Palo Alto Networks, Inc. — Form 10-Q Summary
Reporting period: Fiscal third quarter and nine months ended April 30, 2019. Amounts are in U.S. dollars; financial statement amounts are in millions unless stated otherwise. Prior-year figures were adjusted retrospectively for the revenue-recognition standard and, for cash flows, restricted-cash presentation.
Business context and results
Palo Alto Networks provides cybersecurity products and subscriptions for networks, endpoints, and cloud environments. Its hybrid model combines product sales with subscription and support services, which are generally recognized over time. Management attributes growth to increased demand from new and existing customers and adoption of subscription offerings.
| Metric | Q3 FY2019 | Q3 FY2018 | Nine months FY2019 | Nine months FY2018 |
|---|---|---|---|---|
| Total revenue | $726.6 | $567.7 | $2,093.8 | $1,615.1 |
| Product revenue | $278.4 | $218.1 | $790.5 | $607.7 |
| Subscription and support revenue | $448.2 | $349.6 | $1,303.3 | $1,007.4 |
| Gross margin | 71.8% | 71.8% | 71.8% | 71.5% |
| Operating loss | $(18.7) | $(45.3) | $(44.2) | $(121.3) |
| Net loss | $(20.2) | $(40.4) | $(61.1) | $(129.2) |
| Basic and diluted loss per share | $(0.21) | $(0.44) | $(0.65) | $(1.42) |
Financial position and cash flow
- Growth and billings: Q3 revenue increased 28.0% year over year; nine-month revenue increased 29.6%. Q3 billings were $821.9 million, up 13.4% versus 32.7% growth a year earlier. Nine-month billings were $2,432.9 million, up 22.1%. Total deferred revenue was $2,632.2 million at April 30, 2019, compared with $2,279.3 million at July 31, 2018. Remaining performance obligations were $2.7 billion, with about $1.5 billion expected to be recognized within 12 months.
- Margins and expenses: Q3 gross margin was unchanged at 71.8%. Product gross margin improved to 72.0% from 68.4%, while subscription and support gross margin declined to 71.7% from 74.0%, primarily reflecting costs supporting cloud subscriptions. Operating expenses rose to $540.4 million from $453.1 million, but operating loss narrowed; management cited revenue growth and a lower year-over-year lease-related charge among contributing factors.
- Cash generation: Nine-month operating cash flow was $824.1 million, versus $760.5 million. Non-GAAP free cash flow was $746.0 million, versus $673.9 million. Investing activities used $1,377.2 million, mainly reflecting investment purchases and acquisitions; financing activities used $637.8 million, including note repayments and $330.0 million of share repurchases. Cash, cash equivalents, and restricted cash ended at $1,318.3 million.
- Liquidity: Cash, cash equivalents, and investments totaled $3,718.0 million at April 30, 2019, down from $3,950.9 million at July 31, 2018. Working capital was $1,718.7 million. Management stated existing cash and operating cash flow should meet anticipated needs for the foreseeable future.
- Debt: The company had $159.4 million principal outstanding on 0.0% convertible notes due July 1, 2019, and $1,693.0 million principal on 0.75% convertible notes due July 1, 2023. Net carrying value of total notes was $1,572.8 million. A $400 million unsecured revolver was undrawn; the facility may be increased by up to $350 million subject to conditions.
Material changes, outlook, and notable items
- Subscription and support represented 61.7% of Q3 revenue and grew 28.2%; product revenue grew 27.6%. Across the nine-month period, subscription revenue grew 35.9%, faster than support revenue at 21.7%.
- Research and development and sales and marketing spending increased with headcount and investment in product development and international sales. Management expects operating expenses to rise in absolute dollars, while potentially declining as a share of revenue over the longer term; it expects gross margins to fluctuate. The filing does not provide a specific numerical earnings or revenue forecast in the supplied text.
- Demisto was acquired on March 28, 2019, for $474.2 million in cash, stock, and replacement awards; preliminary purchase accounting recorded $387.8 million of goodwill. RedLock was acquired in October 2018. In May 2019, the company agreed to acquire Twistlock for approximately $410 million cash and PureSec for approximately $47 million cash, subject to adjustment; closings were expected in fiscal Q4 2019.
- Share-based compensation was $138.2 million in Q3 and $431.7 million for nine months. The company reported $1.4 billion of unrecognized compensation cost expected to be recognized over a weighted-average 2.8 years. This is a significant expense and dilution consideration.
- A new $1.0 billion share-repurchase authorization was approved in February 2019, expiring December 31, 2020. No shares were repurchased under the new authorization during Q3; $1.0 billion remained available at quarter end. Nine-month repurchases of $330.0 million were made under the prior authorization.
- Unusual and accounting items include a $4.1 million additional cease-use loss for former headquarters space; the 2019 notes’ conversions and related cash repayments; and a $28.3 million accumulated-deficit adjustment on adoption of intra-entity tax-transfer guidance. Revenue-standard adoption was retrospective and changed certain reported comparisons, especially deferred contract costs and accumulated deficit.
- Management identifies risks including intense competition, dependence on distributors and resellers, reliance on manufacturing and component suppliers, customer renewal and sales-cycle variability, rapid growth and integration of acquisitions, cybersecurity incidents, and international, regulatory, privacy, and foreign-exchange exposures. Three distributors represented 65.1% of nine-month revenue and 51.9% of gross accounts receivable at quarter end. Legal proceedings were described as ordinary-course matters; no significant litigation loss accrual was recorded and management did not identify a probable or reasonably possible estimable loss.
Important facts for investors to verify
- Whether billings growth slowing to 13.4% in Q3, despite 28.0% revenue growth, reflects timing or a sustained change in demand; review subsequent billings and deferred revenue.
- How the July 2019 maturity and conversion or cash-settlement of the remaining $159.4 million 2019 notes affected liquidity and share count after quarter end.
- Whether subscription growth and cloud-related costs support gross margins, and how acquisition integration affects operating expenses and returns.
- Final purchase accounting, integration progress, and cash impact of Demisto, RedLock, Twistlock, and PureSec, including completion of the announced subsequent acquisitions.
- Exposure from distributor concentration, manufacturing commitments, and total contractual obligations, including $509.0 million of gross lease payments and $434.6 million of purchase obligations.
- Potential dilution from convertible notes, warrants, and equity compensation, alongside the actual pace and funding of the new repurchase program.