Palo Alto Networks, Inc.

Good day, everyone, and welcome to Palo Alto Network's fiscal first quarter 2020 earnings conference call. I am Clay Bilby, head of Palo Alto Network's investor relations. Please note that this call is being recorded today, November 18th at 1.30 PM Pacific time. With me on today's call are Nikesh Arora, our chairman and chief executive officer, and Deepak Galecha, our chief financial officer. Our chief product officer, Lee Klarich, will join us in the Q&A session following his prepared remarks. You can find the press release and information to supplement today's discussion on our website at investors.palawanetworks.com. While there, please click on the link for events and presentations where you will find the investor presentation and supplemental information. In the course of today's conference call, we will make forward-looking statements and projections that involve risk and uncertainty that could cause actual results to differ materially from forward-looking statements made in this presentation. These forward-looking statements are based on our current beliefs and information available to management as of today. Risks, uncertainties, and other factors that could cause actual results to differ are identified in the safe harbor statements provided in our earnings release and presentation and in our SEC filings. Palo Alto Networks assumes no obligation to update the information provided on today's call. We will also discuss non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with GAAP and should not be considered as a substitute for performance prepared in accordance with GAAP. We have included tables which provide reconciliations between the non-GAAP and GAAP financial measures in the appendix to the presentation and in our earnings release, which we have filed with the SEC and which can be found in the investor section of our website. We would like to note several upcoming events. Management is scheduled to participate in upcoming virtual investor conferences in December hosted by Credit Suisse and Barclays. And now I would like to turn the call over to Nikesh.

Thank you, Clay, and good afternoon, everybody. As you can see, that was a video showing you some snippets from Ignite, our user and customer conference, which is just wrapping up. It's been a bit of a busy week at Palo Alto Networks, where we've had 27,000 customers and partners register to engage with us virtually. Moving on to where we are at the end of Q1. Q1 was quite a familiar story from a demand perspective. We saw strength across major geographies and industries driven by heightened cybersecurity awareness. We've seen people at the top of organizations across government and private sector. They understand that it's their responsibility to ensure they're securing their environments against the increasingly malicious threat landscape. This quarter, you saw a fair amount of press out of Washington, D.C., as cybersecurity funding was included in the recent infrastructure bill and executive orders are mandating focus from federal agencies. In the private sector, corporate boards are forming cybersecurity committees and directing their teams to raise the bar in terms of cybersecurity posture. We at Palo Alto Networks instituted our security committee as well this quarter. Earlier in the year, Gartner updated its forecast for spending on information security and risk management technology and services, calling for growth of 12% year-over-year in 2021. We see this backdrop as sustainable beyond this year as customers not only grapple with familiar events like ransomware and data breaches, but also new threats coming to light as they adopt cloud services and also try to hire enough qualified security professionals to keep their environment safe. All in all, I think demand is strong, attention to cybersecurity is high, and there is a long-term positive secular trend in place which gives us great comfort towards the three-year plan we highlighted for you. Diving into our results for the quarter. At our analyst day in September, we updated you on our company strategy and outlined our three financial targets. The last three months have bolstered our confidence in this strategy in the numbers that we shared with you. We were extremely happy with our Q1 performance, which was ahead of our guidance on all measures. We saw revenues go 32% year-over-year, our fastest Q1 in five years. Coming on the back of a strong Q4, our billings grew 28% year over year. Q1 strength was broad based with exceptional performance from our hardware business, but also strength in our Prisma, both SASE and cloud. Hardware strength fueled 25% product growth in Q1, a result of not only strong orders that we talked about in our Q4 call, but also a continuation of this trend in Q1 and our ability to ship those orders to our customers. Based on our strong performance in Q1 and visibility into our hardware pipeline in the second quarter, we're going to be raising our hardware forecast for the year and subsequent quarters. Within our business, we continue to drive transformation towards a higher mix of software solutions as we continue to bring new innovations to market. You see this in our next generation security RR, which continues to increase with our business mix. Growth in our NGS solutions was driven by Prisma SASE and cloud. We balanced profitability well, with non-GAAP operating income growing 9% a year and non-GAAP EPS for 7 cents ahead of the midpoint of our guidance. The $554 million in adjusted free cash flow is the largest we have ever reported in a quarter as a company. Beyond our financial results, we continue to see industry accolades highlighting the strong position of our best-of-breed products across our three platforms. I always maintain that to be a leader in cybersecurity, we have to be the leader in innovation in cybersecurity, something I personally believe has not been practiced in the past decades by cybersecurity companies. I'm delighted to see that we came out of FY21 with a recognized strong position in six product areas. In Q1, we continued our position as a leader in the Gartner WAN Edge Magic Quadrant, where again named a leader for the 10th straight year in the Gartner Network Firewall Magic Cordon. Additionally, we added two new awards being named a leader in Forrester Zero Trust Network Access, New Wave, and also a strong performer in Forrester's XDR New Wave. We look forward to earning further industry recognition driven by our strong innovation pipeline, as well as the efforts of our product teams across the world. Diving deeper into our three platforms, starting first with our network security business. We are benefiting from having the industry's most comprehensive platform across hardware appliance, virtual appliance, and as a service form factors, supported by a consistent set of security subscriptions and world-class customer support. We continue to innovate rapidly in network security with announcements we made this week at Ignite that I encourage you to review if you haven't already done so. Appliance demand was strong as our team capitalized on the broad opportunity across network security. As the pandemic conditions eased and offices started to open up, we saw an uptick in refresh activity. Our new appliances with improved price performance saw strong demand from both new and existing customers. We saw strong competitive win activity as customers looked to standardize on our broad network security platform. Lastly, we did see some impact from pricing actions and customers that were ordering product based on concerns around lead times and availability. These forces combined drove 25% growth in product revenue in Q1, a significant re-acceleration, and strong demand continuing into Q2 as well. Let me comment a bit more on the supply chain challenges that the entire industry is dealing with and all of you continue to pay attention to. As you've seen, despite the challenges, we have managed to deliver against our orders. There have been some longer lead times selectively for some of our customers, but overall, I think our teams have done a phenomenal job in managing in this environment. We will continue to do our best effort to manage over the next few quarters. I expect these challenges to dissipate over the next six to nine months, and we will do our best to continue to navigate them. During this period, the industry will probably end up having lead times which are two to four weeks more than normal. The scarcity of some components and needs to expedite are causing some short-term cost increases which we are managing in the overall budget envelope at Palo Alto Networks. We expect to be able to manage our expenses within our guidance outlined to you for the full year. We do expect though that given the vagaries of supply chain, we will not be able to beat them as aggressively as we have been in the past. Our focus is on making it easy for our customers to consume our firewall technology across public cloud and on-prem deployment. We introduced Firewall Flex late last year, and on the back of this have nearly 1,000 customers that have taken advantage of this license agreement. continue to take share in the firewall industry between our various form factors firewall as a platform buildings to 29 the fastest growth we have seen in almost two years as customers consolidated network security spend with us on account of the breadth of our product line and our leadership position in each area software was 37 percent of our five buildings q1 continuing to our transition to a higher mix of software switching to sassy Prisma SASE continues to be a source of strength in our business as our customers proceed on their journey towards a permanent state of hybrid work. We see many customers in the very early stages as this journey involves network transformation to enable access to all apps from any location. Only Palo Alto Networks can provide a comprehensive solution with our consistent network security platform across all form factors. We see many customers in our installed base recognizing this. So far, we have 1,400 of our over 57,000 next generation firewall customers that have adopted our SASE technology. Our network security sellers and channel partners are becoming increasingly proficient in this natural extension of our core firewall offering, and we see this as a continuation of our growth in the SASE space, allowing us to gain share in firewall as a platform, as a category, as well as in SASE. Overall, we saw our SASE customers grow 61% a year at over 1,700. We're happy with our progress selling SASE into our installed base. What is also interesting is over the last 12 months, we have seen more than 25% of our SASE customers who have come from outside of our installed base, which is not just exciting to see because customers are choosing our network security stack despite having other people's firewalls. It is also a sign showing that in the future, we can expect to share our innovation and hardware and software firewalls to SASE customers, allowing us once again to expand our installed base. We believe this is an important indicator, not just of the competitiveness of our SASE offering, but also an opportunity for us to provide a comprehensive zero trust architecture to our customers. We're also seeing good initial interest in our OQ appliance, which you expect to be part of our enterprise solution later in this fiscal year. Switching to Prisma Cloud. Our Prisma Cloud business continues to benefit from the dual drivers of customer adoption of hyperscale public cloud technology, as well as a growing awareness of the need for security in cloud environments. As I've noted earlier, we introduced significant new enhancements to our Prisma Cloud offering this week at Ignite. And again, I encourage you to check out the highlights from the session that Lee and our CMO Zainab hosted on Tuesday. Total Prisma Cloud customers grew 26% a year. Beyond customer ads, we remain very focused on customers consuming credits across our platforms. Credit consumed increased to 2.2 million in Q1, including strength from some of our new modules. Credits being consumed are validation of customers deriving value from our products. Beyond this broadening of consumption, we're also seeing an uptick in expansion as renewal volumes grow and greater participation in Prisma Cloud from our channel partners. This is all important as we grow the business and focus on SaaS economics. We have continued to see strong results from BridgeCrew. As a reminder, BridgeCrew has a sales motion where they target developers, and combined with this popular open source offering checkoff, we have seen strong traction in the market. On a standalone basis, a five-figure opportunity is a large deal for BridgeCrew. As part of our networks, we have seen these deals get substantially larger as customers understand how to leverage bridge crew in our comprehensive Prisma Cloud roadmap. This quarter, bridge crew was an important driver of a million dollar deal in the insurance article. Overall, Prisma Cloud is leading this important trend towards securing the cloud native environment. It's clear that the overall market has caught on to this trend that we identified early and has been aggressively funding companies in cloud native security, as you might have noticed. I think we do More air out in one quarter and pretty much the annual air of most of these companies that are being funded at extremely lofty levels. we're going quickly and executing well across with my cloud, where we believe we have a long term ability to win switching to our security automation capabilities. Our Cortex platform continues to deliver innovative integrated capabilities, unifying our market-leading technologies across XTR, XO, and Xpans. Total customers across XTR Pro and XO reached almost 2,800, increasing over 75% year-over-year. Beyond new customer traction, we also saw an increase in expansion on the back of increased general activity in Q1. Our Cortex products, again, received strong industry recognition. XDR, as I said, was identified as a strong performer in the 2021 Forester XDR New Tech Wave. This was based on our 2.9 version and early in Q1. We just released XDR 3.0. 3.0 significantly enhances XDR's capability in the cloud and also includes a built-in forensics response capability to help SOC teams automate the full lifecycle of threat detection investigation response. XSOAR continues its leadership position, being named a leader in the GigaOM SOAR evaluation. We also continue to see traction on the partner front as well across Cortex. We saw strong partner activity continuing around the XO marketplace with over 80% growth in bookings influenced by our systems integrators and MSP partners around Cortex. At Ignite, we have just launched an ex-MDR partner specialization with our partner program with launch alliance partners including PwC, Orange Cyber Defense, Critical Start, and Trustwave. On the back of very strong large deal performance in Q4, we followed this up with strength in Q1. Driving a broad, repeatable, and efficient large deal motion is a key initiative for our sales organization in FY22. Amit Singh, our chief business officer, is focused in partnership with our president, BJ Jenkins, to drive deeper multi-platform relationships with a wider cohort of our customers. While Q1 is seasonally our lightest quarter of the year, we closed 167-figure deals within the quarter. Furthermore, the total dollar value of the seven-figure deals signed in the quarter were up 36% year-over-year. Our millionaire customers were 1,025 in Q1, approximately 29% year-over-year. This was our fourth consecutive quarter where year-over-year growth in millionaire customers was north of 30% or close to. Turning to some of our larger wins in the quarter, there are several trends that should be evident in these large deals. First, we're seeing success with multi-product adoption. Second, customer commitments are increasing in size, reflecting both the growing importance of cybersecurity as well as our leadership position across our platforms. The value for large deals is up materially year over year and growing faster than our business overall. This is becoming a more repeatable process for us and is also an area for us to continue to mature and drive efficiency in our sales organization. Third, there are a few areas of success emerging where we see trends. These include an uptick in proxy replacement, significant expansion in SASE, deployments in the back of initial purchases driven by work from home, standardization on Prisma Cloud across customers' cloud footprints, and consolidation across customers' network security architecture. We highlight these deals because they are in line with our strategy to lead in each of our platform areas and also to drive cross-platform success. Bringing it all together, As I said, I think we're on a much stronger long-term secular trend for cybersecurity and Palo Alto Networks is uniquely positioned in that trend to be able to leverage all of our investments and innovations that we've made in the last year across all three of our platforms. We've had a strong Q1. I'm delighted by the innovation and execution of our teams. We laid out our strategy for the year and our medium-term vision in mid-September at Analyst Day, and we remain focused in these areas. We aspire to build a durable business and lead the industry through this unprecedented period of growth. Our focus is on driving innovation, betting on our three platforms, and betting AI and machine learning across our platforms to shift the balance between our customers and cyber adverse adversaries. We leverage our scale to grow our business and drive efficiencies across the company in order to be the trusted security part of our customers. Our revised guidance for the year reflects broad-based strength across our portfolio, resulting in higher revenue and billings for FY22. We're holding our EPS guidance for the year to make sure we can deliver on strong demand with the current supply chain backdrop. With that, let me turn the call over to Deepak to go into more detail on the Q1 performance and our guidance.

Thank you very much, Nikesh, and good afternoon, everyone. Please note that all comparisons are on a year-over-year basis, and financial figures are all non-GAAP unless specifically noted otherwise. We delivered results ahead of our guidance provided in August across all metrics as we continue to grow and transform our business. In Q1, the acceleration of our top line continued, driven by strength in our broad portfolio, including both our appliance offerings and our next-generation security offerings. For Q1, revenue of $1.25 billion grew 32% and was above the high end of the guidance range. Growth was driven by product revenue in all geographies and all three platforms. Total deferred revenue in Q1 was $5.16 billion, an increase of 31%. By geography, Q1 revenue growth was strong across all regions. The Americas grew 30%, EMEA was up 35%, and JPAC grew 38%. Next Generation Security, or NGS ARR, finished the quarter at $1.27 billion, continuing a steady growth trajectory. Within NGS, we saw exceptional strength in our Prisma platform, as well as XOR and XDR. In the first quarter of 22, we delivered billings of $1.38 billion, up 28% and above the high end of our guidance range. As a reminder, Billings is total revenue plus the change in total deferred revenue, net of acquired deferred revenue. NGS Billings of $366 million grew 38% year over year. Remaining Performance Obligation, or RPO, was $6.0 billion, increasing 37%, with current RPO growing in line with total RPO. As I mentioned at our analyst day, we believe RPO adds meaningful insight into our future revenue as it includes both prepaid and contractual commitments from our customers. As we also forecasted during our recent analyst day in September, our appliance business accelerated in Q1 as we achieved 25% year-on-year product growth, the fastest product growth in 10 quarters. This was ahead of our guidance of low double digit growth as we saw both fulfillment of strong Q4 orders and also follow through in demand in our Q1 orders. Customer reaction to the new appliance launch in late fiscal year 21 has been positive. As Nikesh noted, strength in our appliance business was broad based and whilst refresh was a positive driver, we also see signs that demand is sustainable beyond this refresh activity as customers return to pre-COVID patterns of purchasing. subscription revenue of $579 million increased 35% support revenue of $373 million increased 33% in total subscription and support revenue of $952 million increased 34% and accounted for 76% of our total revenue. Gross margin of 74.4% was down 140 basis points year over year as we incurred additional costs related to appliances. We will continue to ensure that we're focused on enabling shipments to our customers in the current environment. Operating margin of 18% was up sequentially and down year over year as expected as we absorbed the strong rate of hiring we had in the second half of fiscal 2021. Our operating expenses came in below our forecasted levels as we focused on driving operating efficiencies to offset high input costs on our products. Net income for the first quarter grew 8% to $170 million, or $1.64 per diluted share. Our non-GAAP effective tax rate was 22%, and our GAAP net loss was $104 million, or $1.06 per basic and diluted share. Turning now to the balance sheet and cash flow statement. We finished October with cash equivalents and investments of $4.4 billion. These days outstanding on sales was 74 days a decrease of seven days from a year ago, driven by a combination of strong collections and improved buildings linearity. cash flow from operations was $589 million and we generated record free cash flow 554 million at a free cash flow margin of 44.4%. It's also worth noting that in Q1, we moved our customer count methodology to active customers from our historical method of sold to customers. As we continue to transform our business with the growth in software form factors and ARR-based solutions in next generation security, it's important for us to mature our customer acquisition, retention, and expansion framework. As we're increasingly focused on active customers internally, we believe it makes sense to align our external reporting in this way. In the appendix of our presentation, we've adjusted the customer counts provided over the last five quarters in our investor slides to conform to the active customer methodology. Our capital allocation priorities, as outlined in our September analyst day, are unchanged and aligned with the optimization of long-term shareholder returns. The pillars of our total shareholder return framework were in action in Q1. We delivered industry-leading growth for our revenue scale, highlighted by 32% revenue growth, and the highest Q1 growth rate Palo Alto Network has reported in five years. We're focused on investments that will continue to sustain this growth while delivering EPS ahead of our guidance and the street for Q1. We did this with a bias towards making sure we could fulfill customer demand while driving operating efficiencies to help offset higher product related costs. We believe this additional expense is a good investment for us as a crude value in our long-term customer relationships. Our free cashflow margin of 44% for this quarter was strong and puts us on track for our annual and multi-year goals. We remain focused on share repurchase as the largest use of our free cash flow generation. However, there were several material events in the quarter that made it challenging to buy back stock, including our mid-quarter analyst day and the transfer of our stock listing to NASDAQ. We'll continue to be opportunistic buyers of our stock, as you have seen over the last 12 months. We have a billion dollars remaining on our share repurchase authorization, expiring at December 31st, 2022. Lastly, on the TSR front, as many of you have likely seen in our 2021 proxy statement, our compensation committee revised Palo Alto Network's executive compensation program to add in a TSR multiplier into our fiscal year 22 plan to better align executive pay with shareholder interests. We closed a very small acquisition during Q1, Gamma Networks, that brings us additional technology in the DLP area and was part of the announcement of our next-gen CASB this week at Ignite. As we have assembled the key pillars needed to execute on our platform strategy, we continue to expect only incremental M&A activity in fiscal year 22 as compared to the recent past. Lastly, moving now to guidance and modeling points. As Nikesh mentioned, and you're undoubtedly aware, there is some disruption in the global supply chains. Our teams have navigated through these challenges extremely well, although we did incur some incremental cost of product revenue in Q1. The guidance we're giving today considers the latest inputs we have around the supply chain and other factors. We do expect that we will incur additional cost of product in Q2 and the fiscal year, which we have factored in. At the same time, we're focused on driving operational efficiencies in our overall business to help offset this. In that context, we're pleased in our ability to hold our operating margin, EPS, and free cash flow margin guidance with the fiscal year 2022. We note that at the high end of our guidance range, we would achieve the rule of 60, which was our aspiration at our analyst day, adding together our revenue growth and free cash flow margin. For the second fiscal quarter of 2022, we expect billings to be in the range of $1.51 to $1.53 billion, an increase of 24 to 26%. We expect revenue to be in the range of $1.265 to $1.285 billion, an increase of 24 to 26%. Non-GAAP EPS is expected to be in the range of 1.63 to 1.66 based on a weighted average dilution count of approximately 105 to 107 million chats. For the full fiscal year 2022, we expect billings to be in the range of 6.675 to 6.725 billion dollars, an increase of 22 to 23%. We expect revenue to be in the range of 5.35 to 5.40 billion dollars, an increase of 26 to 27%. We expect our next-gen security ARR to be $1.65 to $1.7 billion, an increase of 40 to 44%. We expect our product revenue growth percent to be in the mid-teens year over year. We expect our operating margins to be in the range of 18.5% to 19%. And our non-GAAP EPS is expected to be in the range of 7.15% to 7.25% based on an average diluted count of approximately 106 million to 108 million shares. Adjusted free cash flow margin is expected to be in the range of 32% to 33%. Additionally, please consider the following additional modeling points. Based on the seasonality of spending we discussed last quarter, as well as progress during the year so far, we're forecasting that we will deliver slightly more operating income in the first half of the year than we noted on our Q4 call. To help you further calibrate your modeling of our seasonality, we expect approximately 33 to 34% of our annual operating income to come in Q4. We expect our non-GAAP tax rate to remain at 22% for Q2 2022 and fiscal year 2022, subject to the outcome of future tax legislation. We expect net interest and other expenses of $5 to $6 million per quarter. And for Q2 2022, we expect capital expenditures of $80 to $85 million. For fiscal year 22, we expect capital expenditures of $205 to $215 million, which includes approximately $39 million related to our Santa Clara headquarters. With that, I will turn the call back over to Clay for the Q&A portion of the call.