Questions Dog Palo Alto in Ugly Quarter

Palo Alto Networks (NYSE: PANW) had no sooner delivered its quarterly earnings results on February 24 than its share price nosedived in after-hours trading — and kept dropping to close today at $196.96 (-$40.37 -17.0%). But the reasons for the battering remain in question. While the company is charging hard to meet enterprise demand for network and security combinations, management hasn’t satisfied inquiring analysts.

On the face of it, the earnings look good: Fiscal second quarter 2020 revenue grew 15% to $816.7 million. Non-GAAP net income was $120.3 million, or $1.19 per diluted share.

But those earnings were down substantially from last year’s second-quarter figures, when non-GAAP net income was $147.0 million, or $1.51 per diluted share. Also, Palo Alto missed its guidance of $838 million to $848 million. And while subscription and support revenues grew 30% year-over-year to $570.2 million, revenues from the vendor’s stock-in-trade firewalls dipped 9% from last year’s quarter, to $246.5 million.

A Move Away from Firewalls

“Am I disappointed with what happened with our product revenues? Yes,” admitted CEO Nikesh Arora on last night’s conference call. He said the company’s mistake six months ago was to instruct salespeople to focus on Palo Alto’s next-generation security offerings instead of its firewalls. The sales force complied, and firewalls took a back seat to Cortex, Palo Alto’s security analytics and orchestration software, and Prisma, a cloud-enabled security suite.

Management says the company’s working hard to correct the droop in product sales. By the end of fiscal 2020, product revenue should improve, but it won’t meet initial profit expectations until fiscal 2021.

Analysts don’t accept this entirely. They seem to think Palo Alto, which added software defined wide area networking (SD-WAN) to its products in December 2019, fell behind rival Fortinet, which in November 2019 was already crediting SD-WAN for raising its firewall revenue 21% year-over-year.

“It's just hard to believe that there's not competitive activities there,” one analyst said during last night’s call. How could Fortinet show double-digit revenue while Palo Alto’s down 9%?

Here’s part of how Nikesah Arora answered that question: “Fortinet has different revenue than we do…. They operate in different segments, we operate in different segments. They didn't see strength in SD-WAN. They didn't see strength in the low end market where we compete for price.”

But at an investor briefing at the RSA conference in San Francisco today, Palo Alto execs maintained that their company tends to lose channel sales at the lower end of the spectrum to Fortinet. The reasons? Fortinet is priced lower and does not have as many security features as Palo Alto does.

Questions about Service Providers

At RSA today, Palo Alto execs also fielded questions about how they’re marketing their security wares. Why not target service providers more with next-generation hardware? This seems important, in part due to the rise of SD-WAN managed services.

To which Lee Klarich, EVP and chief product officer responded: “You’re right. We haven’t had as much success [with service providers] quite frankly as we could and we can.” The company is working to change that, he said.

Then there’s the matter of guidance. “Palo Alto had trouble establishing and then hitting targets,” grumbled one analyst last night. To which CEO Arora once again said the sales force mission was misguided and has been corrected.

Despite analyst criticisms, Palo Alto seems intent on pursuing the market trends in digital transformation. Through a number of acquisitions, including the $150 million purchase of Aporeto last November, the vendor is incorporating workload fingerprinting, AI and machine learning, containerization, and a range of other innovations into its products and services.

Most importantly, Palo Alto is focused on unifying SD-WAN and security, which enterprises have demanded since the onset of the current move to cloud networking.

Whether Palo Alto was too slow on the SD-WAN uptake, wasn’t focused on the most lucrative market segments, or simply can’t produce reasonable financial guidance may not matter; market results will be the final word. In the meantime, this company has many strengths to leverage, and rationalizing its failings isn’t helping.