For Palo Alto Networks, Is the Best Yet to Come?

Abstract shield depicting cybersecurity.

Palo Alto Networks (NYSE: PANW) was primed to deliver a strong second-quarter earnings report, and the company didn't disappoint. The cybersecurity specialist beat the high end of its own expectations and raised the full-year guidance thanks to strong demand for its services, which led to terrific customer growth last quarter.

Not surprisingly, Palo Alto shares shot up to fresh 52-week highs following the report. But can this pure-play cybersecurity company sustain its terrific momentum, especially considering the stiff competition it faces from bigger rivals such as Cisco ? Here is a closer look:

A rapidly growing customer base will be a tailwind

Palo Alto added approximately 3,000 new customers last quarter, taking its total customer count to 48,000. The good news for investors is that the company has seen an impressive uptick in customer addition rates this year. In fiscal 2017, Palo Alto's customer additions averaged 2,130 a quarter. By comparison, the company added over 2,500 new customers during the first quarter of fiscal 2018 and followed it up with a stronger jump during the recently reported quarter.

More important is the fact that Palo Alto's existing customers are now striking bigger deals with the company, which points toward the growing importance of its cybersecurity offerings. The spending from its top 25 customers increased 54% year over year during the previous quarter as it won more business from rivals. This combination of Palo Alto's expanding customer base and bigger deal sizes boosted the company's deferred revenue to $2 billion at the end of the quarter, a 33% jump from the prior-year period.

By comparison, Palo Alto's quarterly revenue had increased 28% year over year during the latest quarter, so its deferred revenue is growing at a faster pace. Deferred revenue is the money received by the company for services that will be provided at a later date. So the faster growth in this metric means that Palo Alto's customers are spending more on its offerings, which should ideally lead to a stronger top-line performance in the future.

Almost half, 45%, or $908 million, of Palo Alto's deferred revenue was long-term in nature during the second quarter, which means that it will be recognized on the income statement only after a period of more than one year. By comparison, 45%, or $671 million, of its deferred revenue was long term a couple of years ago.

This means that Palo Alto customers are now getting into longer contracts with the company. In fact, the company claims that the average contract length of its new subscription and support contracts is three years, which points toward secure long-term growth.

The subscription business is powering margin growth

Palo Alto has been pivoting its business away from product-oriented sales to a subscription-based model, which is the catalyst behind the jump in its deferred revenue. Last quarter, the subscription and support business supplied almost 63% of its top line, up from 60% in the year-ago period. This helped the company boost its operating margin by 0.8% to 20.5% during the quarter because it costs less to service an existing subscription customer than it does to acquire a new one.

The increasing clout of the subscription and support business boosted Palo Alto's non- GAAP net income by 35.7% year over year, which is greater than the pace of its revenue growth. And the subscription and support business should get better in the future as evident from the jump in its deferred revenue and the long duration of average customer contracts. This will eventually improve Palo Alto's bottom line.

Palo Alto is winning business from rivals

Gartner estimates that worldwide cybersecurity spending will increase 8% in 2018. Palo Alto's growth is outpacing the overall cybersecurity market, which wouldn't have been possible if it wasn't winning business from rivals.

I have already mentioned that the company is up against the likes of Cisco in the cybersecurity space, but the good news is that it is still thriving by taking the game to the networking equipment giant. Last quarter, Palo Alto displaced Cisco at one of the largest manufacturing companies in Europe to secure its global network encompassing 150 branch offices and factories.

But this wasn't the only notable design win against a rival. Palo Alto won the contract to provide endpoint security to a hospital system from a legacy antivirus company, while it displaced Check Point Software at a global oil company to secure their gas stations.

So there's a lot to love about Palo Alto's latest performance. The company is racking up customers at an impressive pace, winning business from rivals, and recording margin improvements thanks to a booming subscription business. As such, it won't be surprising to see Palo Alto shares deliver more upside in the future as it is making the right moves to boost long-term growth.

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Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Check Point Software Technologies. The Motley Fool recommends Cisco Systems and Palo Alto Networks. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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