Cybersecurity is a fast-growing industry. The only problem is that most of the growth is being generated by next-gen security services, leaving many legacy software vendors scrambling to get their wares up to date with the times.
Palo Alto Networks (PANW 0.11%) has been embarking on just such a (seemingly) scrambled journey the last few years, though the company's acquisition strategy has many investors and industry professionals divided on its long-term viability. Undeterred, Palo Alto went shopping again ahead of its fiscal 2021 first-quarter report card.
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Don't expect acquisitions to abate anytime soon
Cybersecurity needs were already changing fast due to rapid growth in cloud computing, but the pandemic this year has greatly accelerated the trend. Workforces have been dispersed and are working remotely like never before, but this new dynamic greatly increases the number of outlets that malicious actors can exploit. Paired with quickly and steadily rising use of the cloud, organizations have a complex new landscape to try to secure.
Since the start of 2018, Palo Alto has made 10 acquisitions totaling several billion dollars in response to these rapidly changing needs, and takeover number 11 was just announced: attack surface management firm Expanse for a total price tag of $800 million, consisting of $670 million in cash and another $130 million in equity awards. Expanse is generating $67 million in annual recurring revenue and is currently growing at a rate over 100%, so this is an attractive purchase, especially considering how fast the company is expanding.
But besides allowing it to get its hands on a small-ish up-and-coming security firm, Expanse helps fill in some gaps with Palo Alto's existing security suite. Expanse will join the Cortex segment (which was started when Demisto was purchased in early 2019), bolstering the unit's capabilities in orchestrating and automating security responses. Specifically, Expanse helps its customers get an outside view of operations to test, monitor, and mitigate any risks -- especially as they manage their transition to the cloud, remote work, and other changes brought on by the pandemic this year.
With a solid Q1 in the books, Expanse could be a good move
Nevertheless, Palo Alto Networks' strategy has had its critics. The company has continued to outpace overall growth in the cybersecurity industry the last few years and remains in double-digit percentage growth mode. However, much of that growth is thanks to the steady pace of smaller firms it has taken over, takeovers which have turned into almost a quarterly event unto themselves.
In fact, CEO Nikesh Arora said 15% of its forecasted billings (revenue plus the change in deferred revenue) for the year ahead are thanks to the $2.7 billion worth of acquisitions made since 2019. He went on to defend the strategy during the last earnings call, though, reiterating the company's success in purchasing and plugging upstarts into its ecosystem over the last few years. According to Arora, "acquisitions [are] a strategic competitive advantage, and we expect to continue to be opportunistic to increase our long-term growth strategy."
While a high rate of spend is certainly controversial, I'm not one to be overly critical of companies like Palo Alto that can successfully pull it off. Managing a stepfamily is difficult, but if the previously disparate parts can be taught to gel and remain in growth mode, there's something to be said for that. This shows up in Palo Alto's Q1 results. Revenue growth accelerated to 23% year over year, handily besting expectations Arora and the top team outlined a few months ago. The "Next-Generation Security" segment that includes all of those acquisitions specifically notched 53% growth in billings.
The better-than-anticipated quarter also prompted an upgrade to full-year 2021 guidance. Full-year revenue is now expected to increase no less than 20% to 21%, and free cash flow (operating cash flow minus capital expenditures) was upgraded to flat with last year's amount. Backing out acquisition expense, Palo Alto expects free cash flow profit margin to be a healthy 29% in the year ahead.
The world of cybersecurity is changing rapidly, but it's clear that -- despite the controversy -- Palo Alto Networks' spend-happy strategy is yielding results. There's no reason adding another high-growth member to its family won't work out to similar success as the others. Palo Alto aspires to stay in front of the pack as the largest pure-play security software vendor around. It might not have the most conducive plan for generating profits, but that will be a concern for another time.
