Palo Alto Networks, Inc. — Q2 FY2019 Form 10-Q
Reporting period: Three and six months ended January 31, 2019. The company provides cybersecurity products and services across networks, endpoints, and cloud environments. Comparative 2018 figures were adjusted retrospectively for accounting changes, including revenue recognition.
Financial performance and liquidity
| Metric | Q2 FY2019 | Q2 FY2018 | Six months FY2019 | Six months FY2018 |
|---|---|---|---|---|
| Revenue | $711.2M | $545.6M | $1,367.2M | $1,047.4M |
| Revenue growth, year over year | 30.4% | 29.8% | 30.5% | 28.0% |
| Gross margin | 71.5% | 70.8% | 71.8% | 71.3% |
| Operating income (loss) | $6.6M | $(22.5)M | $(25.5)M | $(76.0)M |
| Net loss | $(2.6)M | $(25.6)M | $(40.9)M | $(88.8)M |
| Billings | $852.5M | $673.2M | $1,611.0M | $1,268.6M |
- Revenue mix: Q2 product revenue was $271.6M, up 32.6%; subscription and support revenue was $439.6M, up 29.0%. Subscription and support represented 61.8% of quarterly revenue. Management attributed growth to higher demand from new and existing customers.
- Cash flow: Six-month operating cash flow was $527.7M versus $518.6M. Non-GAAP free cash flow was $469.9M versus $460.8M, calculated as operating cash flow less $57.8M of property, equipment, and other asset purchases.
- Liquidity: Cash, cash equivalents, and investments totaled $3,638.6M at January 31, 2019, down from $3,950.9M at July 31, 2018. Working capital was $1,619.3M. Deferred revenue totaled $2,525.7M; remaining performance obligations were $2.6B, with about $1.4B expected to be recognized in the next 12 months.
- Debt: Convertible notes had $1,852.4M aggregate principal outstanding: $159.4M of 0% notes due July 2019 and $1,693.0M of 0.75% notes due July 2023. The company had repaid $415.6M of 2019 Notes principal during the six months. A $400M unsecured revolving facility was undrawn at quarter-end.
- Cash movement: Six-month investing cash outflow was $1,236.9M, primarily reflecting investment purchases and the RedLock acquisition; financing cash outflow was $669.6M, including note repayments and $330.0M of share repurchases. Cash, cash equivalents, and restricted cash decreased by $1,378.8M.
Material changes versus the prior comparable period
- Quarterly revenue grew 30.4%; billings grew 26.6%. Six-month revenue and billings grew 30.5% and 27.0%, respectively.
- Q2 operating results moved from a $22.5M loss to $6.6M income, while the quarterly net loss narrowed to $2.6M. The six-month net loss also narrowed, to $40.9M from $88.8M.
- Gross margin improved modestly. Management cited operational leverage and supply-chain improvements, partly offset by lower margins on newly introduced appliances and higher cloud-service costs.
- Interest expense rose to $20.6M for Q2 and $43.3M for six months, primarily due to the 2023 Notes and associated discount amortization.
- Revenue comparisons reflect retrospective adoption of the new revenue standard. The change lengthened amortization of certain initial sales commissions to a five-year benefit period; prior-year results and balances were restated. A separate accounting adoption adjustment reduced accumulated deficit by $28.3M as of August 1, 2018.
Outlook, commentary, risks, and unusual items
- Outlook: The filing gives no specific numerical revenue, earnings, or cash-flow guidance. Management expects operating expenses to rise in absolute dollars, while potentially declining over time as a percentage of revenue; it expects subscription and support revenue to increase over the long term and gross margins to fluctuate. Management stated that operating cash flow and existing cash and cash equivalents should meet anticipated needs for the foreseeable future.
- Acquisitions and products: RedLock was acquired in October 2018 for $158.2M of total consideration, primarily cash, adding cloud-security analytics; acquisition-related accelerated equity vesting resulted in $14.2M of share-based compensation. In February 2019, the company agreed to acquire Demisto for approximately $560M in cash and stock, subject to adjustment, with closing expected in fiscal Q3 2019. It also introduced PAN-OS 9.0 and a DNS Security Service in February.
- Capital allocation: The prior $1.0B repurchase authorization expired December 31, 2018; $330.0M of shares were repurchased during the six months. A new $1.0B authorization was approved in February 2019, expiring December 31, 2020.
- Commitments and contingencies: Contractual obligations totaled $2,806.2M, including $159.4M of 2019 Notes due within one year, $509.0M of gross operating lease payments, and $444.8M of purchase commitments. The filing reported $69.9M of liabilities for uncertain tax positions. It reported no significant litigation accrual and no loss that management determined was probable or reasonably possible and reasonably estimable.
- Key risks: Results may vary with seasonality, sales timing, renewals, competition, and customer spending. The filing highlights dependence on channel partners and a concentrated distributor base: three distributors generated 66.2% of six-month revenue, and four represented 75.2% of gross receivables. Other risks include cybersecurity incidents or product defects, reliance on manufacturing and component suppliers, acquisition integration, international and currency exposure, privacy and regulatory obligations, and the ability to manage rapid growth.
- Other notable items: Share-based compensation was $293.5M for six months, including the RedLock-related charge; $1.4B of unrecognized compensation cost remained at quarter-end. Q2’s 230% effective tax rate reflects a small pretax-income denominator; the six-month rate was negative, with a $9.4M one-time tax benefit from a partial valuation-allowance release related to RedLock.
Important facts for investors to verify
- Reconcile revenue growth with billings and deferred revenue, and assess the sustainability of subscription and support renewals.
- Review the 2019 Notes’ July 2019 maturity and conversion-related cash requirements, alongside liquidity after the Demisto acquisition and new repurchase authorization.
- Assess the effect of share-based compensation, including the $1.4B unrecognized balance, on GAAP profitability and potential dilution.
- Monitor distributor concentration, receivable collections, and the operational and financial integration of RedLock and Demisto.
- Confirm future margins and cash generation against the company’s qualitative outlook; this filing does not provide numerical forward guidance.