Palo Alto Networks, Inc.

Good day, everyone, and welcome to Palo Alto Network's fiscal second quarter 2022 earnings conference call. I am Clay Bilby, head of Palo Alto Network's investor relations. Please note that this call is being recorded today, Tuesday, February 22nd, 2022, at 2 p.m. 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 the prepared remarks. You can find the press release and information to supplement today's discussion on our investor website at investors.palaluzonetworks.com. While there, please click on the links for events and presentations where you will find the investor presentation and supplemental information. In the course of today's 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 as a part of today's presentation. 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 or superior to measures of financial 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 can also be found in the investor section of our website. Please also note that all comparisons are on a year-over-year basis unless specifically noted otherwise. We would also like to note that our management is scheduled to participate in the Morgan Stanley Investor Conference in March. I'd like to apologize for the delay in our start time. We experienced a technical issue that required delaying the call by 30 minutes. I will now turn the call over to Nikesh.

Thank you, Clay. Good afternoon. Thank you, everyone, for joining us today for our earnings call. As you've seen by results we released, we had an exceptional Q2. We continue to accelerate the growth of our business in line with our stated direction of fiscal year 22 being the year of focused execution. But first, let's talk about the market and the trends we're seeing. Firstly, we continue to see a strong demand for cybersecurity. We have not seen any changes in the IT spending patterns of our customers or a slowdown in companies investing in IT systems to drive competitive advantage. On the contrary, we see acceleration around trends associated with the shift to the cloud, as well as a continued effort to redefine network architectures to enable employees to work effectively from anywhere, a trend which has been bolstered by the pandemic, and we continue to believe we are still in the early innings here. Both these factors underpin continued demand for cybersecurity services. Secondly, we continue to see an evolving and complicated threat landscape. We have highlighted in the past that cybersecurity is at the front and center of all conversations around risks and threats at companies as well as nation-state levels. We believe cybersecurity will continue to become more and more relevant and important. With increased reliance on technology and the prevalence of cyberattacks, there is an ability to disrupt businesses and critical systems, making cybersecurity an area that will need continued focus and investment. In addition to industry-specific trends, we're seeing a trend that is unique to Palo Alto Networks. Given our investments in the areas and continued relevance across multiple platforms and needs of our customers, we're having more and more significant partnership conversations which encompass the entire Palo Alto Networks offering. Whilst early, we believe this is the true differentiation that Palo Alto Networks provides, both best of breed and integrated security that works. Thirdly, our continued focus on execution. This focus is bearing fruit as we execute multiple dimensions across our business. Execution from our product teams means continuing our rapid pace of integrated platform delivery. We will talk about the innovation across our platforms, but to highlight, just today we unveiled our XIM product, which is poised to reimagine security operations centers and truly deploy technology to resolve cyber attacks in real time. Execution from our go-to-market teams means focusing on the broader customer-driven priority of helping them significantly improve their cybersecurity posture. This is demonstrated by the multi-platform large deal commitments we're beginning to see. Execution from our supply chain team means we're able to work with our suppliers in this tough environment to deliver critical security appliances to our customers. We had to balance some of the increased costs with price increases as an offset, but we've been able to keep these increases modest in comparison to our peers. Execution from our people leaders means, despite this being a hot market for great talent, we're able to attract and retain the best minds in cybersecurity. As you saw in the opening of the call, we launched a welcome home program to welcome back employees that had left our company. We have seen good initial success here. Let's take a quick look at some of the outcomes caused by the focus on execution. In Q2, revenue was up 30%, while the leading billing and RPO metrics were up 32% and 36% respectively. We're building a more predictable business model. Our CRPO balance of $3.4 billion gives us significant visibility into our next 12 months revenue. Next Generation Security, or NGS, ARR, finished Q2 at $1.43 billion. As we hit our mid-year point, we have greater confidence that our strategy is working, which is driving us to make further investments in these businesses. At the same time, we continue to transform our core network security business, where the software mix within our firewall as a platform billings came in at 40%, up five points versus last year. We drove these strong top line results while balancing non-gap profitability, even as we absorbed some incremental expenses from supply chain challenges. Operating income grew 20%, and adjusted free cash flow grew 33%, we outperformed our non-GAAP EPS guidance midpoint by 9 cents. For a number of quarters, we've talked about our large deal momentum. To accelerate these results, as we exited fiscal 2021, we layered on a sales strategy to elevate our focus and drive efficiency in our largest opportunities. With a growing portfolio of products across three platforms, making large deals selling a repeatable process is core to our sustaining and accelerated growth trajectory. With BJ Jenkins taking over the leadership role for our broader sales organization, We've had an ability to increase management attention on the largest deals in the form of Amit Singh, our CBO. We're pleased with the results we have seen in the first half of the year. These deeper multi-platform relationships are a win-win for Palo Alto Networks and our customers. As a testament to this, at the end of Q2, 47% of our global 2,000 customers used products from all three of our platforms, up from 38% a year ago. In Q2, we closed 221 seven-figure transactions, including three transactions over $20 million. Our millionaire customers were 1,077 in Q2, up 26% year-over-year. Our combined rate of growth in millionaire customers, as well as an increase in size of our large deals, has helped us sustain the accelerated level of growth we've seen over the last several quarters. In all, as a strong coordinator, I want to thank our global teams for their strong execution across the board. Driving these results are the transformation of our firewall business and our focus on capturing growth in next-generation security. In particular, this quarter, our strengths were well balanced in both of these categories. Let's do a quick review of our progress across our three platforms. As you know, we have them designed modularly so customers can initiate their partnership journey with Palo's Networks, whatever their current need is. But over time, we work with them to both expand across any one of our platforms and also work with them to adopt our other platforms in line with their plans. At the heart of our three platform strategy is innovation. This is a fuel of our growth, especially in next generation security, where we play in markets that are early in their life cycle. In the first half of fiscal year 2022, there are 22 major product releases, which is equal to all the releases we had in the full year of fiscal 2020. Even more impressive is that this quarter marks the end of all integrations of our acquired businesses over the last few years, i.e. all of our products are now seamlessly integrated and can have organic development continue on them. We're also pleased to receive two new industry awards, adding one in developer security tools and another in secure web gateway. We now have a leadership position in 10 categories. Focusing first on our firewall business, we're continuing to refresh our platform. And just last week, we announced two more new families with the PA3400 and PA5400. These new Generation 4 platforms have industry-leading performance on real-world encrypted traffic using our single-pass architecture and performance that is three times faster than similar Gen 3 appliances. We also rolled out PanOS 10.2 Nebula release, which adds significant new capability in using machine learning to stop the current generation of highly malicious attacks in line. This capability powers our recently released advanced URL and new advanced threat prevention subscriptions, as well as brings significant enhancements to the capability of our DNS security subscription. We added the industry's first integrated AIOps to our next generation firewalls. Our 10th subscription added to the firewall family. This capability assists customers to prevent firewall misconfigurations and proactively addresses performance issues before they impact customer networks. We were pleased with our ability to grow our product revenues at 21%. This contributed to our Q2 revenue upside and was ahead of our guided mid-teens growth for the full year, which we will be raising. Our teams worked tirelessly during Q2 to ensure we could fulfill product demands to customers as quickly as possible, while also navigating through the Gen 3 to Gen 4 refresh. We did see demand for our next-generation firewall appliances outstrip our ability to ship in the quarter, and this is reflected in the growing RPO I spoke about earlier. Strong security demand, innovations we are bringing to customers such as our Nebula release, as well as customer appetite for our Gen 4 gives us strong conviction in sustained product demand into fiscal year 2023. Next, I want to spend some time in our NGS business. This is one where our teams have done work which I personally believe has not been done in the cybersecurity industry before. And this is what makes Palo Alto Network special. We have built a formidable set of services which are cloud first, and these services are resonating with our customers. This success is truly driven by us working with our customers to anticipate their challenges, delivering best-of-breed solutions in an integrated fashion whilst continuing to focus on security outcomes. This has resulted in us building an NGS ARR stream of 1.43 billion, driven by Billings' growth of 79% in NGS. Diving deeper into SASE, which has been a strong contributor to NGS, we continue to see strong uptake from our existing customers. We're also seeing marquee new customer wins, which are reflected in our current customer count of 1,983, which is up 62%. A recent report from the IT Industry Analyst Enterprise Strategy Group noted that 78% of organizations have begun or are planning SaaS implementations. We see this mirrored in our customer conversations, where hybrid work is now the way many of these companies are planning on supporting the future work. We are pleased to again stand on Okta's Business at Work report, where we were identified as a leading provider of remote access solutions. We're seeing SASE emerge as a key platform for our customers, with these customers looking to Prisma SASE to deploy needed capabilities. We rolled out integrated CASB within Prisma Access 3.0, including a new capability around inline DLP for SaaS, and in particular, collaboration applications. We continue to see success attaching autonomous digital experience management, or ADEM, as an upsell in Prisma Access, as customers rely more on SASE as the foundation of the network architecture. On the cloud front, we're seeing mainstream adoption of hyperscale public cloud in our customer base, as well as an acceleration in production workloads. This is driving sustained strength we're seeing from Prisma Cloud. Four years ago, we made it a conscious strategy to be a first mover with multiple big bets to proactively invest where we believed the future of security was going. Our pivot began with several acquisitions targeting companies with the best technologies. We developed a unique go-to-market approach, allowing us to promote future modules as part of an integrated offering. We're seeing tremendous success with this approach. While our active customers grew 21% to 1,810 in Q2, we saw north of 56% growth in credit consumptions, driven both by increased adoption of the cloud by our customers and their continued adoption of more security modules in Prisma Cloud. While our two core modules, cloud security posture management and cloud workload protection are mainstream within most of our customer base, we're seeing an increase in adoption of three and more modules. There are two areas I would like to highlight in Prisma Cloud this quarter. First, the launch of cloud code security. And second, the launch of agentless scanning. Approximately one year ago, we acquired BridgeCrew, which has strong early traction in DevSecOps, enabling security to be shifted left into the software development lifecycle. This addresses security problems before they are created in production deployments and is far more efficient. A single deployment template can be propagated hundreds of times. If there are multiple vulnerabilities in the code, each deployment could create hundreds of security events even once in production. BridgeCrew had significant traction with its Chekhov open source tool, momentum that has significantly accelerated since its acquisition closed and downloads of up to five times here over here. Building on the BridgeCrew technology, in Q2, we released our fifth Prisma Cloud pillar, Cloud Code Security, which is part of our three-order release. Our standalone bridge crew product has about 70 customers. We're pleased to see DevSecOps customer momentum building as Prisma Cloud customers adopt cloud security to several weeks after its integrated release into our platform. Let's talk about agentless scanning. You've seen a number of smaller provider focus on small initiatives in cloud native security, providing only agentless scanning is one of them. What we hear clearly from our customers that they want a platform approach to cloud security, which offers the flexibility of both agent and agentless scanning. depending on their architecture and security needs. Towards this end, our teams rallied and delivered agentless scanning in record time. This makes sure that our customers can deploy either approach via the integrated platform that is Prisma Cloud. Now turn to Cortex, our endpoint security security analytics and automation solution. We continue to see significant customer demand for automation and security as the threat data and volume of security events grow at exponential rates. The human-only approach to interpreting data and responding to events is not keeping pace. We're seeing strong customer adoption for market-leading technologies across XDR, XOR, and Xpans. Total customers across XDR Pro and XOR reached 3,232 and increased over 69%. Q2 is a strong quarter for new customers, both those that are brand new to pilot networks and also across cells to Cortex. We also saw Q2's strength across all of our geographies for Cortex. At our Ignite event last November, we launched our managed partnership program, XMDR, and we continue to see partners join the program to further align the opportunity across the Cortex portfolio. We now have 27 partners here and have a strong pipeline of interest to partners working through the certification process. Cortex's growing success with Cortex is the innovation and investments we have made over the last year in XDR, XO, and Xpans with market-leading capabilities in each. shortly after releasing XTR 3.0 in Q1 to enable cloud detection response to release XTR 3.1 in Q2 to further enhance our cloud asset visibility and insights. Q2 also marked the release of our intelligence module for XSort providing end-to-end real-world threat intelligence to help identify and discover new malware familiar families or campaigns or attack techniques that are related to security incidents. This morning, We announced our Cortex Extended Security Intelligence and Automation Management, or XIM, platform and shared our vision to provide an autonomous cybersecurity solution as a modern alternative to SIM solutions. We believe security operations teams have an urgent threat detection remediation problem, and only by leaning into a natively AI-driven platform, we will be able to bring down response times from hours and days to seconds and minutes. We're on a mission to revolutionize how data, analytics, and automation is leveraged in cybersecurity, and Ex-SIME is a product of years of research and development we've been doing in this area. Ex-SIME is currently available to a limited number of customers and will be broadly available later this year. In summary, I am very pleased with our Q2 results. We both continue to benefit from strength in our core next-generation firewall business, and it's a strong sign of our future growth prospects, significant strength across our next-generation security portfolio. This balanced performance is a hallmark of our long-term strategy to drive durable growth. On the back of this trend, and based on what we're seeing in our pipeline, heading into the second half of fiscal year 2022, we are raising our total revenue, product revenue, and total billings guidance for the year. Within this top line, given our confidence in both our pipeline and our sales execution in GS, we're also raising in GS AR for the year. Lastly, we're delivering this top line while we continue to make significant investments in our business for future growth. We not only continue to see strong near-term demand, but also strong medium-term trends in cybersecurity, fueled by underlying strength in IT spending and secular trends like hybrid work and cloud native adoption. We have aligned investments both to building sales capacity for fiscal year 23, as well as medium-term investments in product capability. These investments have been made while also absorbing unexpected supply chain related costs this year. Despite this, we have been able to deliver upside to our non-GAAP EPS forecast so far this year. We're lifting a non-GAAP EPS guidance for the year, reflecting much of the upside we saw in Q2. With that, I will turn the call over to Deepak to go into more detail on the Q2 performance and our guidance.

Thank you, Nikesh, and good afternoon, everyone. We again delivered results ahead of our guidance across all metrics as we continue to transform our business. Top-line growth remains strong in Q2 with balanced strength across our portfolio, including product and especially in our next-generation security offerings. Supported by the strength in our differentiated offerings, we're raising our full-year guidance. For Q2, revenue of $1.32 billion grew 30% and was above the high end of our guidance range. Product grew 21% and total services grew by 32%. We saw strong growth in all geographies and across all platforms. By geography, the Americas grew 33%, EMEA was up 22%, and JPAC grew 23%. NGS ARR finished the quarter at $1.43 billion, supported by broad strength across each of our platforms. Prisma Access ARR more than doubled year on year, and we continue to see especially strong growth from XDR and Prisma Cloud. This demonstrates that our portfolio approach to driving growth in our high growth markets is working, and what gives us confidence to raise our guidance here, which I will talk more about shortly. In the second quarter of 2022, we delivered total billings of $1.61 billion, up 32%, and also above the high end of our guidance range. Total deferred revenue in Q2 was $5.4 billion, an increase of 31%. As a reminder, billings is total revenue plus the change in total deferred revenue, net of acquired deferred revenue. Our NGS billings grew 79% year over year, Going forward, we encourage investors to focus on our NGS ARR metric as we view this measure as being more indicative of the underlying drivers of this business. We will not be updating NGS billings in the future. Remaining performance obligation, or RPO, was $6.3 billion, increasing 36%, with current RPO growing largely in line with total RPO. As mentioned previously, we believe RPO adds meaningful insight into our future revenue as it includes both prepaid and contractual commitments from customers. The strength of our RPO growth gives us confidence in our future quarters as it effectively provides us a head start from a revenue perspective. Our product growth was 21% in Q2 and above what we have seen historically, reflecting strong customer demand for our appliance and software offerings. Within our firewall as a platform business, we saw billings grow 26% in line with the growth we have seen over the last year as customers purchase hardware, software, and SASE form factors. Within FWAP, our software mix increased 5 points to 40%. Last quarter, we raised our fiscal year 22 outlook for product revenue growth to mid-teens. We're raising this outlook to high teens as we continue to balance the forces of very strong customer demand and supply chain constraints. Turning to the details of our results, product revenue was $308 million, growing 21%. Subscription revenue of $618 million increased 34%. Support revenue of $391 million increased 30%. And in total, subscription support revenue of $1.01 billion increased 32% and accounted for 77% of our total revenue. Non-gap gross margin of 74% was down 130 basis points in part due to the ongoing costs associated with the supply chain. Our production teams have done an outstanding job in fulfilling the growing demand and keeping the priority focused on enabling shipments to customers. We will continue that posture moving forward. Non-GAAP operating margin of 18.4% was again up sequentially and down year over year as expected, with higher product and support costs impacting the year over year trend. Non-GAAP net income for the second quarter grew 20% to $185 million, or $1.74 per diluted share. Our non-GAAP effective tax rate was 22%. Our GAAP net loss was $94 million, or 0.95 cents per basic and diluted share. Turning now to the balance sheet and cash flow statement. We finished January with cash equivalents and investments of $4.2 billion. Today's sales outstanding was 60 days unchanged from a year ago. Cash flow from operations was $483 million. We generated adjusted free cash flow of $441 million, a margin of 33.5%. in qt we again balanced multiple financial priorities with strength in both top line underlying non-gap profitability and in cash conversion we believe it is important to hold ourselves to this discipline even when growth is robust in order to drive a best-in-class financial model as we scale into a larger company we continue to execute on our capital allocation priorities that outlined in our september analyst bay During Q2, we repurchased approximately 1 million shares on the open market at an average price of approximately $534 per share for a total consideration of $550 million. We continue to expect a large part of our cash flow to be used for share repurchase. We have approximately $450 million remaining on our authorization for future share repurchases expiring December 31st, 2022. On the M&A front, we did not close any acquisitions in Q2. As we noticed at Analyst Day, we continue to focus on managing down our stock-based compensation as a percentage of revenue. This quarter, we reduced SBC by about two points year over year as we apply our overall discipline to this process whilst balancing the current market for cybersecurity talent. We look forward to continuing this trend. Similarly, we talked about an aspiration for achieving the rule of 60, combining revenue growth and adjusted free cash flow margins. You will see that with the revised midpoint of our fiscal year guidance, we are now expecting to achieve this once aspirational goal. Lastly, moving to guidance and modeling points. As Nikesh highlighted, we continue to see very balanced demand. This includes demand from our appliance form factors that outstrips our ability to fulfill them in the short term, as well as strength in our next generation security portfolio. Our Q3 guidance takes into account the strong demand picture as well as the best information we have today on supply chain and other factors. Turning to our guidance for the third quarter of fiscal 22, we expect billings to be in the range of $1.59 to $1.61 billion, an increase of 24% to 25%. We expect revenue to be in the range of $1.345 to $1.365 billion, an increase of 25% to 27%. Non-GAAP EPS is expected to be in the range of $1.65 to $1.68, based on a weighted average diluted count of approximately 106 to 108 million shares. For fiscal year 2022, we expect billings to be in the range of $6.8 to $6.85 billion, an increase of 25 to 26%. We expect revenue to be in the range of $4.25 to $5.475 billion, an increase of 27% to 29%. We expect NGS ARR to be $1.725 to $1.775 billion, an increase of 46% to 50%. We expect product revenue to grow in the high teens with the seasonality weighted to Q4, as we have seen in prior years. We continue to expect operating margins to be in the range of 18.5% to 19%. Non-GAAP EPS is expected to be in the range of $7.23 to $7.3 based on a weighted average diluted count of approximately 106 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. We expect our non-GAAP tax rate to remain at 22% for Q3 22 and fiscal year 22, subject to the outcome of future tax legislation. We expect net interest and other expenses of 5 to 6 million per quarter. For Q3, we expect capital expenditures of 40 to 45 million dollars. For fiscal year 22, we expect capital expenditures of $185 to $195 million, which includes $39 million outlaid in Q2 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. Thank you.