Palo Alto Networks’ Bull Run Probably Won’t Be Ending Anytime Soon

Palo Alto Networks(NYSE: PANW) freshly minted CEO, Nikesh Arora, didn’t get a warm reception from Wall Street thanks to the company’s mixed fiscal third-quarter report a few days after his appointment was announced. The cybersecurity specialist easily beat expectations in the June 4 quarterly report and raised its full-year revenue guidance, but the market apparently took a dim view of its tepid earnings guidance and Arora’s lack of expertise in the cybersecurity space.

But that would be nitpicking in what was otherwise a stellar quarter. I think Arora brings just what Palo Alto needs to keep its growth engines humming.

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Arora’s arrival could help Palo Alto accelerate faster

Palo Alto Networks has been adding customers at a terrific pace, driven mainly by its strategy of attacking various niches within the cybersecurity space by way of acquisitions.

Data from Palo Alto. Chart by author.

Palo Alto’s customer base has been increasing by a larger number with each passing year as it has managed to win business from rivals. More importantly, the company’s existing customers have been spending more money on its products and services. This is evident from the 43% annual jump in the lifetime value of purchases made by its top 25 customers to $28.7 million.

This is great news for Palo Alto, as customer lifetime value is the amount of money a company makes from a client after deducting acquisition and servicing costs. The increase in this metric can be attributed to the company’s strategy of becoming a platform-based provider of cybersecurity solutions, allowing clients to develop and deploy their own features using the various tools provided by Palo Alto.

Arora has been chosen to take this vision forward. In the press release announcing his appointment, Palo Alto noted Arora had served as president and chief operating officer at Softbank and chief business officer at Google, where he was “instrumental in growing Google’s search business from $2 billion in revenues to over $60 billion in revenues, led more than 20,000 employees, and developed a substantial track record of driving innovation and delivering business success.” Palo Alto’s board believes Arora’s experience will come in handy as it lines up with the cybersecurity specialist’s growth strategy. They lauded his experience in scaling technology businesses.

Detractors might argue that Arora lacks cybersecurity expertise, but one shouldn’t ignore that he will have a team of seasoned Palo Alto executives to back him up. Additionally, the new executive’s wide-ranging contacts in the world of technology could help boost Palo Alto’s customer base. Arora has been brought in to scale up Palo Alto’s business, and he has already displayed a penchant for doing the same in his previous roles.

The bottom line is getting better

Palo Alto’s GAAP net loss fell 23% year over year to $46.7 million in the latest quarter as it had to spend less money to acquire customers. It spent nearly 49% of its revenue on sales and marketing last quarter, down from 52.5% in the prior-year period.

More importantly, higher spending by Palo Alto’s customers has led to a terrific increase in its deferred revenue, which refers to the amount of money earned by a company for services to be delivered at a later date. Deferred revenue is recognized on the income statement when the actual service delivery takes place, so it acts as an indicator of the company’s top-line health in the long run.

Last quarter, Palo Alto’s deferred revenue shot up almost 22% year over year to $2.15 billion. What’s more, 46% of its deferred revenue was long-term in nature, up from 42% a couple of years ago. This provides clear evidence that Palo Alto is able to lock in customers for a longer time period, which bodes well from a profit standpoint as it is leading to lower customer acquisition costs.

Palo Alto is currently sitting on nearly $1 billion in deferred revenue, an increase of nearly 23% from the prior-year period. Looking ahead, the company’s deferred revenue should keep getting better; it still has a lot of room to grow the subscription and support business, which supplied around 62% of Palo Alto’s total revenue in the previous quarter.

The subscription business carries a much lower cost of revenue of just 26%, while the cost of revenue of the product business is 32%. So, subscription growth in subsequent quarters will positively impact Palo Alto’s deferred revenue, as well as its bottom line thanks to the superior margin profile.

Exciting times ahead

Palo Alto investors might not be an excited lot right now thanks to a mixed quarterly performance and the executive turnover. But it might not be long before a change of perception takes place, since the company is growing quite aggressively, as its exceptional quarterly report shows. Additionally, it has set its sights on dominating the cybersecurity space in the long run by appointing Arora, who could supercharge Palo Alto’s fast-growing customer base by scaling up the company’s business through new partnerships or acquisitions.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares) and Alphabet (C shares). The Motley Fool recommends Palo Alto Networks. The Motley Fool has a disclosure policy.

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