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Cloud Stocks: Should Palo Alto Networks Acquire ZScaler?

Posted on Thursday, Feb 27th 2020

This week has been slow for the stock markets. The growing fear of the spread of Coronavirus, coupled with the uncertainty about the elections and overall economic conditions have sent the stocks tumbling. It was not the best week for cyber security player Palo Alto Networks (NYSE:PANW) to announce its disappointing quarterly results. Not only did the company fail to meet market expectations on revenues for the quarter, but its outlook was also weak.

Palo Alto Network’s Financials
Q2 revenues grew 15% to $816.7 million, missing the Street’s estimate of $844 million and the management’s forecast of $838-$848 million for the second quarter. GAAP net loss was $73.7 million, compared with a net loss of $2.6 million a year ago. On an adjusted basis, net income was $1.19 per share, compared with $1.51 per share reported a year ago. The market was looking for an EPS of $1.12 per share.

By segment, Product revenues fell 9% to $246.5 million. Subscription and support revenues grew 30% to $570.2 million driven by a 37% increase in SaaS-based subscription revenues and 20% rise in support revenues.

Among other metrics, billings improved 17% to $998.9 million and Deferred revenues grew 27% to $3.2 billion. Palo Alto added more than 2,500 customers during the quarter.

For the current quarter, Palo Alto expects revenues of $835-$850 million with an EPS of $0.96-$0.98 per share. It expects to end the year with revenues of $3.35-$3.39 billion and EPS of $4.55-$4.65. The market was looking for revenues of $873 million with EPS of $1.25 for the quarter and revenues of $3.47 billion with EPS of $4.95 for the year.

Palo Alto Network’s Product Concerns

Palo Alto attributed its weak revenue performance to the continued impact of sales incentives related to its Next-Generation Security products. This was represented in the 9% reduction of its products business.

Its sales incentive changes that went into effect last year had impacted its sales team’s focus on product versus next generation security. The company had addressed the issue by implementing several go-to-market programs to reignite the firewall sales growth. It was counting on the programs to deliver improvement this quarter, but that did not happen. Product performance continued to decline and it now realizes that the sales incentive change will take longer than expected.

To help drive performance, it is implementing several other initiatives. It recently launched its offering in the emerging software-defined wide area networks (SD-WAN) market across its entire firewall estate. The SD-WAN network technology links corporate headquarters with branch offices and remote workers. As more and more offices allow off-premise cloud computing services, the growth of SD-WAN products will continue to rise. SD-WAN allows companies migrate away from the costly private data networks leased from telecom companies, but it increases the need for security to manage data going over the public internet.

According to a recent report, the global SD-WAN market is estimated to grow at 33% CAGR from $1 billion in 2018 to $4 billion by 2023. Palo Alto wants to deliver on this high growth market with its new offering. It believes that the integration of Prisma Access with SD-WAN will offer a great Secure access service edge (SASE) solution to the market as it will extend its cloud security strategy to provide end-to-end protection for modern applications.

Earlier this week, Palo Alto also announced Cortex XSOAR, an extended security orchestration automation response platform that will natively integrate threat intelligence management. Cortex XSOAR will help redefine the SOAR category by making threat intelligence much more actionable at scale.

Besides product innovation, I think Palo Alto should look at expanding its presence through acquisitions. An acquisition of a rival like Zscaler appears to be a prudent choice. San Jose-based Zscaler pioneered an approach to security that connects the right user to the right application, regardless of the network. Its cloud platform delivers Security as a Service and eliminates the need for traditional on-premises security appliances. As mentioned earlier, more and more organizations are shifting their work boundaries outside their networks and migrating data and workloads into the cloud. Organizations are losing the boundaries that were contained by a traditional firewall. Companies like Zscaler have been built on this cloud-focused future. Acquisition of Zscaler will help Palo Alto leapfrog into this space and address its present firewall issue as well.

Zscaler went public in 2018 and raised $192 million at a valuation of $1.9 billion. Prior to the listing, it had raised $148 million in funding with the last round in 2015 valuing it at $1 billion. Since it went public, ZScaler’s stock has grown rapidly. It is currently trading at $50.4 billion with a valuation of $6.6 billion. ZScaler 2019 with revenues of $302.8 million, up 59% and a net loss pf $28.7 million. It expects to end the current year with revenues of $395 to $405 million. 

Palo Alto Networks is counting on its innovation to deliver a turnaround, but analysts appear to be losing patience. Some analysts believe that a slowdown of this magnitude is more “like a network firewall hardware problem” that could take longer to fix. An acquisition like that of Zscaler could help address the issue. Palo Alto’s stock was trading at $237.33 with a market capitalization of $19.3 billion. But after the result announcement, it fell to a 52-week low level of $187.52. It hit a 52-week high of $260.63 in March last year.

This segment is a part in the series : Cloud Stocks

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