Palo Alto Networks Talks Acquisition Strategy, Explains Transition to Shorter Contracts

Palo Alto Networks (NYSE: PANW) this week announced mixed fiscal third-quarter results that paired strong sales growth with net losses. The cybersecurity specialist notched some key operating wins in the period, including bulking up its customer list and securing higher spending from existing clients. On the downside, its average contract length shrank, and the company's aggressive acquisition strategy continued to drain cash from its books.

In a conference call with investors, Chairman and CEO Nikesh Arora and his team broke down the rationale for the company's latest purchases while expressing optimism about Palo Alto Networks' broader growth strategy. Here are a few highlights from that presentation.

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Growth wins

"Our core business continues to be strong, with customers becoming more security aware and looking for simplicity in their infrastructure," Arora said. "We continue to make it easier to deploy more services in our firewalls in the most secure way, and you should expect us to add more capability here."

Palo Alto Networks grew sales by 28% to $727 million, which easily surpassed the 24% forecast management issued back in late February. The robust gains were powered by a rising customer base, including the signing of one of its largest deals to date. The company is also finding plenty of ways to offer more services to existing clients, and it boosted spending by more than $5 million each with 10 of its current customers. Average spending among its biggest 25 customers was up 35% year over year, CFO Kathy Bonanno said.

Transitioning to subscriptions

"The new products and delivery mechanisms are more [software-as-a-service-] based and have a different consumption model, and many cloud customers purchase annual subscriptions rather than a multiyear deal," Arora said.

A few growth metrics deteriorated this quarter as a result of what management called a healthy transition toward more term-based contracts. Billings growth dipped to 25% from 27% in the prior quarter, and deferred revenue gains overall slipped to 27% from 32%. Average contract length shrank to 36 months from 40 months.

Executives said they weren't worried about these shifts, since they were mainly a consequence of customers' increasing appetite for cloud-based subscription contracts over outright license purchases. This move will pressure growth over the short term but should lift cash flow and operating margins over time. Palo Alto Networks is also shifting its marketing focus away from multiyear contracts that typically include large discounts. As a result, investors should continue to see contract lengths shorten while gross profit margins improve.

Aggressively buying growth

"This is a rare feat -- to acquire a company, transform its revenue and its profile and trajectory in six months is unheard of," Arora observed.

After spending more than $1 billion acquiring several niche security companies since early 2017, investors might have expected Palo Alto Networks to ease off the large purchases. Instead, the company this week announced plans to buy Twistlock and PureSec in cash deals worth more than $400 million total. Twistlock will add container security to its suite, while PureSec is a leader in serverless security.

The acquisitions are creating expenses in addition to the buyout price. They're also taking up valuable time from the management team as it integrates them into the Palo Alto Networks umbrella. Executives are confident that the deals will pay off, and, to support that claim, they noted that the recent RedLock deal has already delivered robust sales growth. More important, Palo Alto Networks believes customers increasingly want to buy a full suite of services in an all-in-one package.

Thus, it makes sense for the software specialist to plow ahead with its acquisition strategy. "We are driving hard and fast to try to keep creating integrations," Arora explained, "so customers don't have to buy these products and spend time integrating" themselves.

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Demitrios Kalogeropoulos has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Palo Alto Networks. The Motley Fool has a disclosure policy.