Palo Alto Networks, Inc.

Good day, everyone, and welcome to Palo Alto Network's Fiscal Third Quarter 2025 Earnings Conference Call. I am Hamza Farawala, Senior Vice President of Investor Relations and Strategic Finance. Please note that this call is being recorded today, Tuesday, May 20, 2025, at 1.30 p.m. Pacific Time. With me on today's call to discuss our fiscal third quarter results are Nikesh Arora, our Chairman and Chief Executive Officer, and Deepak Galecha, our Chief Financial Officer. Following our prepared remarks, Lee Claridge, our Chief Product Officer, will join us for the question and answer portion. You can find the press release and other information to supplement today's discussion on our website at investors.paloaltonetworks.com. While there, please click on the link for quarterly results to find the Q3 25 supplemental information and Q3 25 earnings presentation. During the course of today's call, we'll be making forward-looking statements and projections regarding the company's business operations and financial performance. These statements made today are subject to a number of risks and uncertainties that could cause our actual results to differ from these forward-looking statements. Please review our press release and recent SEC filings for a description of these risks and uncertainties. We assume no obligation to update any forward-looking statements made in the presentation today. This presentation contains non-GAAP financial measures and key metrics relating to the company's past and expected future performance. Non-GAAP financial measures should not be considered a substitute for financial measures prepared in accordance with GAAP. The most directly comparable GAAP financial measures and reconciliations are in the press release and the appendix of the investor presentation. Unless specifically noted otherwise, all results and comparisons are on a fiscal year-over-year basis. We also note that management is scheduled to participate in the Bank of America Technology Conference this quarter. I will now turn the call over to Nikesh. Thank you, Hamza.

Good afternoon, everyone, and thank you for joining us for our earnings call. I'm delighted with our Q3 results. We continue to make progress on our platformization strategy while releasing a number of unique innovations in Q3 that set the pace for our industry. It is becoming increasingly clear that as organizations aspire to simplify and modernize their security architectures in the age of AI with data at the center, our strategy is resonating, resulting in larger deals. Most notably, we crossed an important milestone of $5 billion in next-generation security ARR, up 34% year-over-year, delivering industry-leading growth at scale. Our net new ARR growth also showed positive momentum in the third quarter. We believe we've reached an inflection point in our next-generation security story, as a growing majority of our incremental growth this year is derived from our AI-powered XIM, SASE, and software firewalls. These offerings with large TAMs should help underpin your confidence in the sustainability of our NGS ARR growth as we march towards our $15 billion ARR target for FY30. On the profitability front, Q3 continues to show the leverage in our business model. As we drive efficiencies from our scale and benefit from the economies of larger multi-product deals, in addition to continuing to drive AI efficiency benefits slowly and steadily. We also generated healthy free cash flow while continuing to manage our transition from a billing focus to RPO. As such, we remain confident in achieving our adjusted free cash flow margin targets over the next few years. Let's be clear. You can't walk around a street corner or a conference without hearing the words AI. The urgency to adopt AI is omnipresent in all of our customers. It no longer seems to be a choice. is becoming a strategic imperative for every customer as the risk of inaction is too high. During every conference, every customer conversation, the topic of AI transformation is more and more frequent. And now the conversation is shifting to agentic AI. What's fascinating is this is actually creating a higher sense of urgency amongst our customers to undertake their technology transformations. Transformations that require a fundamental change in their infrastructure. Traditional IT architectures weren't built for the scale, speed, or complexity of AI. To truly capitalize on AI's potential, enterprises need modern cloud-delivered platforms that can ingest vast amounts of data and operate in real time at scale. We've seen customers who were previously delaying their cloud migrations are now re-accelerating their investment. This is good news for cybersecurity. And as AI becomes more deeply integrated into our customers' businesses, the need to protect the underlying data, models, and infrastructure will become paramount. the next year an estimated more than 300 billion will be spent on ai infrastructure alone that kind of spend does just doesn't just power models you saw the video we opened with glean and we're hard at work enabling secure adoption of this next wave ai powered applications This is precisely why industry must change the paradigm, shifting away from today's fragmented security landscape and towards consolidation. The cost of fragmentation is friction. Friction causes latency. Latency is the enemy of real-time cybersecurity. Now more than ever, bringing data together into a unified platform is critical. At its core, security is a data problem. We believe our depth and breadth of data is amongst the largest in the industry and is something that point solutions simply cannot access. This leads to superior threat detection efficacy, reduced false positives, and faster incident response times, all critical metrics for our customers and key drivers of our market leadership. The volume and complexity of threats are not slowing down either. Bad actors are using AI to move faster than ever. Recently, our Unit 42 team was able to simulate an entire ransomware attack in under 25 minutes using AI at every stage of the attack chain. That's a staggering increase in speed, powered entirely by AI. Over a year ago, we doubled down on our platformization strategy. We're pleased with the large deal momentum we've had since and the endorsement of our strategy broadly across the industry. Our platform approach is working well with customers slowly and steadily. Our approach, which favors better and speedier security outcomes and lower cost of ownership, is being adopted by more and more of our customers. In Q3, we delivered over 90 net new platformization deals and now have a total of approximately 1,250 platformizations within our top 5,000 customers. Digging deeper, the number of customers with multiple platformizations grew nearly 70% year-on-year in Q3. In particular, the number of customers platformized on Cortex was up nearly three times, reflecting strong momentum with XIM. The overall growth in largest customers also reinforces our success. We had 130 customers with over $5 million in NGSA ARR in Q3, up over 40% year-over-year, and 44 customers with over $10 million in NGSA ARR, up over 60%. To give more color to what these platformizations look like, I want to take a look at a few examples from Q3. Of particular note, beyond the size and scope of our deals, is the customer's ability to consolidate a significant number of products with Palo Alto Networks. A leading global consulting firm signed a transaction worth over $90 million in Q3. This customer platformized on Cortex-RX-IM, replacing a legacy incumbent SIM provider. Our differentiated value was centered on our ability to materially reduce mean time to respond. We also reduced costs by consolidating a total of four products in this deal. As a result, our NGSAR of this customer nearly doubled year over year. A leading financial services company signed a $46 million transaction with us. The customer recognized the value of XIAM and consolidated four products with us, including the displacement of their well-established DDR and SIM vendors. Beyond XIAM, the customer also expanded and extended their platformization on our network security platform in the quarter. A US financial services firm signed a $33 million transaction with us. This customer platformized on network security and consolidated cloud security vendors, driven by a company mandate to consolidate their security tools and reduce complexity in their cybersecurity stack. In this deal, they consolidated four products. Now moving on to an update on Cortex. As you can tell from my earlier comments, I'm particularly excited about the momentum we're seeing with XIM. It saw accelerating growth in Q3. XIAM is not only our fastest growing product ever, it is now more impactful to our overall growth rate. I believe that from a strategic perspective, XIAM has the potential of being the game changer for both the industry and Palo Alto Networks. in the first innings of baseball, not cricket, of transforming the cybersecurity industry with XIM. By consolidating security data into a single AI-driven SOC platform, XIM is modernizing and disrupting the traditional SIM market. We're continuing to see amazing milestones, including customers' mean time to respond from weeks to minutes. As security teams face growing complexity and talent shortages, we believe XIM is well-positioned to be the operating system for modern SecOps. The numbers speak for themselves. We now have approximately 270 customers in XIOM, and the average AR per customer is over $1 million. This already makes it one of the most successful products in the history of cybersecurity. What's even more remarkable is that we've reached this level of adoption and impact just 30 months after XIOM was made generally available to customers. XIOM ARR grew over 200% year-over-year in Q3, nearly twice as fast as our closest next-generation SIM competitor. On a trailing 12-month basis, XIM bookings are now approaching $1 billion. About three years into our XIM journey, our sustained strong momentum bolsters our confidence in a long growth runway as we increasingly tap into this estimated $40 billion SecOps stamp. Last quarter, we unveiled Cortex Cloud, our breakthrough in unifying cloud posture and SOC operations. Over the last few months, we have seen strong early customer interest in Cortex Cloud, the nine-figure pipeline spanning hundreds of customers This quarter, we also announced two products that will enhance our ability to further expand Ex-Im and its capability. Ex-Im, once deployed, has become the foundational security data platform for our customers. We now understand the data we're capturing is the data you actually need for a whole variety of use cases. In April, we launched advanced email security to help stop threats before they reached the inbox, and our exposure management capability was launched as well, designed to cut through the noise and focus security teams on the risks that truly matter. But that's not all. Think of XIAM as our data-to-market engine. Every byte of nearly 12 petabytes of telemetry we ingest daily around cloud identity endpoints in email and more act as high-octane fuel. This massive data stream isn't just powering XIAM. It's igniting our ability to identify and accelerate our entry into entirely new markets, unlocking additional time in the tens of billions we're now uniquely positioned to address. Through our comprehensive understanding of data sources and broad data ingestion capabilities, we're beginning to deliver solutions using the multiple content capabilities of XIAM. Every piece of telemetry we ingest makes our platform smarter. The more data we pull in, the further our engine can go. And the smarter it gets, the faster we can build entirely new capabilities on top of it. We're encouraged by the early customer feedback and look forward to continuing to discuss this more in the future. Now shifting our focus to network security. We continue to lead the market in network security and gain share across all three of our best-of-breed form factors. As enterprises look to securely and increasingly secure hybrid workforces and IT environments spanning headquarters, branch offices, data centers, and the cloud, we're uniquely positioned with a consistent security architecture. In Q3, our product revenue grew 16% year-over-year. This growth was broad-based, with software continuing to increase in the overall mix. We also saw stable demand in the appliance market. Software firewall ARR grew approximately 20% year-over-year in Q3 with public cloud deployments continuing to be the primary driver. AI is accelerating cloud adoption, and we believe this trend will expand the long-term need for software firewalls that scale with modern workloads. shifting to SASE, which continues to be our fastest growing form factor in network security and a strong contributor to our overall growth. As customers transform their network to keep pace with delivering first-class security capabilities for remote users and branch offices, we continue to see robust growth for SASE. Many SASE projects are large and comprehensive, which is well-suited to our rich offering and enterprise-focused sales expertise. In Q3, our SASE ARR grew 36% year-over-year, more than twice as fast as the overall market and ahead of our key SASE competitors. Furthermore, 40% of new SASE customers were yet new to Palo Alto Networks in Q3. We now have approximately 6,000 SASE customers, up 22% year-over-year. Meanwhile, the drivers of our SASE momentum are broadening. This quarter, we saw a particular strength in Prisma Access Browser, which again accounted for a third of our Prisma Access seats sold in the quarter. In just 18 months since our talent acquisition, we have now sold approximately 3 million licensed seats on Prisma Access Browser, up more than 10x from a year ago. And we have a healthy nine-figure pipeline. As AI drives more data and applications of cloud, the browser is becoming the primary interface to accessing these resources, acting as the application runtime environment. The operating system in this scenario becomes less about local resources and more about securely connecting to and managing cloud-based services. And as more and more critical applications of data reside within the browser environment, it naturally becomes a target for cyber attacks. Prisma Access Browser's native controls and real-time visibility are designed to help ensure that sensitive data remains safeguarded during browsing sessions regardless of the user's location or the application they're accessing. And we believe Prisma Access Browser is strategically positioned to be the future OS in enabling secure and productive work in an evolving AI-driven world. Now shifting to our newly launched Prisma AIRS, or AI Runtime Security. As I mentioned earlier, It's more important than ever to bring data together in order to leverage AI and enable customers to stay ahead of the attackers. We're also seeing customers demand for us to help them secure their AI transformation journey. In this mad rush for AI in the industry, many of our customers are experimenting with AI. At Palo Alto Networks itself, our teams are leveraging over 35 models across multiple products, each of which and their AI artifacts need to be discovered, scanned, constantly tested, and protected against. Prisma Ares allows for just that. It helps enterprises discover, scan, and test all the AI artifacts to ensure they're safe. It allows for world-class data security posture deployment, and once in production, it ensures that applications using AI are constantly monitored and any security flaws are both protected against as well as remediated across the enterprise. Prisma AIRS extends our existing capability in posture management and runtime security and will add security for AI agents in the future. And we recently announced the intent to acquire Protect.AI, an early innovator leader in security for AI, providing AI model scanning and AI red teaming to further bolster our capabilities. Customer interest has been strong. We currently are in conversation with hundreds of prospects and already have an eight-figure pipeline since making the announcement last month. In summary, we see strong momentum heading into our fiscal year end, driven by continued transformation, and we look for our first north of $4 billion quarter. We see strong desire for consolidation and the desire to implement AI securely, including a robust Q4 pipeline. We continue to take share across multiple security categories, driving strong growth in NGS ARR at an industry-leading scale. Our platformization strategy translates into tangible business benefits for customers, including a strong security posture and improved operational efficiency through vendor consolidation. With our relentless focus on innovation, we believe Palo Alto Networks is the ideal partner to help organizations achieve and secure their AI transformation goals. I'm particularly proud of our teams for driving phenomenal success in a Q3, which was fraught with geopolitical discussions, data discussions, yet our teams kept our heads down and continued to execute, setting us up for what we hope will be a great Q4. Let me hand it over to Deepak to review the quarterly results in detail.

Thank you, Nikesh, and good afternoon, everyone. To maximize our time spent on Q&A, I will provide you with highlights of Q3. You can review the detailed results in our press release and the supplemental financial information on our website. In Q3, total revenue was $2.29 billion and grew 15% at the high end of our guided range. Within total revenue, product revenue grew 16%, while total services revenue grew 15%. Within total services, subscription revenue grew 18% and support revenue rose 10%. On a trailing 12-month basis, the proportion of our product revenue from software is approaching 40%, driven by our growth in our virtual form factors and SD-WAN. We continue to see stable demand for firewall appliances, with market growth in the 0% to 5% range, as we have discussed previously. Moving on to geographies, we saw double-digit growth across all theaters, with the Americas growing 12%, EMEA up 20%, and JPAC growing 23%. Our remaining performance obligation, or RPO, grew 19% to $13.5 billion. Our current RPO was $6.2 billion, growing 16% year on year. The average duration of new contracts remained at approximately three years. Contract duration decreased slightly on both a year-over-year and a quarter-over-quarter basis. Customers continue to make significant commitments to Palo Alto networks through our platformization deals, particularly when adopting XAM to transform their security operations center. We continue to see increasing demand for annual payments, particularly deals over $1 million, but we are absorbing this transition while maintaining the high end of our fiscal year 25 annual adjusted free cash flow margin guidance, as well as reiterating confidence in our adjusted free cash flow margin targets of 37% plus in fiscal year 26 and 27. In line with what we talked about earlier in the year, we saw a year-over-year increase in bookings that went into annual billings in Q3 and a decrease in deals leveraging PANFS with a neutral impact on cash flow. Turning to Next Generation Security ARR, as Nikesh highlighted, we surpassed the $5 billion mark in Q3 and ended the quarter at $5.09 billion in NGS ARR, a growth of 34%. Within NGS ARR, we continue to see significant momentum around our Cortex platform, and our AI ARR is now approximately $400 million in Q3, up over two and a half times year over year. I'm particularly excited about the trends driving the NGS ARR, and I wanted to provide some additional insights around the evolution of our net new NGS ARR. We've made a number of significant investments over the last several years to both continue to lead the network security market as well as build leadership positions in new markets. You've seen the results of this effort in our NGS ARR. Over the last several years in network security, we invested in advanced cloud-delivered versions of our subscriptions that attach to our appliances. We saw strong adoption of these advanced subscriptions as customers saw the value of adding these to their existing network security deployments, and this has driven meaningful NGS ARR growth. In addition, we have NGS product offerings beyond those advanced subscriptions in new markets across network security, cloud security, and security operations. We refer to those as our new market offerings as they have also fueled our NGS ARR growth. We continue to see momentum from our advanced subscriptions in fiscal year 25, driving a healthy and relatively consistent level of net new ARR compared to prior years. At the same time, we've seen our net new NGS ARR from new market offerings grow significantly, and these are becoming a larger proportion of our total net new NGS ARR dollars. This is a result of our strengthened position in these markets, our large sales team becoming more adept at selling these offerings, and platformization taking hold with our customers and in the industry. As we look forward, we expect to see the new market business to be the stronger driver of net new ARR dollars. It is this dynamic that gives us confidence in our long-term targets. Moving down the income statement, total gross margin was 76%, product gross margin was 78.4% in the quarter. As a reminder, we have been transitioning to a contract manufacturing facility in Texas as our primary manufacturing and fulfillment center to benefit from scale and innovation, as well as to take advantage of a foreign trade zone that can help us mitigate tariffs in products that we ship to international destinations. As we said in our previous call, we continue to believe that we differentiate ourselves by being the only pure play cybersecurity firm at scale to assemble all of our hardware in the USA. As a result, tariff impact to our business has been immaterial. We expect product gross margins to remain in the high 70 or low 80% margins in Q4. Our total services gross margin was 75.4%. We are excited to see continued strong adoption of our SaaS offerings. We continue to execute on cloud cost efficiencies, including engaging with our key cloud service providers to negotiate favorable procurement arrangements as the scale of our cloud hosted products continues to increase. Encompassing those gross margin dynamics, we continue to focus on executing our operating margin targets, which delivered year-over-year improvements in operating margin. As I have often said, our business scales well across every single line item of the P&L. On an operating expense as a percentage of revenue basis, we saw 340 basis points of year-over-year leverage this quarter as we drove scale and efficiencies across sales and marketing, R&D, and G&A. We delivered $0.80 of diluted non-GAAP EPS and diluted GAAP EPS of $0.37, our 12th consecutive quarter of positive GAAP EPS. We generated $578 million in adjusted free cash flow in Q3. Turning to the balance sheet, you will see that our debt balance came down by $151 million as we continued to see early conversion of our convertible debt, which occurred at the discretion of the debt holders and was settled by us in cash and equity. As a reminder, our convertible notes reach final maturity in June, and our convertible notes can no longer be early converted. We will settle the remaining convertible debt in cash and equity in Q4. As Nikesh mentioned, we announced our intention to acquire Protect AI for a total consideration of $700 million in cash and replacement equity awards. We expect the transaction to close by our first quarter of fiscal year 2026. We did not repurchase any shares in Q3, and our buyback strategy remains opportunistic. We have $1 billion in authorization remaining through December 2025. With that, let me turn to guidance. For the fiscal year 2025, we expect NGS ARR to be in the range of $5.52 to $5.57 billion, an increase of 31% to 32%. Remaining performance obligation of $15.2 to $15.3 billion, an increase of 19% to 20%. Revenue to be in the range of $9.17 to $9.19 billion, an increase of 14%. Operating margins to be in the range of 28.2% to 28.5%. Our diluted non-GAAP EPS to be in the range of $3.26 to $3.28 per share, an increase of 15%. Adjusted free cash flow margin in the range of 37.5% to 38%. As we noted last quarter, we do expect a higher Q4 contribution to our annual free cash flow. And for Q4 specifically, 80% of the collections are from deals that have already been booked. Our annual cash flow seasonality is more second half and Q4 weighted this year, influenced by the timing of deferred payments from customers that signed deals in prior periods and the timing of bookings within the year. For the fourth fiscal quarter of 2025, we expect NGS ARR to be in the range of 5.52 to 5.57, an increase of 31 to 32%. Remaining performance obligation of 15.2 to 15.3, an increase of 19 to 20%. Revenue to be in the range of 2.49 to 2.51 billion dollars, an increase of 14 to 15%. and diluted non-GAAP EPS to be in the range of $0.87 to $0.89, an increase of 16% to 19%. We've included our typical modeling points in the presentation for your review. With that, I will turn it back to Hamza for the Q&A portion.