we've seen in the past. Obviously, the attach rate of our subscriptions has been reasonably consistent for some time and we're not really anticipating that changing much. We are anticipating that we will release new subscriptions into the future and that will help us drive additional growth in that category.

And that's one of the really exciting things that we're doing that we think will allow us to continue to grow and continue to offer our customers better security, minimizing the number of point products that they have to deploy in their infrastructure. We did that very successfully with the four attached subscriptions that we've offered for many, many years.

And now with DNS and IoT and some of the other things that we're talking about, we think that we'll continue to be able to benefit our customers and allow them to reduce the number of point products in their networks that they have to deploy it. And that's the terrific motion for us going forward.

Karl Keirstead

Yes. So just as we and the Broader Street tries to gauge the risk profile to that 10%, 12%. How much of that is dependent on attached subscriptions like DNS and IoT that have yet to come out a lot? A little?

Kathy Bonanno

I would say little.

Karl Keirstead

Okay. So most of it is just continued growth of the appliances and the attached subscriptions that are already in the market.

Kathy Bonanno

That's right.

Karl Keirstead

Okay.

Kathy Bonanno

I mean, we're talking the guidance that we've given is over the next three years. We've released one. We're talking about an acquisition for IoT. So it takes a while to get those products out.

Karl Keirstead

Yes. But that's good to hear that you're not banking on unusual growth of the products that are just new to market. Okay. So that makes me feel a little bit better too.

Kathy Bonanno

Good.

Karl Keirstead

On the form-factor shift, I think that's an important one because that struck me as, let's say, a new – a bit of a tone shift, where I think you and Nikesh have been talking about it. Certainly, we have another analysts have been picking up anecdotes about hardware to software form-factor shift.

But the emphasis that you and Nikesh have put on, it suggests that over the last couple of quarters or so that shift has picked up momentum. Is that fair? And when you talk to Nir and the rest of the team or the sales folks, can you talk a little bit about what might be driving an acceleration in that form-factor shift? Like what's changed, that might be interesting to the group?

Kathy Bonanno

Yes. I think that we are very excited about where the products are now. And so the product in particular, Prisma Access is – we've just announced the 100 new locations that we can offer by providing this product through GCP and that's really exciting change for us. It allows a lot of customers who want local data that consume our Prisma Access product.

And so we've made a number of new releases to Prisma Access and we're very excited about the shape of that product right now and the competitiveness. And in fact the competitive advantage that we have by having all three of the form factors of firewall security, essentially it puts us in a real strong position relative to the rest of the competition.

And so in many ways you're seeing us really drive this transition to a software form-factor because we think that it benefits our customers, but it also benefits us in the market, right. And so it's great when you find something, a strategy that both a positive for your customers and a positive for you as a company.

And so we want our customers to obviously adopt whichever form-factor suits their needs best and in many cases, we think that choosing the software form-factor in the future is going to be really compelling for a lot of our customers.

Karl Keirstead

Got it. And maybe this is a good question for a CFO, but how does that shift effect Palo Alto's financials? It's not a benign shift. Maybe the best proxy we have as investors is F5, which I know you don't directly compete with, but they're obviously, in the ADC or load balancer space, are themselves going through a hardware to software form-factor shift, and they've outlined the stress it puts on some of the financial metrics that the Street needs to wade through.

So to what extent will Palo Alto have to go through that and maybe to start, what financial metrics does that shift affect? It clearly has an effect I think on your product revenue growth number. But what other metrics might that impact be it cash flow DR margins if any?

Kathy Bonanno

Yes. Really, the shift to these other form factors is primarily revenue issue, right. Because of the ratable nature of software compared to product, which is upfront revenue recognition.

Karl Keirstead

Yes.

Kathy Bonanno

So you do see the product revenue number decline as a result of that, the growth in that number is still growing much faster than the market rate of growth, I would argue. But as we anticipate and in fact drive this shift in form-factor, we would expect that that revenue line is where we'll see the impact, and that's reflected in the growth that you see, but the cash is equivalent.

Karl Keirstead

Yes. And if there's pressure on the product revenue line, the offset from increased demand for software form factors will appear where else on the income statement?

Kathy Bonanno

Well, it will show up in revenue ultimately, but it takes longer to show up in revenue, right. You'll see deferred revenue.

Karl Keirstead

Got it, okay. So maybe that will become a more important metric to monitor as you go through this shift.

Kathy Bonanno

Yes. In billings, we've talked a little bit about an expected duration decline primarily as a result of mix shift towards Prisma Cloud.

Karl Keirstead

That was that 10% over three years number that Nikesh gave?

Kathy Bonanno

That's right. And that's primarily driven by Prisma Cloud, which is provisioned oftentimes in, like in AWS or a GCP marketplace. At the same time they're spinning up workloads there. We want them also to consuming security. And so that tends to have a shorter duration, which is the primary impact to the duration.

Karl Keirstead

Okay. So maybe just to hit a little bit more on the reported product revenue line. Kathy, you had so much ground to cover at the Analyst Day last week that I don't think you had too much time to actually get too much into that quarter's results because I think the emphasis was a little bit more on the go forward.

But if we look at Q4 product revenue growth, it deselled from 28% in the prior quarter to 12% in the July quarter, so do you mind just taking a minute to describe why that shift occurred and to what extent it's due to this very issue that we're talking about?

Kathy Bonanno

Yes. The great thing about Q4, which we thought was a great quarter is that we definitely saw proof points that our speedboat strategy is working and that we’re able to compete and to sell in the next-gen security category, right. And we did have incentives in place for our sales organization to hopefully encourage them to sell something that's relatively newer for them to sell, right. And that's always – for sales, we always think that the path of least resistance is the path that they will follow.

Karl Keirstead

Yes.

Kathy Bonanno

And so we want them to be incentivized to sell things that are harder for them to sell that they don't know as well, that they're not as comfortable with. And so the combination of those incentives, the product updates that we've made throughout the year and all of the hiring that we've done. And we've hired a lot of new sales people into both the core because we see a lot of opportunities still in the core to take share, but also in the next-gen security category.

And the fact that all of those things sort of took place throughout the year, and we finally thought really come to life in Q4, really strong proof points that our sales organization can sell the next-gen security products, and that when we get them incentive properly to sell it that it's really translating into results for them and which is fantastic and for the company obviously. And so we think that the incentive structure was such that they were just very, very motivated to bring in those next-gen security deals, right.

Karl Keirstead

Next-gen…

Kathy Bonanno

And it wasn't an issue of we're losing on the other end.

Karl Keirstead

Right. They kept that engine going.

Kathy Bonanno

It's a matter of how much they – yes, absolutely. It's a matter of how much can they close in a given quarter.

Karl Keirstead

So it feels, Kathy, from the guidance, that that phenomenon will continue into the October quarter. I know you don't guide to product revs, but we all model it. So we take your total revs and it's easier to put reasonable growth estimates on some of your more ratable recurring businesses.

And when we do that and we back into what product revenue growth must be in the October quarter to make all the math work. It feels like it'll be about flat year-over-year, which would be a decline from 28% to 12% to 0%. So that's a little bit alarming for investors.

Kathy Bonanno

Yes.

Karl Keirstead

And so could you talk a little bit about what might be happening in the October quarter to accentuate that? Is it simply all of these things continuing for another quarter?

Kathy Bonanno

I think that's right. What you'll see in pipeline, obviously, the closer we get, the closer we see the deal, the actual deal structure that we think will close and the mix of deals. There's obviously variation because of things that get developed and closed in quarter as well. But we can just see the mix of deals.

Karl Keirstead

Yes.

Kathy Bonanno

And all of the emphasis that we've put, all of the product releases, all of the sales organization changes that we've made and our ability to really drive that into the future, you're seeing that in the mix of products.

Karl Keirstead

So to hit the full-year – please go ahead.

Kathy Bonanno

And let me just say one additional thing on that point. I think the reality is that we're no longer just selling essentially one product, right. We're no longer just selling firewalls and attached subscriptions, right. We have many products that we sell. And so the precise mix of what we'll sell in a given quarter may vary from quarter-to-quarter. But hitting our numbers and being successful as a company is no longer is dependent upon just hitting a product number, right. We have a lot of quivers in our bag, right.

Karl Keirstead

So perhaps you're encouraging us not to focus too much on any one quiver.

Kathy Bonanno

I would encourage that.

Karl Keirstead

Okay. So to get though to the 10%, 12% billings growth guidance for the core, obviously we can't have product revenue growth stay at flat year-over-year. It's going to have to accelerate afterwards, so what's that caused by then?

Kathy Bonanno

Yes. One of the things that we've done is we have – in this year's comp plan, we have – well, first of all, if you look at the growth for the full-year product in fiscal 2019, well it wasn't horribly strong in Q4.

Karl Keirstead

Yes.

Kathy Bonanno

And it was still a good strong number, but it wasn't as strong as the prior three quarters.

Karl Keirstead

Sure.

Kathy Bonanno

It was 25% year-over-year product growth, right. So there's that. We're still selling a lot of products. The fact that in one quarter we had very strong incentives for our sales team to focus elsewhere is not an indication of what's happening with products.

So yes, we see the deal mix in Q1, but we still think we're going to sell a lot of products, right. So that's point number one. But we've also modified our compensation plan a bit this year and we have both a goal for the core – I hate using that term, but the core firewall side of the business as well as the next-gen security side of the business, and so our teams are going to be rightly very focused on selling both.

Karl Keirstead

Okay, got it. Okay. That's great. I could talk all day long with Kathy about all these cool things happening at Palo Alto. I think it's great by the way that you're being bold and going to where the puck is as a good Canadian would suggest and not all your rivals are doing that. So I think it's bold and the right thing to do.

In our last three and a half minutes, maybe I'll be respectful of those in the audience if you've got any questions you'd like to ask Kathy.

Kathy Bonanno

I see some familiar faces who have asked us a lot of questions already, but I think they’re all questioned out.

Karl Keirstead

Okay. Maybe I'll ask one or two more then. You touched a little bit on it vis-à-vis the compression of the invoicing duration. And I know you addressed this at the Analyst Day, but for those that might have missed that. You mind just touching a little bit on the rationale for electing not to transition to annual billing terms?

That was I think a pleasant surprise for a number of investors that you wouldn't kind of force a big licensing invoicing shift on the company while you're trying to do all kinds of other things, but maybe you could explain why you were thinking about it and then what happened such that you and Nikesh elected maybe not to do that quite as aggressively.

Kathy Bonanno

Yes. I think the reality is that our customers are not demanding us that. In fact, we think that if we shifted to that type of model, particularly for the core part of our business, it might actually put us at a competitive disadvantage. And it's not as easy as just saying, oh, I'm going to shift my firewall’s billings practice to annual.

It requires a lot of changes in terms of how our customer – how do you build a customer annually for a firewall? What does that look like? What advantage does that give the customer? And a lot of companies that have shifted to this type of model and have done it successfully have seen a real business model change.

And we were struggling to see the real business model change, particularly on the firewall side of the business. Most of our revenue is ratable already. That's not necessarily a business model change, it's just a factor of how the accounting works.

And so our customers are not really demanding it and we do have the ability for those customers who want to pay annually to allow them to do that in different ways, other than us completely flipping everything upside down and changing the way we sell to our customer.

Karl Keirstead

Okay, makes sense. Why don't we end there because we're short of time. Kathy and David, thanks so much for coming to the DB Tech Conference. Have a great series of one-on-one today.

Kathy Bonanno

Thank you so much for having us. Really appreciate it. Thank you, Karl.

Karl Keirstead

Yes. Thank you. Appreciate it.