5 Takeaways from Palo Alto Networks' Upbeat Earnings Report and Call - TheStreet

Like a few other enterprise tech firms reporting this week, Palo Alto Networks (PANW) - Get Report posted a pretty solid set of top-line numbers.

After the bell on Thursday, the security tech giant reported October quarter (fiscal first quarter) revenue of $656 million (up 31% annually) and non-GAAP EPS of $1.17, topping consensus estimates of $632 million and $1.05. Palo Alto's closely-watched calculated billings totaled $758.5 million, up 27% and slightly above a $756 million consensus.

For the January quarter, Palo Alto expects revenue of $675 million to $685 million (up 24% to 26%) and non-GAAP EPS of $1.20 to $1.22. The revenue outlook is above a $669 million consensus. EPS guidance, impacted a bit by recent acquisitions and tariffs on Chinese-made goods, compares with a $1.20 consensus.

Shares were up 3.4% in morning trading on Friday to $181.99. They're up 25% on the year.

Here are some takeaways from Palo Alto's report and earnings call.

1. Free Cash Flow Remains Much Higher Than Earnings

As is the case for other enterprise tech firms depending heavily on subscriptions that are billed for one or more years but for which revenue is recognized just a quarter at a time, Palo Alto's free cash flow (FCF) is well above its net income. Whereas the company had non-GAAP net income of $115.4 million ($1.17 per share), FCF totaled $275.4 million ($2.79 per share) after backing out a $52.3 million hit related to a debt redemption.

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2. Both Hardware and Subscription Sales Rose Strongly

Palo Alto's "product" sales, which are driven in large part by sales of its next-gen firewall appliances, rose 30% to $240.5 million, topping a $221 million consensus. Software subscription revenue, which covers offerings that handle tasks such as detecting malware, protecting endpoint devices, filtering web URLs and securing the data handled by cloud apps, rose 37% to $231.3 million. Support services revenue rose 24% to $184.2 million.

Historically, much of Palo Alto's subscription revenue came from deals in which subscriptions were attached to hardware sales. However, a growing portion of this business now comes from subscriptions that aren't attached to hardware. Palo previously disclosed its "non-attach" subscription business was on a $274 million annual revenue run rate at the end of its July quarter, up 68% annually.

3. Large Sales Investments Remain a Profit Headwind

Palo Alto's operating expenses rose 22% on a GAAP basis last quarter to $504.6 million, and 27% on a non-GAAP basis to $366.5 million. On a GAAP basis, sales and marketing spend rose 24% to $314.6 million, a figure equal to 48% of revenue and 41% of billings.

Like many other fast-growing enterprise tech firms, Palo Alto hasn't been shy about sacrificing its near-term margins in the name of expanding its footprint. And it doesn't look as if new CEO Nikesh Arora, who was once Google's Chief Business Officer, plans to change that strategy.

4. Palo Alto Is Prepping a New High-End Firewall for Service Providers

On the call, Arora stated Palo Alto plans to launch "a new super-scale next generation firewall" in early 2019 that's built specifically for the needs of service providers. He added that the product will take into account the "price considerations" of service providers, as well as their 5G and IoT-related needs.

"[W]hen I came here, I realized we haven't done as well as we would have liked to do" in the service provider market, Arora said. "[T]he product team really rallied hard the last six months to be able to pull this together, because we believe we already had the industry-leading firewall from a security and networking perspective. We just needed to make sure we were emphasizing some of the features that our service providers need in the future."

Arora did caution, however, that sales will take some time to ramp thanks to the length of service provider sales cycles.

5. Management Insists Amazon, Microsoft and Google Aren't a Threat to its Cloud Ambitions

In October, Palo Alto spent $173 million to buy RedLock, a provider of threat-detection solutions for workloads running on public cloud platforms such as Amazon Web Services (AWS), Microsoft Azure and the Google Cloud Platform (GCP). The purchase follows a $300 million deal earlier this year to buy Evident, a provider of solutions for analyzing security and compliance risks for cloud deployments.

Palo Alto, which also provides a virtual (software-based) firewall solution for cloud deployments, says it plans to combine RedLock and Evident's offerings into a single cloud security solution next year. "The new offering will help security teams better understand their cloud deployments, detect a response faster to the most critical threats and achieve automated remediation," Arora asserted.

When asked on the call about how AWS, which at this week's re:Invent conference unveiled (among many other things) new security solutions and an offering for running AWS services within customer data centers, could potentially challenge Palo Alto, Arora insisted public cloud giants are partners more than threats.

"Most customers are multi-cloud customers. In which case, you need an independent cloud security partner who can help you across this myriad of platforms," he said. Arora also suggested that security accounts for just 2.5% to 4% of the spending involved in typical cloud transitions, and that the cloud giants won't bother competing aggressively for that spending.