Palo Alto Networks (NYSE: PANW) had entered 2017 on a weak footing thanks to an obsolete sales strategy. It looked like the cybersecurity specialist is going to relinquish market share to rivals as it spent too much money to add customers that weren't generating long-term value. Not surprisingly, its outlook had taken a hit and investors lost confidence.
But Palo Alto has steadied the ship remarkably since then, releasing a strong quarterly report that beat the higher end of its guidance range by a wide margin. What's more, the company also raised its full-year guidance thanks to strong demand for its endpoint protection and cloud security offerings.
Therefore, Palo Alto looks set to close the year on a high after gains of almost 30% in the past three months. But investors who have missed the Palo Alto gravy train so far need not worry, as the company is pressing the right buttons to boost its revenue and earnings in the long run.
Palo Alto's costs are coming down
Palo Alto reported adjusted net income of $69.8 million in the latest quarter that ended on Oct. 31, up 36% from the prior-year period. Though its GAAP net loss increased over 12% due to an increase in share-based compensation and expenses related to new headquarters, there's no doubt that Palo Alto is making the right moves to reduce its overall cost profile.
For instance, the company spent just over 51% of its revenue on sales and marketing expenses, down around 420 basis points from the prior-year period. By comparison, Palo Alto's revenue increased 27% year over year, which means that its cost of revenue generation has decreased. More specifically, the company's cost of revenue as a percentage of the top line fell from 27.9% to 25.4%. This can be attributed to the growing clout of Palo Alto's subscription business.
Last quarter, the company got 63% of its revenue from the subscription and support business, up from 58.9% in the year-ago period. Now, it costs less to service a subscription-based customer who is bringing in recurring revenue than to spend money to acquire a new one. Moreover, Palo Alto will have stronger opportunities to cross-sell updated products as subscriptions grow, which means that its costs as a percentage of revenue will continue declining.
All this positively impacts its margins, so it wasn't surprising to see Palo Alto's operating margin improve 1% year over year in the latest quarter. Looking ahead, the cybersecurity player can keep expanding its subscription revenue thanks to the improvements in its end-point and cloud security platforms.
Palo Alto's revenue growth is secure
Palo Alto expects its fiscal 2018 revenue to increase 23% at the mid-point, up from the prior expectation of 22% growth. The company has been encouraged to raise its revenue guidance as its customers are now spending more money on products and services.
The lifetime value of Palo Alto's top 25 customers jumped an impressive 53% year over year last quarter to $23.2 million. Customer lifetime value denotes the amount of profit a company makes from a particular customer. It is arrived at by deducting the acquisition and servicing costs incurred on that customer from the expected revenue gained.
The massive increase in client lifetime value means that Palo Alto is getting more money from its existing clientele while spending less money on them at the same time. Looking ahead, its current clients can increase their spending on Palo Alto's products as it has added new features to its portfolio.
For instance, it has updated its Traps endpoint protection platform with new features that are designed to prevent malware and ransomware attacks. Palo Alto has paid special attention to providing protection against ransomware attacks following the WannaCry and NotPetya breaches that cost users millions of dollars around the globe.
The ransomware protection market is expected to hit $17 billion in revenue in 2021, more than twice the revenue it generated last year. The updated platform will encourage Palo Alto customers to protect themselves against ransomware attacks, while also bringing new clients into its ecosystem who are looking for such a feature.
On the other hand, Palo Alto has expanded its cloud security offering -- Aperture -- to include protection for several solutions provided by Amazon Web Services (AWS), the e-commerce giant's cloud computing platform. This includes the Amazon Elastic Compute Cloud, which is the cornerstone of the company's cloud computing business as it allows users to rent virtual computing power in the cloud.
Palo Alto has made a smart move by adding AWS-specific security features since Amazon leads the cloud computing space with a 35% market share. Therefore, it will now have a better chance at tapping the fast-growing cloud infrastructure security market that's expected to triple in size over the next five years, hitting $12.7 billion in revenue by 2022.
Given these feature additions, it is not surprising to see why Palo Alto's deferred revenue jumped 37% last quarter to $1.9 billion. This is more than the total revenue generated by the company in the past year. More specifically, just over $1 billion of the deferred revenue is short-term in nature, which means that it will be recognized on the books within a year. By comparison, Palo Alto's short-term deferred revenue was $758 million in the prior-year period, representing year over year growth of 34%.
Meanwhile, Palo Alto's long-term deferred revenue grew at a faster pace of 40% year over year in the latest quarter. This means that the company has been successful in securing long-term revenue growth, which will eventually boost its bottom line. Analysts seem to have a similar opinion, as they expect Palo Alto's bottom line to clock an annual growth rate of more than 22% over the next five years.
This is a good sign for Palo Alto investors, portending that its cybersecurity offerings are being well-received by customers and this should set the company up for long-term upside.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, 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 Amazon. The Motley Fool recommends Palo Alto Networks. The Motley Fool has a disclosure policy.