Palo Alto Networks, Inc.

Good day, everyone, and welcome to Palo Alto Network's fiscal third 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, Thursday, May 19th, 2022, 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 the prepared remarks. you can find the press release and information to supplement today's discussion on our website at investors.palowetzownetworks.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 the 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 part of today's presentation. Mike Noble, We also discussed non gap financial measures these non gap financial measures are not prepared in accordance with gap should not be considered as a substitute for or superior to. Mike Noble, measures of financial performance prepared in accordance with gap. Mike Noble, We have included tables which provide reconciliations between the non gap and gap 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 note that all comparisons are on a year-over basis and specifically noted otherwise. We would also like to note management is scheduled to participate in the upcoming JP Morgan, Jefferies, and Bank of America investor conferences in the next several weeks. I will now turn the call over to Nikesh.

Thank you, Clay. Good afternoon, everyone, and thank you for joining us today for our earnings call. In this time of increased macroeconomic volatility and geopolitical uncertainty, we saw a combination of strong cybersecurity market demand and our team's execution in line with our strategy to drive our Q3 financial results. We reported strong top line metrics of both Billings and RPO growing 40% year over year. This is the highest Billings growth we have reported looking back over the past four years. It was driven both by strong demand for our next generation security offerings and strong customer commitments to our network security business. In network security, we saw product again grow over 20% as we continue the transition to software. Customers continue to consolidate their network security to Palo Alto Networks as a result of the significant expansion in our subscription capabilities for the last several years. Our net security ARR ended Q3 at 1.61 billion, up 65% year-over-year. Our top-line performance translated into non-gap operating income that grew ahead of revenue enabled strong cash flow conversion. We were pleased that we were able to achieve these bottom-line results despite challenges in the supply chain. Speaking of the global backdrop, whether it is supply chain, geopolitical conflict, or rising interest rates and inflation, this environment is creating challenges for our customers and testing our execution. I'm pleased our teams have risen to the occasion and shown strong execution across sales, operations, and all areas that support the business. The trend that started with the pandemic and the widespread cyber attacks, the trend of network transformation, cloud transformation, and fortifying one infrastructure continue to be strong. Coupled with consolidation in cybersecurity, we expect this to continue to drive strength and growth both for the industry and us in particular, given our unique three-platform approach. Of course, the events of Ukraine are on everyone's mind. We stand with the people of Ukraine against Russian aggression and have been working to provide direct cybersecurity support to Ukrainian organizations. This geography has not been significant for us in terms of revenue or our overall growth expectations. For this quarter and our most recent quarters, our combined Russia and Ukraine revenue was well below 1%. We have halted new sales in Russia, and we are also complying with all government sanctions. Since December, we have deployed protection for over 3,400 new indicators of attack that defend organizations from disruptive and destructive Russian cyberattacks. As you might expect, we're seeing heightened interest from commercial and government customers in Europe around mitigating this nation-state activity. This ever-challenging threat landscape is driving broader and more strategic customer conversations. We continue to see our customers look for an elevated level of partnership, and this is expanding our market opportunity. We continue to see success in consolidating share within the enterprise market, and this has become a core tenet of our growth strategy. We see evidence of this in our multi-platform sales with 48% of our global 2,000 customers having transacted now with us on all three of our major platforms of Strata, Prisma, and Cortex. The number of million-dollar deal transactions we signed was up 65% in Q3, and the average size of our million-dollar deals increased in the quarter. We also saw the number of $5 million deals increase by 73% year-over-year. Large deals are an important selling motion for us as we further penetrate global 2,000 customers with our second and third platforms. Innovation is the engine that underpins our growth in the market, which Gartner estimates will total over $250 billion in end-user spending by 2026. With the trend towards vendor consolidation in the market, customers appreciate our best-of-breed capabilities within each of our three platforms. This quarter, we added four additional categories to the recognition we received for our best-of-breed capabilities. Remember, they're all integrated into our three platforms, so customers get the benefit of our platforms as well as the individual best-of-breed capabilities which compete effectively against independent vendors in our industry. forced to recognize their position in cloud workload security with a leader designation in the inaugural wave in this market. The only company to have that recognition. Early recognition of the importance of attack surface management, which we entered through the acquisition of Expanse in 2020, was validated as we were recognized as an outperforming leader by GigaOM. We received strong performer designations from Forrester in two categories, incident response and EDR. I'll next provide you an update on our platforms and what progress we've made in the last quarter. Starting with Prisma Cloud. We continue to see strong momentum driven by both new customers and notable for this quarter, large upsell and expansion commitments, which drove 25 deals north of a million dollars. This growth in customers and existing customer expansion is evidenced in our credit consumption, which grew 50% year-over-year in Q3. We continue to drive cloud security leadership across the industry. And as I've said before, all Prisma Cloud customers are inherently customers of hyperscalers, yet they choose us. Customers are looking for a scaled, integrated cloud security platform that Prisma Cloud provides, enabling us to deliver high double-digit growth. Our customers are increasingly recognizing that operating securely in the cloud means ensuring that software that is written for the cloud is secure. This starts with the developer. Early observation of this trend led us to acquire BridgeCrew in early 2021. We have been focused on building out a portfolio of offerings targeted at developers. This is our fifth pillar of Prisma Cloud. Cloud Code leverages all the existing capabilities of Prisma Cloud, including its approach to credit consumption, deployment, and reporting. One quarter from release, we've seen success in six-figure commitments to Prisma Cloud driven by cloud code. And also, this is amongst the fastest modules adopted in Prisma Cloud in terms of credit consumption. Critical to our developer strategy, we continue to see strong downloads of our Chekhov open source offering, which reached over 7 million in Q3. Moving on to Cortex. We are helping customers reimagine how they operate their security operation centers with automation and AI ML at the core. Cortex customers grew over 60% in Q3, supported by multi-product Cortex transactions in EMEA and the Americas. We achieved an important milestone in Q3 with approximately $500 million in Cortex ARR. In Q3, we saw strength in each of our established Cortex product areas with a record number of transactions for XTR and Expanse and nearly that level of business with XOR. XTR continues to shine with industry awards and benchmarks. This quarter, XTR was recognized for 100% tear prevention and detection in the recent MITRE evaluation. Forrester also recognized the significant progress we have made with XTR in our series of releases over the last nine months, recognizing XTR as our strong performer in its EDR wave. Our expanse performance with transactions up well over 100% in the last 12 months shows that attack service management is now seeing an inflection in mainstream demand. After a recent limited release of XIM, we are making progress in our goal to initiate co-design work with 10 partners and expect to be on track at the end of this quarter with our plans. XIM will ultimately enable us to achieve our cortex vision around SOC automation, delivering what we expect to be a very unique value to our customers and disrupting the multi-billion dollar SIM category by offering a modern alternative that leverages AI and ML. Moving on to SASE. Last week, we made a call to the industry to adopt ZTNA 2.0, which ushers in a new era of hybrid workforce security based on key zero trust principles like least privilege access, continuous trust verification, and continuous security inspection across all apps. Our mantra for Prisma Access is to provide zero trust with zero exceptions. The pandemic has accelerated the adoption of SASE. In addition to significant traction from our install base, we continue to see strong momentum from net new customers for whom Prisma SASE is their first significant purchase from us. These customers then become opportunities for incremental engagements across other platforms. SASE saw particular success with large transactions in Europe as we signed 11 large transactions in EMEA, further endorsing the global nature of SASE demand. The SASE is in the early innings, and we're making significant investments to ensure we continue our momentum in this category. Moving on to Strata, our hardware and subscription services platform. For the third consecutive quarter we delivered north of 20% product revenue growth, we saw strength across our portfolio both hardware appliances and software form factors. As you're aware, the industry is dealing with unprecedented supply chain issues which are likely to persist for yet another year. Our team is definitely managing these with our partners, allowing us to maintain better lead times and some in the industry. We have seen instances where we are advantaged in having supply where competitors cannot timely deliver, and we believe this has helped contribute to market share gains. We saw our momentum validated by third-party recognition of market share gains in both hardware and VM form factors, and hardware Omdia recognized Palo Alto Networks as being number one in market share for the appliance market with over 27% share, up more than five points ear-to-ear. In the VM market, according to Deloro, we added six points of market share ear-to-ear and command nearly 34% of the market. We continue to execute our Generation 3 to Generation 4 transition. We have now released nearly all Gen 4 appliance models. Although customers are very early in the devaluation adoption of Gen 4, we expect this Gen 4 adoption will help drive our appliance growth rates ahead of the market growth rate. We're seeing strong uptake of advanced URL subscriptions and strong early demand for new advanced threat prevention subscription. We released next generation CASB last quarter and saw solid Q3 performance here. Lastly, we announced our second partnership with a hyperscaler to embed our network security into the fabric of their cloud. This is differentiated innovation that leverages our engineering scale, our market leadership position, and relationships to hyperscalers. Cloud Next Generation Firewall on AWS brings a combination of Palo Alto Network's industry-leading network security in a cloud native form factor and marries it with ease of use of Amazon Web Services. This relationship with AWS follows the launch of Cloud IDS and Google Cloud Platform last July. We expect Cloud Next Generation Firewall will drive further growth of our firewall as a platform and specifically our software form factors. It also gives customers another reason to standardize on our network security platform. Innovations like Cloud Next Generation Firewall on AWS, Cloud IDS on Google Cloud, and our licensing of security subscriptions to SaaS providers to protect their cloud applications are differentiators for us versus competitors that are primarily focused on the appliance form factor. Bringing it all together, we're very pleased with our Q3 results, where we saw exceptional top-line growth. At the same time, even while going faster, we are prioritizing investments and delivering on the profitability targets we committed during our September 2021 analyst day. We believe this is an important discipline, and we intend to maintain this focus on profitability targets while maximizing growth. We continue to see broadening demand for cybersecurity, which is enabling us to grow and invest from a position of strength. As we focus on our mission to be our customer cybersecurity partner of choice for today and tomorrow, we also aspire to deliver to our shareholders outstanding returns as a proxy for growth of the cybersecurity opportunity, as well as world-class execution. We're very pleased with the first three quarters we have delivered so far in fiscal year 2022. We look forward to updating you in three months on our plans to continue accelerated growth, balance profitability, and look at how we intend to target gap profitability in the near future. With that, I will pass the call over to Deepak to talk about our results in more detail.

Thank you, Nikesh, and good afternoon, everyone. Our strong results continue to be driven by solid demand across the breadth of our offerings, with results again ahead of our guidance across all metrics. In the midst of top-line strength, we balance profitability well. With the strength of this momentum and our favorable outlook, we are again raising our full-year guidance. For Q3, revenue of $1.39 billion grew 29% and was above the high end of our guidance range. Product grew 22% and total services grew by 32%. By geography, growth was balanced across all theaters, with the Americas growing 30%, EMEA up 28%, and JPAC growing by 29%. NGS ARR grew 65% to $1.61 billion, supported by balance strength across this portfolio. As noted in our Q2 earnings, going forward, we focused on NGS ARR as one of our core metrics, as we believe it's indicative of the return we're seeing on our growth investments and also helps investors track the growing mix of this business within our revenue. We saw strong double-digit growth across all of our major NGS offerings with Prisma Cloud, Prisma SASE, and Cortex, as well as growing contributions from recently introduced NGS offerings. We are pleased with this diversified portfolio-driven growth. Overall, this performance, as well as the continued maturity of our go-to-market organization in selling our NGS capabilities, gives us confidence to raise our annual guidance for NGS ARR again in Q3. In the third quarter of 2022, we delivered total billings of $1.8 billion, up 40%, and also above the high end of our guidance range. Total deferred revenue in Q3 was $5.9 billion, an increase of 34%. Remaining performance obligation, or RPO, was $6.9 billion, increasing 40%, with current RPO representing a similar percentage of the total as in recent quarters. Our teams executed very well again in Q3, and you see the result of the strength in these top-line metrics, which lead revenue. There were a few factors to call out that drove the strength that we saw this quarter. In addition to the significant strength in our NGS business, we saw strength in our attached subscriptions. We've seen customers use their budget to make incremental commitments to our attached subscriptions as they anticipate firewall upgrades and overall network security capacity increases. As well, they're seeing the value in newer subscriptions we have brought to the market over the last 12 to 18 months. This gives us further conviction around sustained demand for appliances, as well as our software-based FWAP form factors, as customers look to benefit from our consistent architecture, including these subscription capabilities. Product revenue again was strong, growing 22% in Q3, with demand exceeding our ability to ship due to supply chain challenges. We estimate customers refresh their products every four to seven years, with many now evaluating our Gen 4 hardware. We're in the early days of this refresh cycle, with only a small proportion having updated their products. As I noted earlier, we're seeing signs of customers making commitments to our hardware platform, both based on strong subscription demand and also the beginning of our install-based refresh activity. Our firewall as a platform billings grew 25% on top of the accelerated Q3 growth in the year-ago period. We continue to see this performance well-balanced across our FWAP form factors. Within our FWAP offerings, the strength of our product business held our Q3 software mix at approximately 39%, in line with Q2 and the year-ago quarter. Turning to the details of our results, product revenue was $352 million, growing 22%. Subscription revenue was $640 million, increasing by 35%. Support revenue of $395 million increased 27%. In total, subscription and support revenue of $1.04 billion increased 32% and accounted for 75% of total revenue. Non-gap gross margin of 72.9% was down 170 basis points. The driver continues to be supply chain related costs as we incurred additional expense for components and shipping. Despite the pressure on our gross margins, non-gap operating margin of 18.2% was up 120 basis points year over year. We were able to offset higher supply chain costs with lower operating expenses as we drove efficiencies across the business. Non-GAAP net income for the third quarter grew 38% to $193 million, or $1.79 per diluted share. Our non-GAAP effective tax rate was 22%. GAAP net losses were $73 million, or 74 cents per basic and diluted share. Turning now to the balance sheet and cash flow statement. We finished April with cash equivalents and investments of $4.6 billion. Product and associated subscription shipment shifted toward month three, resulting in day sales outstanding of 71 days. Cash flow from operations was $390 million. We generated adjusted free cash flow of $351 million, a margin of 25.3%. With regard to capital allocation priorities, we did not repurchase stock during Q3. However, we do expect share repurchase to be a major use of cash flow as previously stated. We currently have approximately $450 million remaining on our authorization for future share repurchases. This current authorization expires on December 31st, 2022. On the M&A front, we did not close any acquisitions in Q3. Managing stock-based compensation remains a management focus. This quarter, we reduced SBC as a percentage of revenue by approximately four points year over year and two points quarter over quarter. We will continue to apply discipline to this process while balancing reductions against the market dynamics for cybersecurity talent. Key to our ongoing success is maintaining balanced top and bottom line growth while continuing to acquire and retain top talent. Lastly, moving to guidance and modeling points. As Nikesh highlighted, we continue to see very balanced demand from customers across our portfolio. This includes demand for our appliance form factors that outstrips our ability to fulfill in the near term, as well as strengthen our next generation security portfolio. Our Q4 guidance takes into account the strong demand picture, the best information we have today on supply chain, and other factors. Recall that a year ago in the second half of fiscal year 22, we were hiring aggressively. As we move beyond that comparison, investors should be considering the comments we provided around medium-term margin expansion goals. Turning to our guidance for the fourth quarter of 2022, we expect billings to be in the range of $2.32 to $2.35 billion, an increase of 24 to 26%. We expect revenue to be in the range of $1.53 to $1.55 billion, an increase of 25 to 27%. We expect non-GAAP EPS to be in the range of 2.26 to 2.29, 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 $7.106 to $7.136 billion, an increase of 30% to 31%. We expect revenue to be in the range of $5.48 to $5.50 billion, an increase of approximately 29%. We expect next generation security ARR to be $1.775 to $1.825 billion, an increase of 50% to 55% versus a very strong performance in the fourth quarter of fiscal year 21. We expect strength in product revenue to continue. free cash flow margin for the year of 32% to 33%. Achieving the rule of 60% was an aspiration we called out in our September 21st analyst day. The rule combines revenue growth and adjusted free cash flow margin. Based on our Q4 guidance, we're pleased to project that the combination will exceed 60% in fiscal year 22, which is ahead of our prior stated plan. We've seen strong growth in fiscal year 22. On a revenue basis, our guidance for the year is 3.6 higher at the midpoint than where we started and 7.5% higher at the midpoint for NGS ARR. Along with this top line, we've absorbed incremental supply chain costs and are happy to be able to continue to project the same operating profitability range as at the beginning of the year. Additionally, please consider the following additional modeling points. We expect non-GAAP tax rate to remain at 22% for Q4 and fiscal year 22, subject to the outcome of future tax legislation. For Q4 22, we expect net interest and other expenses of $1 to $2 million. We expect capital expenditures in Q4 of $36 to $41 million, and we expect capital expenditures for the full fiscal year of $190 to $195 million, which includes $39 million outlaid in Q2 2022 related to our Santa Clara headquarters. Stepping back, we're focused on balancing our drivers of total shareholder return, recognizing not only the importance of top-line growth as we focus on executing strong market demand, but also profitability, cash conversion, and our capital structure. Balancing profitability is a commitment we made at our analyst day, and we've been able to deliver on this in fiscal year 22 despite increased costs related to our supply chain. We will continue to make progress on our commitment of 50 to 100 basis points operating margin expansion and 100 to 150 basis points of adjusted cash flow margin expansion beyond fiscal year 22 through 24, whilst balancing top-line growth opportunity. We're on track to achieving our fiscal year 24 targets we outlined in our September 2021 Analyst Day, including $10 billion in billings and $8 billion in revenue. We believe we can continue to deliver shareholders outstanding returns as a proxy for the growth of the cybersecurity opportunity, as well as world-class execution. With that, I will turn the call back over to Clay for the Q&A portion of the call.