Palo Alto Networks (PANW) is down over 6% after delivering an April quarter earnings report that doesn't look bad at first glance. Revenue and EPS both beat expectations, and while Palo Alto's July quarter EPS guidance was a little below analyst estimates due to a $0.12 per share hit from spending related to recent and planned acquisitions and a $0.02 per share hit from tariffs on Chinese imports, revenue guidance was above consensus.
The main culprit behind Palo Alto's selloff: Though revenue grew 28% annually to $726.6 million and beat estimates, the company's billings -- defined as its revenue plus the sequential change in its deferred revenue balance -- grew just 13% to $821.9 million, missing a consensus of $872.6 million.
On the company's earnings call, CFO Kathy Bonanno attributed the billings miss to a decline in multi-year deal activity and an ongoing shift in its sales mix towards cloud software offerings, which often have shorter contract lengths or are billed based on monthly consumption. She later added that Palo Alto is "trying to structure deals to maximize [its] annual recurring revenue stream," and that this is resulting in shorter average contract lengths.
On one hand, a drop in multi-year deal activity isn't good news, particularly given that Palo Alto is operating in highly competitive firewall and security software markets in which a slew of vendors are guaranteed to fight for any major contract that's open for bidding. But at the same time, the reasons given by Palo Alto for its billings miss, together with the fact that its current billings (they only cover revenue set to be recognized within 12 months) rose 25% to $799.5 million, suggest that the billings miss doesn't imply any major weakness in near-term demand and usage of Palo Alto's products.
Moreover -- as RBC Capital noted while defending Palo Alto -- a shorter average contract length does have some silver linings, such as reduced discounting activity and more opportunities to up-sell and cross-sell products to enterprise clients.
Meanwhile, there's a lot to like about Palo Alto's efforts to grow its software exposure to public cloud infrastructures that are gradually accounting for a larger and larger portion of total IT spending, as well as its broader efforts to grow sales of subscription-based software offerings. On Wednesday, in tandem with its earnings report, Palo Alto announced that it's spending $410 million to buy Twistlock, a top provider of software used to secure app containers across public cloud and on-premise environment, and spending an undisclosed amount to buy PureSec, a provider of software used to protect serverless computing deployments on public clouds. Container and serverless adoption have both been growing at a rapid pace.
Palo Alto also announced that it's putting all of its cloud security software offerings -- they include products for protecting public clouds, cloud apps and branch offices, as well as virtual (software-based) firewalls -- into a suite known as Prisma. On the earnings call, CEO Nikesh Arora disclosed that Prisma is now on a $250 million-plus annual billings run rate, and that its RedLock products, which it acquired last year and underpin its public cloud offerings, are on a $100 million-plus billings run rate.
Like many other companies that depend heavily on subscription software revenue streams, Palo Alto's free cash flow (FCF) is well above its reported net income. And following its Thursday selloff, the company sports an enterprise value (market cap minus net cash) that's equal to 15.3 times its expected fiscal 2020 (ends in July 2020) FCF, and just 12.5 times its expected fiscal 2021 FCF.
Even if one chooses to value Palo Alto cautiously thanks to its billings miss and competitive environment, its current valuation looks pretty reasonable, given the company's current top-line growth, the health of the broader IT security spending environment and Palo Alto's attempts to increase its exposure to faster-growing IT security markets.