Please ensure Javascript is enabled for purposes of website accessibility

How Palo Alto Networks, Inc. Makes Most of Its Money

By Demitri Kalogeropoulos – Jun 20, 2017 at 10:31AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Here are the key contributors to this fast-growing cybersecurity business.

Since it was founded over a decade ago, Palo Alto Networks (PANW 0.37%) has only generated net profit in one fiscal year: 2012. Yet the next-generation security specialist is amassing a large customer base that has helped power strong sales growth despite the stubborn losses. Revenue spiked by 49% last year and by 55% in fiscal 2015. 

Below, we'll look at the major contributors to that revenue growth.

A digital lock.

Image source: Getty Images.

Services over products

Palo Alto Networks' business divisions are split into two segments: products and services. Product revenue comes from sales of its software applications including Panorama, its centralized security management solution.

In addition to these straight licensing sales, the company offers subscriptions that deliver ongoing support and maintenance to customers through contracts that typically last between one and five years. 

The subscription side of the business is growing at a much faster clip than products as customers increasingly opt for term-based licenses. In fact, services reached a bare majority of the business (51%) last year -- up from 47% in 2015 and 43% in 2014. But the company has plenty of room to expand on this score. Almost 80% of rival FireEye's (MNDT) business, for example, comes from subscriptions and services.

Palo Alto Networks expects product sales to continue trending lower as a percentage of the business as the customer base expands. That's good news because these contracts are a source of steady, recurring revenue that isn't nearly as volatile as product sales. Slightly offsetting that positive trend is the fact that services carry lower profit margins. Gross profit for the segment was 72.5% last year, compared to 73.9% for the product division.

The U.S. geography

Palo Alto Networks is heavily dependent on the U.S. geography that accounted for 71% of revenue last year and was responsible for a significant chunk of its reported growth. Europe is its next biggest region with 18% of sales. These figures closely track with independent security peers, as FireEye also gets roughly 70% of its revenue from the U.S. and 14% from the Europe region. 

PANW Net Income (TTM) Chart

PANW Net Income (TTM) data by YCharts.

Major networking giants like Cisco aren't nearly as leveraged to the U.S. market, and while that limits growth opportunities during boom times, it also provides scale advantages and valuable diversity. After all, a prolonged slowdown in security spending in the U.S. market could derail Palo Alto's momentum without causing much disruption to Cisco's wider results.

Customer concentrations

Palo Alto's customer base rose to just under 39,000 last quarter, which marked its second-best client acquisition performance in its history. No single customer accounts for 10% or more of revenue, although the company counts many of the largest Fortune 100 businesses as its clients.

The customer base skews toward the federal government, which has a huge appetite for protecting its IT assets from intrusion. This segment carries a few unique risks, though. Across-the-board budget cuts would but a big damper on the business, for one. The federal government also tends to require extra certification and compliance requirements. If Palo Alto Networks falls behind on any of these, it would lose out to rivals.

That's one reason why the company is working toward diversifying into new industries to help lessen these risks. Some of the brightest growth areas include banking, insurance, and utilities.

Palo Alto's long-term success will turn on whether it can develop strong enough security products -- paired with a robust sales and marketing infrastructure -- to convince tech managers that its next-generation solution is worth the extra resources. Its recent billings trends show encouraging momentum on that score, but the proof for investors will be accelerating customer growth eventually powering consistent profitability.

Demitrios Kalogeropoulos has no position in any stocks mentioned. The Motley Fool recommends CSCO, FireEye, and Palo Alto Networks. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.