Palo Alto Networks Inc (PANW) Q2 2021 Earnings Call Transcript

Good afternoon, and thank you for joining us on today’s conference call to discuss Palo Alto Networks’ Fiscal Second Quarter 2021 Financial Results. I am Karen Fung, Senior Director of Investor Relations. This call is being broadcast live over the web and can be accessed on the Investors Section of our website at investors.paloaltonetworks.com. With me on today's call are Nikesh Arora, our Chairman and Chief Executive Officer; Luis Visoso, our Chief Financial Officer; and Lee Klarich, our Chief Product Officer. This afternoon, we issued a press release announcing our results for the fiscal second quarter ended January 31, 2021. If you would like a copy of the release, you can access it online on our website. We would like to remind you that during the course of this conference call, management will be making forward-looking statements, including statements regarding the impact of COVID-19 and the SolarStorm on our business, our customers, the enterprise cybersecurity industry and global economic conditions, our expectations related to financial guidance, operating metrics and modeling points for the fiscal third quarter of fiscal year 2021 and 2022, our intent to acquire Bridgecrew, our intention to be carbon-neutral by 2030, our expectations regarding our business strategies both in equity structure for the ClaiSec business and the vehicle for employees to invest in such equity, our competitive position and the demand and market opportunity for our products and subscriptions, benefits and timing of new products, features and subscription offerings as well as other financial and operating trends. These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today. You should not rely on them as representing our views in the future and we undertake no obligation to update these statements after this call. For a more detailed description of factors that could cause actual results to differ, please refer to our quarterly report on Form 10-Q filed with the SEC on November 19, 2020, and our earnings release posted a few minutes ago on our website and filed with the SEC on Form 8-K. Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. For historical periods, we have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the supplemental financial information that can be found in the Investors section of our website located at investors.paloaltonetworks.com. And finally, once we have completed our formal remarks, we will be posting them to our Investor Relations website under the Quarterly Results section. We’d also like to inform you that we will be virtually participating in the Morgan Stanley 2021 TMT Conference on March 2. Please also see the Investors section of our website for additional information about our conferences we may be participating in. And with that, I will turn the call over to Nikesh.

Thank you, Karen. Hello, everyone. I know Walter Pritchard, you are listening in. Enjoy your last earnings call from the other side. Next quarter, Walter will join us at this end as our new Senior Vice President of Investor Relations and M&A Finance. Well, moving on to the quarter. So let me start with SolarStorm, which many of you are describing as one of the most serious and sophisticated cyber attacks in history. The SolarStorm attack highlighted that enterprises need a comprehensive, up-to-date map of their full IT infrastructure environments, including understanding their own networks, as well as external attack surfaces and supply chains. In order for security teams to have an edge over the adversaries, they need to embrace next-generation technologies that leverage AI, machine learning, and automation. To help our customers, we set up a rapid response program, and when I say rapid, it was rapid. Our acquisitions of Expanse and Crypsis almost felt pre-assigned. The team swung into action. We updated XDR for all the new threat vectors. We offered free assessments from our Crypsis team. We also evaluated the attack surfaces from the outside in for Expanse and discovered that there were dozens of affected customers, including major government agencies and large companies, many of which were actively communicating with SolarStorm malware command and control infrastructure. So far, we've received over 1,000 assessment requests and have completed over 500. We believe that the SolarStorm attack raises the mid and long-term criticality of the cybersecurity industry as a whole. This will result in more awareness and focus on cybersecurity, which, in all candor, is the need of the hour given the complete reliance on technology in these times. We expect that this attack will be a wakeup call to all enterprises to modernize cybersecurity and will serve as a net incremental tailwind, not just for us, but also for the industry. Before I turn to our fiscal Q2 2021 results, I have an admission to make. Perhaps I was too cautious at the outset of the pandemic. The current sustained performance, resilience of our teams, and execution have been turning more optimistic. We had a great second quarter with strong business momentum as the organization executed across all platforms and strategies. As a result, we beat Q2 guidance and consensus. Here are some highlights. We delivered billings of $1.2 billion, up 22% year-over-year with strong growth across the board. Let me give you some additional context. Due to COVID, we have provided billing plans to a select number of impacted customers. When adjusting for these billing delays within the reported 22% year-over-year growth. This trend has been in place and has been growing over the last few quarters. Consequently, our revenue growth is higher than billings growth and accelerated to 25%, reaching $1 billion for the first time ever. Yes. Our first billion dollar revenue quarter with accelerating revenue growth. The strength has been across the board. And as we continue down the path of more and more of a subscription-based model, the revenue predictability will continue to rise. Non-GAAP EPS was $1.55, up $0.36 from last year. EPS expansion was driven by revenue growth and operating expense leverage. While there continue to be beneficial impacts due to lower travel because of COVID, we do continue to hire resources to support our product expansion, which we expect to continue. Free cash flow margin for the quarter was 32.7%. In the first half of fiscal year 2021, we generated $838 million of free cash at a margin of 42.7%. We still expect free cash flow to normalize for the year around our full year guidance due to some seasonality we see in the second half. Last quarter, we started the dialogue around network security and cloud and AI and shared the P&L for both businesses. We received great feedback on the additional transparency and we want to continue to drive more transparency to unlock shareholder value. Let's first take a deep dive into Network Security business, which we are calling NetSec. Our NetSec business is undergoing a transformation towards software and SaaS, making it more predictable and sustainable. Starting with our hardware firewall business and associated services. Rather than building solutions only as hardware, we have chosen to offer security services and software subscriptions. Over the last two years, we have doubled our security subscriptions from four to eight with the introduction of DNS, SD-WAN, IoT, and DLP. We are seeing great progress with DNS, which has acquired nearly 5,000 customers since launch. These new subscriptions, along with the introduction of a higher tier of support, platinum support, have allowed us to increase our next-generation firewall support and security subscription revenue significantly. As you can see, we have sustained a 15% CAGR in hardware, subscriptions and support, and our hardware contribution has gone from 39% to 29% in that time. To continue to drive software growth, we have made these subscriptions available across all form factors, Firewall FLEX, and Prisma Access 2.0. We just recently completed the process of making it available on our product Prisma Access 2.0, which is our firewall in the cloud. Turning to our software firewalls. We continue to see a transformation to software form factors. With the introduction of advanced features, cloud-native integrations, and the development of the industry's first containerized next-generation firewall, we continue to see product market fit. As a result, VM and CNCs grew over 60% in the first half of FY 2021. We recently launched Firewall FLEX, another industry first, a unique approach in how we offer virtual firewalls in the CN-Series to increase customer flexibility and enable a consumption model to drive additional growth. This new flexible consumption model features credit-based licensing that lets you consume VM and CNCs firewalls, choose the number of CPUs needed, and add any or all of our eight security subscriptions, which previously was limited to five. We believe that by providing greater flexibility to our customers, we will continue to drive growth and achieve greater subscription attach rates. To highlight how our software firewalls are transforming, how customers approach security, we closed a deal with a leading telecommunications company to secure their 5G network. The transition to 5G is driving a number of very important architectural changes, including a highly distributed design, containers as a foundation, and security for enterprise customers as a critical business driver. We were first to deliver enterprise and service provider clouds, 5G, and container security. In doing so, we empower our customers to provide a secure 5G service to their customers and provide managed security offerings to their enterprise end customers. Now, let’s talk about Prisma Access, when COVID dramatically changed how work gets done at companies across industries around the world, the needs for securing a remote workforce have also changed. No longer is it sufficient to have partial access to applications or what is sometimes called good enough security. Overnight, connectivity to every application was needed; security became business-critical and user experience determined the difference between maintaining productivity or falling behind. Even before COVID accelerated this change, we were already working on turning Prisma Access into an industry-leading solution for enabling a secure remote workforce. What initially started as a GlobalProtect cloud service started to transform in 2019 with the launch of Prisma Access. In the last year and a half, we've built out industry-leading capabilities. In that timeframe, Prisma Access has gone from less than 150 customers to now nearly 1,000 customers and 30% of the Fortune 100. Last week, we announced Prisma Access 2.0, the biggest update since introducing this service. Prisma Access is a full security platform; it’s the cloud with machine-learning-based security, preventing unknown threats in-line and at line speed, a full firewall delivered as a service, and includes features like Zero Trust Network Access, Secure Web Gateway, CASB, DLP, and IoT security. Prisma Access secures both web and non-web apps. As an example, conventional web security approaches to cloud-delivered security miss 53% of all remote workforce threats that ride over non-web apps. Those threats cannot be ignored and, unlike alternative solutions in the market, we prevent them with Prisma Access. We have completely reimagined the way customers manage Prisma Access with an entirely new cloud-based UI that delivers better security outcomes through built-in security assessments. The new digital experience management add-on provides native end-to-end visibility and insights for SASE and the ability to self-heal when digital experience problems occur. Prisma Access is built on a low-latency and highly scalable infrastructure with Google Cloud as our backbone. Lastly, Prisma Access, along with the Prisma SD-WAN, our rebranded product from CloudGenix, delivers a complete SASE offering. With the recent addition of CloudBlades, we now have a SASE platform, which allows for an API platform for seamless third-party service integration. Prisma Access securely enables access to all applications, delivers best-in-class security to meet enterprise security needs without compromise, and enables a user experience that maintains or even improves worker productivity. In Q2, we closed an eight-figure deal with a leading technology company with over 100,000 employees and businesses in over 100 countries; as part of their digital transformation, the company was launching a new remote work initiative. In order to realize their vision, they needed a secure and optimized network that would support a flexible remote work environment. Palo Alto Networks was ultimately chosen ahead of several of our security peers as the customer saw us as the only vendor that was offering a true SASE solution. Ultimately, Prisma Access was a key product given their goal to rapidly enable remote work, but the customer also purchased next-generation firewalls, VM Series firewalls, and enhanced their store capabilities through Cortex XDR and XSOAR. This was definitely a cross-platform deal to be proud of and we look forward to a great partnership with the customer going forward. Lastly, several of you have asked in the past about a software transition and the associated economics. While the first phase of VM and Prisma Access purchases have mostly been incremental use cases, we put together a few key examples of what we see in the market when a customer chooses to replace a hardware-based security solution with software and SaaS. Our use cases are VMs replacing hardware firewalls, like this example of a local retail store running software firewalls and third-party hardware, along with other software applications. We estimate that the five-year revenue of this VMC deal is roughly equal to that of deals deploying a separate physical next-generation firewall. For use cases, our Prisma Access replaces hardware firewalls. We took a typical branch office use case and estimated the five-year revenue of a Prisma Access deal is two times larger than a next-generation firewall deal. From a customer perspective, we estimate that the customer's total cost of ownership is generally reduced as they move to virtual and cloud-delivered form factors. As you know, Prisma Access is only a year old. So, our gross margins aren't as favorable as hardware, but we expect them to improve over time. Now moving over and looking at our cloud and AI business. We started this call by discussing SolarStorm, but didn't talk about our own experience with an attempted SolarStorm attack. Back in December, we shared with the broader security community that Cortex XDR instantly blocked a SolarStorm attempt on Palo Alto Networks. Thanks to its behavioral threat protection capability. We continue to be bullish around the rapid pace of innovation that is going into our Cortex XDR product. In fact, Cortex XDR was recently recognized by AV Comparatives as the strategic leader in their latest endpoint prevention and response evaluation, while still delivering a lower total cost of ownership than several endpoint security peers. Importantly, last month, Cortex XDR and Data Lake achieved FedRAMP moderate authorization, which should make it a key piece of technology in the Federal space. As further validation of our vision, we see more and more players in the endpoint security space rushing to jump on the XDR wave that we established two years ago. Overall, we continue to see the Cortex portfolio developing into the industry's first proactive security platform, and we see penetration into the largest companies continue to grow. 35% of our Global 2000 and 66% of the Fortune 100 are now Cortex customers indicating that automation and advanced threat detection are top of mind for these customers. In Q2, we closed deals with a retailer. The company chose Cortex XDR to increase visibility, control, and protection of the endpoints by adopting a more complete solution with XDR rather than using EDR. With Cortex XDR support for mobile, the customer is also able to easily extend Cortex XDR to additional devices leveraged on-site of their stores to identify their endpoint security policy across their entire enterprise. We then expanded the conversation to address their SOC's operational challenges by demonstrating how Cortex XSOAR's out-of-the-box preprocessing rules and alert deduplication could reduce their alert volumes dramatically. With the combination of enhanced visibility, protection, and control with an entire endpoint estate, coupled with automating and orchestrating, the Cortex platform will have an immediate impact on this new customer. Switching to Prisma Cloud, Prisma Cloud is building the most comprehensive and best-of-breed cloud-native security platform and we continue to see strong customer interest. Prisma Cloud has now acquired over 2,000 customers with 74% of the Fortune 100 and secures 2.5 billion cloud-released workloads. We also continue to see an increase in Prisma Cloud customers who are using both cloud security posture management and cloud workload protection for containers and services with applications now at 50%. Additionally, last month, Prisma Cloud also achieved FedRAMP moderate authorization along with Cortex XDR and Data Lake, as we said. This allows U.S. government customers to leverage our visibility, compliance, and governance capabilities for securing multi-cloud and gov cloud deployments. The last deal I'd like to highlight is the largest Prisma Cloud deal that we've ever closed, an eight-figure deal with a leading SaaS company. Like many in the industry, they are moving from a private cloud environment to a public cloud. As part of this shift, they are moving to a containerized application architecture. The customer had unique scalability, availability, and vulnerability requirements for securing their containers across AWS, GCP, and Azure Clouds. The maturity, the superior vulnerability detection of the container security capabilities, and the scalability of runtime protection of Prisma Cloud helped convince the customer to choose Prisma Cloud as their container security platform of choice. Last week, we announced our intent to acquire Bridgecrew, an early pioneer of security for the development community. The next big challenge we are taking on in cloud security is what is known as shiftless security. Developers are playing an increasingly important role in cloud security, both in terms of what products are used and how they are operationalized. Today, a single error in development can be replicated hundreds of times over, resulting in thousands of security alerts to be flagged. This drags down productivity and increases the likelihood of security issues in production applications. These issues upfront, where they are easy and quick to fix. It's a win for developers and a win for security. Bridgecrew recognized the need for shiftless security and pioneered an approach to infrastructure as code designed for developers. To engage the developer community, they released an open-source product called Checkov that was downloaded over a million times in the last year and a paid product gaining early traction. When we bring network security and cloud together, we see tremendous synergies to power the platform of Palo Alto Networks. When looking at our Global 2000 customers, we see that these customers are increasingly adopting Strata, Prisma, and Cortex; 68% of our Global 2000 customers have purchased more than one platform, up from 62% a year ago and 56% two years ago. Given the momentum that we are seeing, we are raising guidance for the full fiscal year. For fiscal 2021, at the midpoint of guidance, we expect total revenue growth of 22%, up 200 basis points from our prior guide. Total billings were at 20%, up 100 basis points from our prior guide, slightly lower than our revenue raised due to the impact of billings plans as we discussed earlier. We continue to expect next-generation security ARR at $1.15 billion, up 77% year-over-year. Product revenue is flat year-over-year, unchanged from our prior guidance. Lastly, non-GAAP operating margin of 50 basis points and adjusted free cash flow of 29%, unchanged from our prior guidance as we continue to invest to capture the opportunities in the market. Now let's review our fiscal year projections for NetSec and ClaiSec. Overall, we are confirming our ClaiSec projections while raising NetSec billings by 100 basis points and revenue by 200 basis points given the strong performance of SASE and VMCs. Moving on to adjusted free cash flows. We expect Network Security will deliver a free cash flow margin of 41% in FY 2021, up from 38% in FY 2020. We expect cloud and AI free cash flow margin of negative 43% in FY 2021, an improvement from negative 59% in 2020. As mentioned last quarter, for the next few years, we expect cloud and AI to achieve gross operating and free cash flow margins in line with industry benchmarks as we gain scale and our customer base matures and becomes more efficient. As you can see, we have been able to dig deeper and align our resources further with our business areas of ClaiSec and NetSec. And as I noted earlier, there are tremendous synergies in the power of the platform at Palo Alto Networks. At the same time, we’ve also been increasing our focus on our software transformation and hardware firewalls, while building a new cloud and AI business. To continue this transformation and strengthen our financial profile, we feel that we can create more focus by aligning the teams around NetSec and ClaiSec. So we are officially going from three speed boats on aligning our efforts around these two business areas with six focused efforts as speedboats in our next fiscal year. For NetSec, we are focused on driving this transformation from hardware to software and delivering a best-in-breed hardware solution as required. As you saw, this transformation is actually financially neutral to net-positive for us and always beneficial to our customers. The speedboat sales will be firewalls including virtual firewalls, SASE in our growing security subscriptions. ClaiSec, the business area where we drive cloud security and our Cortex efforts have proven that with focus and an opportunistic, organic, and inorganic strategy, we can create an industry-leading set of solutions for cloud security and solutions like XSOAR and XDR driven by AI and ML. Here, we need continued investment for us to drive customer scale and for us to continue to invest in both continued product development and customer adoption. We'll do so by continuing our focus on Cortex, Prisma Cloud and Palo Alto Networks' incident response services, a newly formed team combining Crypsis' Unit 42, which Wendi Whitmore has joined to help lead. We are also excited to announce that with the Board's consent, we are finalizing the filing needed for an equity structure for the ClaiSec business. Our goal is to make sure the value of the ClaiSec business is more transparent. In addition, the Board approved the development of a vehicle for employees to invest in such ClaiSec equity, strengthening the alignment of shareholders and the interest of employees regarding the success of our ClaiSec business. Lastly, I am also proud to say that Palo Alto Networks recently made a commitment to address climate change, which Luis will go over in more detail around how we will be carbon-neutral by 2030. With that, let me turn the call over to Luis.

Thank you, Nikesh. Climate change is an existential threat and at Palo Alto Networks, we are all in to do our part to address this crisis. We have done some important work up to this point including LED certifications, recycling, and community involvement. We plan to step up our efforts and contribute even more. I am proud of our commitment to be carbon-neutral by 2030. We have already activated renewable energy and high-quality carbon-offset strategies. We will be reducing our emissions aligned to science-based targets and we will work across our value chain to have a lasting impact and advocate stewardship. The Paris Agreement calls on all of us to limit global warming below two degrees Celsius by 2050. We plan to reach our commitments by 2030. We will keep you informed of progress along the way. We will continue to participate in the carbon disclosure project and start sharing plans and progress using protocols set by the task force on climate-related financial disclosures. During the World Economic Forum's Davos agenda last month, we committed to increasing transparency by reporting on the International Business Council’s stakeholders, capitalism metrics over time. It will take creativity, collaboration, and visionary thinking to protect the planet, and we are up for the challenge. We call on others to join us, consider aligning to the Paris Agreement and make your commitment to do your part. Now turning on – turning to our financials, as Nikesh indicated, we had a great second quarter and we continue to deliver winning innovations and adding new customers at a fast pace. This strength gives us confidence to raise our guidance for the year. I would like to start with our performance in firewall as a platform or FwaaP, which had a great quarter as we continue to grow faster than the market. FwaaP billings grew 21% in Q2, as we continue to transition from hardware to software and SaaS form factors. As you can see, FwaaP billings declined 3% in Q2 2020 and over the last four quarters, we've been able to drive sustained execution and growth in this area to 21% in Q2 2021. Next-Generation Security or NGS continues to expand and now represents a quarter of our total billings at $309 million, growing 59% year-over-year. In Q2, we added over $120 million in new NGS ARR, reaching $840 million. Let me remind you, at our last Analyst Day in September of 2019, NGS was a gleam in our eye and we called for $1.75 billion in billings by 2022. We are on track to beat those numbers. In Q2, total revenue grew 25% to $1.0 billion. Looking at growth by geography, the Americas grew 27%, EMEA grew 24%, and APAC grew 14%. Q2 product revenue of $255 million increased 3% compared to the prior year. Q2 subscription revenue of $462 million increased 35%. Support revenue of $300 million increased 32%. In total, subscription and support revenue of $762 million increased 34% and accounted for 75% of total revenue. Excluding revenue from Crypsis and Expanse, subscription and support revenue increased 31%. Turning to billings, Q2 total billings of $1.2 billion net of acquired deferred revenue increased 22%. Strength was broad-based as we continue to see strong execution across the company. The dollar-weighted contract duration for new subscriptions and support billings in the quarter was slightly down year-over-year but remained at approximately three years. For the first half of fiscal 2021, billings of $2.3 billion increased 21% year-over-year. Product billings were $495 million, up 3% and accounted for 22% of total billings. Subscription billings were $1.2 billion, up 23%. Support billings were $733 million, up 34%. Total deferred revenue at the end of Q2 was $4.2 billion, an increase of 30% year-over-year. Remaining performance obligation or RPO was $4.6 billion, an increase of 41% year-over-year. In addition to adding approximately 2,400 new customers in the quarter, we continue to increase our wallet share of existing customers. Our top 25 customers, all of whom made a purchase this quarter, spent a minimum of $59 million in lifetime value through the end of fiscal Q2 2021, a 27% increase over the $46 million in the comparable prior year period. Q2 gross margin was 75.3%, which was down 110 basis points compared to last year, mainly driven by a higher mix of our NGS products, which are less mature. Q2 operating margin was 19.8%, an increase of 190 basis points year-over-year. The operating margin expansion is driven by operating expense leverage behind operational efficiencies, lower travel, and event expenses due to COVID, which more than offset the incremental investment in headcount. We ended the second quarter with 9,038 employees, including 176 from Expanse at the close of the acquisition. On a GAAP basis, for the second quarter, net loss increased to $142 million or $1.48 per basic and diluted share. Non-GAAP net income for the second quarter increased 28% to $154 million or $1.55 per diluted share. Our non-GAAP effective tax rate for Q2 was 22%. Turning to cash flow and balance sheet items. We finished January with cash, cash equivalents, and investments of $4 billion. On December 4, 2020, our Board of Directors authorized an increase to our share repurchase program and extended the expiration date to December 31, 2021. As of January 31, 2021, $1 billion remained available for repurchases. Q2 cash flow from operations of $365 million increased by 19% year over year. Free cash flow was $332 million, up 29% at a margin of 32.7%. DSO was 60 days, an increase of three days from the prior-year period. Turning now to guidance and modeling points. For the third quarter of 2021, we expect billings to be in the range of $1.22 to $1.24 billion, an increase of 20% to 22% year-over-year. We expect revenue to be in the range of $1.05 to $1.06 billion, an increase of 21% to 22% year-over-year. We expect non-GAAP EPS to be in the range of $1.27 to $1.29, which incorporates net expenses related to the proposed acquisition of Bridgecrew using 100 million to 102 million shares. Additionally, I'd like to provide some modeling points. We expect our Q3 non-GAAP effective tax rate to remain at 22%. CapEx in Q3 will be approximately $30 million to $35 million. As Nikesh reviewed earlier, for the full fiscal year, we are again raising our guidance across most metrics. We expect billings to be in the range of $5.13 billion to $5.18 billion, an increase of 19% to 20% year-over-year. We expect next-generation security ARR to be approximately $1.15 billion, an increase of 77% year-over-year. We expect revenue to be in the range of $4.15 billion to $4.20 billion, an increase of 22% to 23% year-over-year. We expect product revenue to be flat year-over-year. We expect operating margins to improve by 50 basis points year-over-year. We expect non-GAAP EPS to be in the range of $5.80 to $5.90, which incorporates net expenses related to the proposed acquisition of Bridgecrew using 99 million to 101 million shares. Regarding free cash flow for the full year, we expect an adjusted free cash flow margin of approximately 29%. With that, I'd like to open the call for questions.

Our first question comes from Keith Weiss of Morgan Stanley.

Excellent. Thank you guys for taking the question and very nice quarter. I was hoping to dig in a little bit into SolarStorm and if you could talk to us about any impacts that you saw in this quarter and more expansively, how do you expect the impacts of that event to play out as we go through the year? Is there more on the comment? And what parts of the product portfolio do you think are going to get most impacted by that event?

Hey, Keith. Thanks. Look, as we said in the call, we launched a series of initiatives to make sure that our customers are protected against SolarStorm. That was a sustained attack, which was planned over a series of quarters, if not years. What we realized is that once you get into the supply chain and start being able to respond to 18,000 customers, the impact is going to be far-reaching. What's happened is that people were first reacting to that, starting to make sure on an emergency basis that there is nothing in their infrastructure that is already infected and they have not effectively been compromised. Now, with that slowly and steadily behind us, we are noticing people are doing cybersecurity assessments. Every board is out there saying, 'Take a look at what we've got; make sure there are no breaches; ensure that we won't be breached.' The first question was, 'Are we breached?' The answer was, 'No, we are fine.' Somebody thought, 'Wait a minute. Could we have been breached if we had SolarStorm?' The answer is, 'Yes.' So what we are noticing is there is a rethinking of the cybersecurity architecture. In that context, our Crypsis acquisition was very helpful because that's where we had the field force to address these situations which came to light. I don't know if you know Wendi Whitmore; she was with PAN-IBM X-FORCE until now and she is going to come join us. She has had stints at CrowdStrike, FireEye, and Mandiant as well, so she's going to drive that effort more aggressively for us. We also saw that in our own case, XDR protected us, which again becomes an important distinction for us because it was a zero-day attack and we identified it thanks to behavioral anomalies that were happening on the endpoint, which is effectively a key feature of XDR. So we are seeing a lot more conversations around that. Expanse's ability to assess what assets are exposed to the outside, which in this case were SolarStorm servers, we also leveraged Expanse to investigate and discovered that there were hundreds of customers with open SolarStorm servers on their networks. So it's been generally useful for us in the XDR part, the XSOAR part, the Crypsis part, but more importantly, the increased board focus on cybersecurity hygiene has been critical.

Excellent. Thank you.

Our next question comes from Philip Winslow of Wells Fargo.

Great. Thanks for taking my question, and congrats on another fabulous quarter. I really want to focus in on Prisma Cloud and the VM and CN-Series. Obviously, you saw a massive uptick in the number of workloads that you protect in the cloud with Prisma Cloud and then obviously a massive uptake year-over-year, I think, more than four times in terms of the number of firewall software customers. So I guess, kind of two related questions here. First, Nikesh, what are you hearing that customers are choosing your Prisma Cloud, obviously aside from the largest deal in that product's history this quarter? And then the follow-up to that, when you think about Prisma Cloud, plus the success you are seeing in the VM and CN-Series, are those two combined kind of changing the customer dialogue that you are having as you are seeing these customers accelerate their shift to cloud?

Yes, Phil. Thank you. Look, if you abstract yourself, we grew our firewall as a platform by 21%. Right? And we've been talking about trying to get that growth to the 15% range. You can see all that growth has come from firewall in the cloud, i.e., Prisma Access 2.0, and has come from our VM and CN-Series firewalls. It's hard to understand if you are not sitting with the customer. We've seen a few deals revert from hardware to software in the last week. Literally, customers aimed to buy a bunch of hardware and said, 'Wait, hold on. You guys launched this Firewall FLEX; why don't we just go into this flexible credit program where we can spin up as many firewalls as we want and spin them down when we don’t need them and carry those credits to the cloud?' So, I think something very important to understand is that we are going through a hardware-to-cloud transition in the industry. It does not mean the demise of the hardware industry. It just means that the incremental shift is beginning to happen. It's gathering momentum. You can't keep posting tens of billions of dollars on billings for AWS, GCP, and Azure and not see a gradual decline in datacenter spending over time. It's going to happen. If you look past the quarters and in that transition, it becomes very important to understand how customers are going to protect themselves in the future. So we are beginning to see customers go from hardware to software, and honestly, we are encouraging it to the extent that the customer wants our opinion. We have the ability to sell hardware, which is the best in the industry and the ability to sell them software firewalls, along with the opportunity to sell them Prisma Access 2.0 in the cloud. We are sitting down with them and saying, 'You pick the best architecture; we'll service it. If you ask us, we'd rather you went down the software route.' And that's when all of you start asking us, 'Wait a minute. If you go to software, do you lose money?' Well, so we put up a slide saying, 'Look, we don't lose money; we make more money.' We don’t say that loudly because that's not a good thing to say openly; it’s a better security solution for the customer, with a reduced total cost of ownership, but we are seeing that transition. I think that’s the most important part of the story, and as we highlighted, we did a big deal in the telecom space, where security matters in 5G. Because, honestly, when you and I walk around with our iPhones and Android devices, if you've got malware on them, tough luck. But if you are a car driving down the highway, and that can be infected with malware, that's a serious problem. So the 5G enterprise networks must be secure. All 5G networks are being built in the cloud.

Okay. Great. Thank you very much.

The next question comes from Sterling Auty of JPMorgan.

Yes. Thanks. Hi, guys. So, in the context of the guidance increase, I did notice that the next-generation security ARR is staying the same despite what looks like good results in the quarter. Was there any pull-forward or what additional commentary can you give us around that NGS ARR outlook for the year?

Honestly, there is no hidden meaning and there we are not trying to tweak it in such a way that, look, we've seen strength in cloud firewall. We've seen phenomenal strength in Prisma Access. I have to tell you that this pandemic has forced the network conversation about how do I make sure Sterling can access every application at home, not just the ones that I let him access. It's evolved from being okay to have remote access to having to have remote access, and then the security conversation started garnering attention on network architecture. Lee and his team have delivered this phenomenal next upgrade where we can look at both web-based and non-web-based apps. So we are seeing phenomenal success. So there is no tempering of our expectation and ambition on NGS. It's just how the math works right now.

That makes sense. Thank you.

Next question comes from Saket Kalia of Barclays.

Okay. Great. Thanks for taking my question here, guys. Nikesh, maybe for you, you touched on this in your prepared comments. Can you talk about the cloud and AI equity structure? What's the reason for setting up that structure now? And how is it going to work mechanically?

Well, Saket, two and a half years ago, when I came here, we talked about building a cloud security business and we talked about establishing an AI/ML-based business. Last quarter, we started showing you the two pieces of NetSec and ClaiSec. You've seen that we are aspiring against $735 million of ARR in cloud AI security. We also shared our left-hand side; our Network Security business actually has phenomenal cash flow margin, 38% going to 41%. That's a cash-generative part of our business whilst we go through a hardware-to-software transformation. On the right-hand side, we are competing with behemoths out there today, like the CrowdStrikes of the world and a bunch of startups in the cloud space. That's an area for investment. We think that the market inherently values both those businesses fundamentally differently. It values the network security business in cash flow and it values the cloud AI business in ARR. So we want to create opportunities for the market to value our businesses differently to create more transparency for shareholders and it also allows us to keep investing in the cloud AI business in the interest of driving more ARR. So as you saw, we’ve separated our financials, showed you both NetSec and ClaiSec. Luis and his team have worked hard to get them audited and ensure that we can keep reporting them on a more regular basis going into next fiscal year. We are looking at various equity structures that allow us to create incentive plans as well as potentially in the future, monetize the ClaiSec business for a different set of investors compared to the Palo Alto investor.

Our next question comes from Fatima Boolani of UBS.

Good afternoon. Thank you for taking the questions. My question is around the firewall as a platform business and the metrics there. Appreciate that deals sort of changed flavor in the 11th hour, to your point, Nikesh. So, what are some of the core assumptions we should leave with around the installed base refresh opportunity, as well as the R&D pipelines for hardware and appliance refreshes within the product portfolio on the Strata side?

Well, Lee, do you want to talk about the hardware refresh plans? All I am saying is that we are not taking our foot off the gas. We are going aggressively to continue to build the next generation of hardware and focus on refresh. I will tell you that in absolute dollars, we still sell the largest number of hardware firewalls in the industry. We have lost some percentages. It doesn't matter if other vendors are out there generating 18% growth; we still sell more absolute dollars of product in a quarter than anybody else. Lee, can you talk about the hardware?

Yes. We are always working on the next generation of hardware since the beginning of the company until now, and we have some amazing new platforms coming. I won't tell you too much until they are out, but we are always working on that, really exciting stuff there. The software side as well with PanOS and new security capabilities, and another set of amazing things we are working on. One thing I'll point out though is the leverage we get across hardware, software, and cloud-delivered. Part of what really resonates with our customers is not that they get to pick which one they use from us, but their ability to actually use hardware where they need hardware, software form factors when they need software, and cloud-delivered when they need that, with a set of consistent security capabilities that are easy to manage and operationalize. That's something that only we can deliver to our customers.

Thank you.

The next question comes from Brian Essex of Goldman Sachs.

All right. Great. Hi, thank you. Thank you for taking the question. I was wondering, Nikesh, if you could dig into a little bit about Firewall FLEX and your credit-based licensing model for next-gen firewall. What was the timing of that rollout? How long has it been in the market and how much adoption is that in terms of the way it's impacting your model?

I'll give you the preface of it and then Lee can jump in and give you the details. But look, we hadn't refreshed our VM pricing policy; it was set up more like a hardware business, where you had to tell us which particular model of software you wanted and you were basically stuck to that model. If you think about software deployment, it’s key. I can give you a key with more capacity or a key with lower capacity. So we just felt that we were being too pedantic in our approach in selling software in a very hardware-centric model, where you can only buy five subscriptions out of eight. We worked hard over the last 18 months to get this all done into a new credit-based model where you can right-size your requirements, so you can spin them up and spin them down. But if I say everything, then Lee doesn't get to say much. So, Lee, I'll stop.

Yes. In my defense, when we came up with the model that was sort of the normal model, and that's what others were doing. I am actually – and our customers are very excited about this new Firewall FLEX model, because it's the first of its kind in the industry, giving our customers the flexibility, and as Nikesh was saying, to choose how many CPUs they need, what subscriptions they want, and where they want to deploy it, whether cloud or on-prem, etc. That level of flexibility allows us to keep it simple at the same time. The last piece I should address is that in the old model, it was getting too cumbersome to offer all the different security subscriptions. This model allows us to easily scale up to all of the current security subscriptions, plus any future ones we come out with.

Lee, how long has it been working with this?

Sorry. We just launched it at the beginning of February. So it's only been out for a few weeks. We are already receiving incredibly positive feedback from customers regarding it.

All right. Very helpful. Thank you.

Next question comes from Gray Powell of BTIG.

Hey, great. Thanks. Can you guys hear me okay?

Yes.

All right. Congratulations on the good numbers. So, yes, last week, you all announced cloud secure gateway features in Prisma Access. How important is that functionality to your customer base, and do you think it creates an opportunity to gain incremental share from legacy players like Symantec or even some of the higher-growth companies like Zscaler?

Well, sorry. Okay. Now he changed his definition of legacy. Never mind. Sorry, I was just kidding. We get punchy after too much coffee on our earnings call day. So, Lee, go ahead. This one is yours.

As I think all of you have seen or heard from us before, we used to set up this sort of either-or approach, either it was a next-gen firewall approach to security or a proxy approach and you've heard us talk a lot about the challenges associated with the proxy approach. Limited application support, some of the challenges with applications, and breakage in performance, but at the same time, we recognized that there are certain use cases out there where there is a right way to do it and it could be very complementary to what we do from a next-gen firewall perspective. So with this release, we basically integrated that into Prisma Access, such that we can give our customers the ultimate flexibility on how they connect to the cloud through both the secure web gateway model and our next-gen firewall natively integrated to provide all the great security capabilities we have.

So I think, Gray, what Lee is saying is we changed the approach to proxies. Now we also support proxies as part of our product and we also support the app-based approach. So now you can go after web-based apps and non-web-based apps. You mentioned that 53% of your breaches come from non-web-based apps, and proxies are used less for non-web-based apps. But we cover both opportunities by doing it the proxy way or the non-proxy way.

Got it. Okay. Thank you very much.

Next question comes from Patrick Colville of Deutsche Bank.

Hey there. Thank you for taking my question. I appreciate it. Just want to ask about Bridgecrew. Is that deployed on-prem in the cloud? Who buys it? Is it the kind of developer buying it with a credit card type payment model? Or just help us understand that product better, please.

Yes, look, again, I’ll take this one. We’ve been making bets over the last two and a half years on where security is, particularly in the cloud space. We’ve moved from workloads to containers to micro-segmentation to DLP to IAM. What we realize is there's a bunch of - so what happens is, you know, you build an application with a developer, you give it to your IT team, and they deploy it and say, 'Hey, you've got a bunch of security bugs.' The developer says, 'So what are my security bugs? Why didn't you tell me before?' So they started going to open source and trying to find security monitoring software to see if they could ensure they don’t build stuff with security bugs in it. What Bridgecrew has is such a - it's an open-source, free, no-credit-card-needed piece of software just to track security bugs in your development and CICD sides. So it tells the developer, 'You are making a mistake; fix it.' Now what happens is you fix it, and then you give it to the security guy, and he says, 'Wait, you still have bugs.' So wait a minute. I checked it. So what we've done is we've bought Bridgecrew. We'll take the open-source tools that they have. We'll look at the policies there. We'll map them with the policies on the enterprise side to check if you need to find data, and if they are going to check it for you in real-time and in production, you get to check it for free as a developer. There are 26 million developers developing; they are similar to security professionals. If you can get 26 million people to start checking it while they are building the application, then it's consistent with what they will check on the enterprise side. That’s the muscle we didn’t have; that’s a DevOps muscle. Most DevOps companies don't have a security muscle. We have a security muscle; we don’t have a DevOps muscle. That’s precisely why we bought that muscle.

Okay. And so the monetization is…

So, what happened is, they have an enterprise version of the free software to give away to developers. It's kind of like Slack; it's kind of like Dropbox. If a lot of people started using it, you want that to be in the enterprise section because you don't want it being checked against a different product set of policies. We are going to merge that enterprise capability in Prisma Cloud, because we already checked it, and we will say whatever your developers check for free is going to be checked in production; they are consistent. If they didn't find a bug when they were writing the code, the likelihood is they won't find it when we are running it.

Next question comes from Tal Liani of BOA.

Hi, guys. I want to go back and ask about the legacy or the hardware piece. I am trying to understand the competitive landscape now and trying to understand the customers' reaction to the fact that the market is migrating somewhere else. Are there still competitive replacements? Or is this a case where customers just keep the status quo, whatever they have today, because if they take a decision, it's going to be a decision to migrate out of hardware into a more modern solution? So I am trying to understand the dynamics, the underlying dynamics in the market and from it to understand what's the competitive landscape like?

Yes, Tal. Thanks for the question. Look, what's going to happen in my version of the world is you will still have 40% to 50% of the customers who will still stick to a data center and a hardware-based strategy. I think what the market has not fully embraced and understood is when you move to cloud, the cloud can be expensive. Many companies will say, 'Wait a minute. I don't need to do all the stuff in the cloud. I'm going to continue to keep a data center for some of the less expensive stuff here; why do I want to take everything and make it real-time bleeding edge in the cloud?' So, you are going to end up in a hybrid world, where people are going to maintain data centers and maintain the cloud. I don’t think every customer in the world is moving to the cloud, but I think that on the margin, yes, you are seeing a bigger shift to cloud than you are seeing people sticking out to. This fact in mind, we do see competitive replacements when customers have end-of-life for existing hardware installs. They are sitting there and saying, 'I am coming to end-of-life for legacy vendor A, B, C, D, or E. Should I replace this with new versions of legacy A, B, or C? Or should I look at a new network architecture that allows me flexibility of having hardware and software?' So, the example we gave, we did a $20 million deal with a customer who built - who bought Prisma Access for half of their employees, who bought hardware firewalls for the data centers and who bought virtual firewalls for their cloud; and they make sure they are all consistent. So we do see customers end-of-life in legacy hardware, which is dead-ended, and which doesn't have a software form factor or a firewall in the cloud capability, and we do see them transitioning to a hardware and software model. So it's not zero sum; it’s not either-or. It sometimes ends up being this and that.

Got it. Thank you.

Next question comes from Brent Thill of Jefferies.

Thanks. Nikesh, there are a lot of questions from investors about this proposed equity structure and the timing and what this means. I am curious if you could just double-click on what you think this looks like and why are you doing this right now?

Thanks for the question. Look, it's not – first of all, we have spent the last six to eight months preparing for the financial visibility and transparency of ClaiSec and NetSec. It requires a lot of work on our accounting side, establishment of lots of rules to ensure how we do transfer pricing between the entities. How do we leverage our common sales force from Palo Alto Networks? We are not doing anything yet; all we have is presented to the Board, and they have agreed that this is an area for us to go ahead and work further on. This means we are looking at seeing how can we make the ClaiSec equity more transparent if we believe the market values it differently than the Palo Alto equity. Now the market could say, 'This is great; we love your Palo Alto equity and we will help it achieve all the price targets some of the more enthusiastic and optimistic ones you have.' In which case, we may not have to do anything. If not, we may actually look to take a look at the ClaiSec equity and see how we can create more transparency because, fundamentally, if you look at it, you've got one business generating $1.5 billion in free cash flow, which is fantastic, and we like it, 38% margin now gone to 41% while we are going through the hardware-software transition. On the other hand, we have a $735 million ARR business growing at 77%. That business has negative cash flows and the market looks together and values us one certain way; maybe the market will value it differently if we look at it differently. So we are just exploring the opportunity to be able to make that value more transparent. We are not going to change the operating structure of the company. We are still going to run it as one company with two agile business units, if that makes sense.

Our next question comes from Michael Turits of KeyBanc.

Hey. Good afternoon, everybody, and nice quarter. It was a really good quarter on firewall platform as a service and you raised Network Security, but the product itself was just a slight beat and you didn't raise it. So what's the delta? What really raised that guidance on networks for the year and drove the outperformance?

That’s software.

What was the biggest piece, VM-Series, Prisma Access, subscription attach; how would you rank those?

Access, VMs, and subscriptions. Not because subscriptions aren’t doing well; it's a very large number. So, sustaining a large number growing at 30% is a good thing.

Great. So it's really, Prisma Access was the big driver?

Yes. I mean, look at Access; when I joined, it was called GlobalProtect Cloud Service. It was barely $10 million in the quarter. Now it's going gangbusters. I just said, now I just said we did a $20 million deal across a customer's entire enterprise which included Cortex and Prisma Access in there. So, we can get to $10 plus million deals in Access in one deal where we were doing $10 million in one quarter, three years ago. So that makes it interesting.

Next question comes from Jonathan Ho of William Blair.

Hi there. I just wanted to get some additional color in terms of the subscriptions that you've been, I guess, selling with the firewalls. Is there any way that you can maybe provide some additional perspectives on maybe which ones are doing well and what the average number of subscriptions being taken are?

Yes, Jonathan. The – obviously, we had four when I joined and they all had over 50% attach rates even before. The one which has gone from zero to 500 is DNS secured in the last two years. As we just announced, we crossed the 5,000 customer mark. Many of the newer subscriptions were just launched as part of 10.0 with our software. So they are all very recent, including IoT, SD-WAN, and DLP. Yes, those things. Sorry, I got Lee sitting next to me, socially distanced; I keep nodding, asking him what I forgot. But SD-WAN and DLP, you can see is combined with our CloudGenix efforts. So we see SD-WAN traction between the two of them. We are seeing a lot of interest in DLP, which is very early; it's only a few weeks old, and IoT, we see situations, but that's more of an architectural sale because not just that subscription; people want to look at the IoT architecture for the enterprise. But we launched healthcare IoT, so it's part of the IoT effort. I have expectations from DLP. I have expectations from SD-WAN, and obviously a combination of CloudGenix and IoT, but I think we'll see different approaches and different trajectories in terms of adoption. IoT is a bigger ticket when we sell it. DLP is a simple attach and it’s easy to deploy, just like DNS security is. So they take different trajectories at different prices.

Our last question comes from Andy Nowinski of D.A. Davidson.

Great. Thank you for squeezing me in. So, you mentioned a number of eight-figure deals for both Prisma Access and Prisma Cloud, which were record deals for the company. Just wondering if you could provide any more color with regard to your overall large deal activity for the quarter? Was the activity up year-over-year? And if you did see an increase in the overall activity, kind of what drove the growth? Thanks.

Yes. Andy, I think purely math. I am waiting for Luis to look at this, but purely mathematically, we added the same number of customers this year as we did last year and our billings grew 20%. So we definitely got to have more bigger deals in there. Hurry up, Luis, what are you doing? So, yes, we are seeing strength. But I would say, it's kind of interesting. If you look at the landscape, the higher end of the cloud sales see bigger deals because you are comparing them to large GCP, AWS, Azure spending. So even if you get 2 to 5% of the GCP, Azure, AWS commitment, you end up with the large deal, which is typically the seven plus figure range. You see a similar activity in Prisma Access because it typically ends up being a three-year TCV style deal where if you get the top end, like 100,000 plus users, you end up with a seven-and-a-half figure deal. XDR in the market typically ends up in the $1 million to $2 million range, because of competitive pressures and competitive activity. So you just need to do a lot more XDR deals to get there. So, it's different depending on the specifics; obviously, firewall, again, depends on the installed base, the estate, the end-of-life, and ELAs have their characteristics depending on again how much estate is there and how much people are re-upping and how much software they are buying. Luis?

So, here is how I look at it. If you add up the billings of the last largest deals that we did this quarter and you compare that to a year ago, the total is 35% higher. So, it just gives you a magnitude of how significant those large deals are for us.

All right. Well, see, Brad Zelnick, if you change your mind about us, you don't even get to ask a question. All right. Thank you everyone. Thank you for joining us, and thank you very much for all your questions. We look forward to seeing many of you in our upcoming investor events. I also want to thank our customers, partners, and of course, our employees at Palo Alto Networks. Have a great day.

Thank you.