Palo Alto Networks Inc

NASDAQ:PANW

Earnings Call Transcript 2021-Q2

[Karen Fung, Senior Director-Investor Relations]

Good afternoon, and thank you for joining us on today’s conference call to discuss Palo Alto Networks’ Fiscal Second Quarter 2021 Financial Results. I am Karen Fung, Senior Director of Investor Relations. This call is being broadcast live over the web and can be accessed on the Investors Section of our website at investors.paloaltonetworks.com.

With me on today's call are Nikesh Arora, our Chairman and Chief Executive Officer; Luis Visoso, our Chief Financial; and Lee Klarich, our Chief Product Officer.

This afternoon, we issued a press release announcing our results for the fiscal second quarter ended January 31, 2021. If you would like a copy of the release, you can access it online on our website.

We would like to remind you that during the course of this conference call, management will be making forward-looking statements, including statements regarding the impact of COVID-19 and the SolarStorm on our business, our customers, the enterprise in cyber security industry and global economic condition, our expectations related to financial guidance, operating metrics and modeling points for the fiscal third quarter fiscal year 2021 and 2022, our intent to acquire Bridgecrew, our intend to be carbon-neutral by 2030, our expectations regarding our business strategies both in equity structure for the ClaiSec business and the vehicle for employees to invest in such equity, our competitive position and the demand and market opportunity for our products and subscriptions, benefits and timing of new products, features and subscription offerings as well as other financial and operating trends.

These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today. You should not rely on them as representing our views in the future and we undertake no obligation to update these statements after this call. For more detailed description of factors that could cause actual results to differ, please refer to our quarterly report on Form 10-Q filed with the SEC on November 19, 2020 and our earnings release posted a few minutes ago on our website and filed with the SEC on Form 8-K.

Also please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. For historical periods, we have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the supplemental financial information that can be found in the Investors section of our website located at investors.paloaltonetworks.com.

And finally, once we have completed our formal remarks, we will be posting them to our Investor Relations website under the Quarterly Results section. We’d also like to inform you that we will be virtually participating in the Morgan Stanley 2021 TMT Conference on March 2. Please also see the Investors section of our website for additional information of our conferences we may be participating in.

And with that I will turn the call over to Nikesh.

[Nikesh Arora, Chairman and Chief Executive Officer]

Thank you, Karen. Hello everyone. I know Walter Pritchard, you are listening in. Enjoy your last earnings call from the other side. Next quarter, Walter will join us at this end as our new Senior Vice President of Investor Relations and M&A Finance.

Moving onto the quarter. Let me start with SolarStorm which many of you are describing as one of the most serious and sophisticated cyber attacks in history. The SolarStorm attacked highlighted that enterprises need a comprehensive up to date map of their full IT infrastructure environment, including understanding their own networks as well as external attack services and supply chains. In order for security teams to have an edge over the adversaries, they need to embrace next generation technologies that leverage AI, machine learning and automation. To help our customers, we set rapid response program and when I say rapid it was rapid.

Our acquisitions of Expanse and Crypsis almost felt pre-assigned. The teams swung into action. We updated XDR for all the new threat vectors.

We offered free assessments from our Crypsis team. We also evaluated the attack surfaces from the outside in for Expanse and discovered that there were dozens of affected customers including major government agencies and large companies. Many of which were actively communicating a Solarstorm malware commenting to full infrastructure.

So far we’ve received over 1,000 assessment requests and have completed over 500. We believe that the SolarStorm attacked raises the mid and long-term criticality of the cyber security industry as a whole. This resulted more awareness and focus of cyber security which an in all candor is the need of the hour, given the complete reliance of technology in these times.

We expect that this attack will be a wakeup call to all enterprises to modernize cyber security and will serve as a net incremental tailwind not just for us but also for the industry.

Before I turn to our fiscal Q2 2021 results, I have an admission to make. Perhaps I was too cautious to the outset of the pandemic. The current sustained performance, resilience of our teams and execution has been turning more optimistic. We had a great second quarter with strong business momentum as the organization executed across all platforms and strategies.

As a result, we beat Q2 guidance and consensus. Here are some highlights. We delivered billings of $1.2 billion, up 22% year-over-year with strong growth across the board.

Let me give you some additional context. Due to COVID, we have provided billing plans to a select number of impacted customers. When adjusting for these billings within the reported 22% year-over-year growth. This trend has been in place and has been growing over the last few quarters. Consequently, our revenue growth is higher than billings growth and accelerated to 25% reaching $1 billion for the first time ever. Yes, our first billion dollar revenue quarter with accelerating revenue growth.

The strength has been across the board. And as we continue down the path of more and more of a subscription-based model, the revenue predictability will continue to rise. Non-GAAP EPS was $1.55, up $0.36 from last year. EPS expansion was driven by revenue growth and operating expense leverage.

While there continues to be beneficial impacts due to lower travel due to COVID, we do continue to hire resources to support our product expansion, which we expect to continue.

Free cash flow margin for the quarter was 32.7% and in the first half of fiscal year 2021, we generated $838 million of free cash at a margin of 42.7%. We still expect free cash flow to normalize for the year around our full year guidance due to some seasonality we see in the second half.

Last quarter, we started the dialogue around network security in cloud and AI and shared the P&L for both businesses. We received great feedback on the additional transparency and we want to continue to drive more transparency to unlock shareholder value.

Let’s first take a deep dive into the Network Security business which we are calling NetSec. Our NetSec business is undergoing a transformation towards software and SaaS making it more predictable and sustainable. Starting with our hardware firewall business and associated services, rather than building solutions only as hardware we’ve chosen to offer security services software subscriptions.

Over the last two years, we have doubled our security subscriptions from four to eight with the introduction of DNS, SDRAM, IoT and DLP. We are seeing great progress with DNS, which has acquired nearly 5,000 customers since launch. The new subscriptions, along with the introduction of higher tier support, Platinum support has allowed us to increase our next-generation firewall support and security subscription revenue as a percentage of next-generation firewall hardware revenue over the last year.

As you can see, we have sustained a 15% CAGR in hardware, subs and support and our hardware contribution has gone from 39% to 29% in that time. To continue drive software growth, we have made these subscriptions available across all form factors, firewall FLEX and Prisma access 2.0. We just recently completed the process of making it available on our product Prisma access 2.0 which is our firewall in the cloud.

Turning to our software firewalls, we continue to see a transformation in software form factors. With the introduction of advanced features, cloud-native integrations of the development of industries first containerized next-generation firewall, we continue to see product market share. As a result, VM and CN-Series goal was 60% in this first half of FY 2021.

We recently launched Firewall FLEX, another industry first, the unique approach in how we offer virtual firewalls in CM Series to increase customer flexibility and enable a consumption model to drive additional growth.

This new flexible consumption model features credit-based licensing that lets you consume VM and CN-Series firewalls, choose the number of CPUs needed and add any or all of our eight security subscriptions which was previously limited to five. We believe that by providing data flexibility to our customers, we will continue to drive growth and achieve greater subscription attach rates.

To highlight how our software firewalls are transforming, how our customers approach security, we closed a deal with a leading telecommunications company to secure their 5G network. The transition to 5G is driving a number of very important architectural changes, including a highly distributed design, containers as a foundation and security for enterprise customers as a critical business driver.

We are first to deliver enterprise and service provider class 5G in container security. In doing so, we empower our customers to provide a secure 5G service to their customers and provide managed security offerings to their enterprise and customers.

Now let’s talk about Prisma Access. When COVID dramatically changed how work gets done, the companies across industries around the world, the need for securing a remote workforce have also changed. No longer is it sufficient to have partial access to applications, or what are sometimes called good enough security.

Overnight, connectivity to every application was needed, security became business critical, and user experience determines the difference between maintaining productivity are falling behind. Even before COVID accelerated this change, we were already working on turning Prisma Access into an industry-leading solution for enabling a secured remote workforce.

What initially started is a GlobalProtect Cloud Service, started to transform in 2019 with the launch of Prisma Access. In the last year-and-a-half, we built out industry-leading capabilities and in that timeframe, Prisma Access has gone from less than 150 customers to now nearly 1,000 customers and 30% of the Fortune 100.

Last week, we announced Prisma Access 2.0. The biggest update since introducing this service. Prisma Access is a full security platform for the cloud, a machine learning based security, preventing all known threats in line at line speed, a full firewall delivered to the service and includes features like zero trust network access, secure web gateway, CASB, DLP and IoT security.

Prisma Access secures both web and non-web apps. As an example, conventional web security approach to cloud delivered security misses 53% of all remote workforce threats that tried over non-web apps. Those threats cannot be ignored and unlike ultimate solutions to the market we proven that with Prisma Access.

We have completely reimagined the way customers manage Prisma Access with an entirely new cloud-based UI that delivers better security outcomes for builder security assessments. The new digital experience management add-on provides native end-to-end visibility and insights for SASE and the ability to self field when digital experiences problems occur.

Prisma Access is built on a low latency and highly scalable infrastructure with Google Cloud as backbone.

Lastly, Prisma Access, along with the Prisma SD-WAN, our rebranded product from CloudGenix delivers a complete SASE offering. With the recent addition of CloudBlades, we now have a SASE platform which allows for an API platform for seamless third-party service integration. Prisma Access securely enables access to all applications, best-in-class security to meet enterprise security needs without compromise and enables a new experience that maintains or even improves worker productivity.

In Q2, we closed an eight figure deal with a leading technology company with over 100,000 employees with businesses over 100 countries, as part of the digital transformation, the company would launch a new remote work initiative. In order to realize their vision, they need a secure and optimized network that will support a flexible remote work environment, Palo Alto Networks was ultimately chosen ahead of several of our security peers as the customers saw us as the only vendor that was offering a true SASE solution.

Ultimately, Prisma Access was a key product given their goal to rapidly enable remote work, but the customer also purchased next-generation firewalls, CN-Series Firewalls, enhance their store capabilities through Cortex XDR and XSOAR. This was definitely across platform deals we caught up and we look forward to a great partnership with the customer going forward.

Lastly, several of you have asked in the past about a software transition in the associated knowledge. While the first phase of VM and Prisma Access purchases have mostly been incremental use cases, we put together a few key examples on what we see in the market, what a customer does choose to replace a hardware-based security solution with software and SaaS.

Our used cases are VMs replace hardware firewalls, like this example of a local retail store running software firewalls and third-party hardware, along with other software applications, we estimate that the five year revenue over the VM series deal is roughly equal to that of deals at place in separate physical firewall.

For used cases, our Prisma Access replaces hardware firewalls. We took a typical branch office used case and estimated the five year revenue of a Prisma Access deal is two-times larger than a next-generation firewall deal. From a customer perspective, we estimate that the customers’ total cost of ownership is generally reduced as they move to a virtual and cloud delivered form factors.

As you know, Prisma Access is only year old. So our gross margins aren’t as favorable as hardware, but we expect them to improve over time.

Now moving over, and looking at our Cloud & AI results. We started this call by discussing Solarstorm, but didn’t talk about our own experience with an attempted Solarstorm attack. Back in December, we shared with the broader security community that Cortex XDR instantly blocked a Solarstorm attempt on Palo’s networks, thanks to its behavioral threat protection capability.

We continue to be bullish around the rapid pace of innovation that is going into our Cortex XDR product. In fact, Cortex XDR was recently recognized by AV-Comparatives as a strategic leader in their latest endpoint prevention and response evaluation while still delivering lower total cost of ownership than several endpoint security peers.

Importantly, last month, Cortex XDR and Data Lake achieved FedRAMP modernization, which should make it a key piece of technology in the Federal space. As further validation of our vision, we see more and more players in the endpoint security space rushing to jump on the XDR route that we have established two years ago.

Overall, we continue to see the Cortex portfolio developing as an industry’s first proactive security platform and they see penetration into the largest companies continue to grow. 35% of the Global 2000 and 66% of the Fortune 100 are now Cortex customers indicating that automation advanced threat protection are top of mind for these customers.

In Q2, we closed a deal with a retailer, the company chose Cortex XDR to increase its ability to control and protection of the endpoints by adopting a more complete solution with XDR rather than using ADR. With Cortex XDR support for mobile, the customers are also able to easily extend Cortex XDR to additional devices leveraged on-site at their stores to unify the endpoint security policy across the entire enterprise.

We then expanded the conversation to adjust SOX operational challenges by demonstrating how Cortex explores out of the box pre-processing rules and alert de-duping could reduce volumes dramatically. With the combination of announcements ability, production in total, with an entire endpoint state coupled with automating and orchestrating alert volume, the Cortex platform will have an immediate impact from its new customers.

Switching to Prisma Cloud. Prisma Cloud is building the most comprehensive and best-of-breed cloud-native security platform and we continue to see strong customer interest. Prisma Cloud has now acquired over 2,000 customers with 74% of Fortune 100 and secures 2.5 billion cloud released workloads. We also continue to see an increase of Prisma Cloud customers while using both cloud security posture management and cloud workload protection for containers and servers with applications now at 50%.

Additionally, last month, Prisma Cloud also achieved FedRAMP modernization, along with Cortex XDR and Data Lake as we said. This allows U.S. government customers to leverage our visibility compliance and governance capabilities for securing multi-cloud and gov cloud deployments.

Lastly, I’d like to highlight as a largest Prisma Cloud deal that we’ve ever closed. An eight figure deal with a leading SaaS company. Like many in the industry, they are moving from a private cloud environment to the public cloud. As part of this shift, they are moving to a containerized application architecture.

The customer had unique scalability, availability and vulnerability requirements for securing their containers across AWS, GCP and Azure clouds. The maturity, the superior vulnerability detection of the container security capabilities and the scalability of run time protection of Prisma Cloud help convince the customer to choose Prisma Cloud as their container security platform of choice.

Last week, we announced our intent to acquire Bridgecrew, an early pioneer of security for the developer community. So, next the challenge we are taking on in cloud security is what is known as shiftless security. Developers are playing an increasingly important role in cloud security, both in terms of what products are used and how they are operationalized.

Today, a single error in development can be replicated hundreds of times over resulting in 1,000 security list to be faced. This drags down productivity and increases the likelihood of security issues and production application. These issues upfront where they are easy and quick to shape is a win for developers and a win for security. Bridge could recognize a need for shiftless security and pioneering approach the infrastructure scored designed for developers. To engage the developer community, they released an open source product called Checkout that was downloaded over million times in the last year and a paid for product gaining early traction.

When we bring network security and cloud together, we see tremendous synergies to power platform of the partners. We are looking at our Global 2000 customers, we see that these customers are increasingly adopting Strata, Prisma and Cortex. 68% of our Global 2000 customers have purchased more than one platform, up from 62% a year ago and 56% two years ago.

Given the momentum that we are seeing, we are raising guidance for the full fiscal year. For fiscal 2021, and at the midpoint of guide, we expect total revenue growth of 22%, up 200 basis points from our prior guide. Total billings was at 20%, up 100 basis points from our prior guide, slightly lower than our revenue impact of billings plans as we discussed earlier.

We continue to expect next-generation security ARR at $1.15 billion, up 77% year-over-year. Product revenue is flat year-over-year, unchanged from our prior guidance. Lastly, non-GAAP operating margin of 50 basis points and adjusted free cash flow of 29%, unchanged from our prior guidance as we continue to invest to capture the opportunities in market.

Now let’s review our fiscal year projections for NetSec and ClaiSec. Overall, we are confirming our ClaiSec projection, while raising NetSec billings by 100 basis points and revenue by 200 basis points given the strong performance of SASE and CN-Series.

Moving on to adjusted free cash flows, we expect Network Security will deliver a free cash flow margin of 41% in FY 2021, up from 38% in FY 2020. We expect Cloud and AI free cash flow margin of negative 43% in FY 2021 and improve from negative – improvement from negative 59% in 2020.

As mentioned last quarter, for the next few years, we expect Cloud and AI to achieve gross operating and free cash flow margins in line with industry benchmarks as we gain scale and our customer base matures and becomes more efficient.

As you can see, we have been able to dig deeper on our resources further with our business areas of ClaiSec and NetSec. And as I noted earlier, there are committed set of tremendous synergies in the power of the path forward for Palo Alto Networks. At the same time, we’ve also been increasing our focus on our software transformation and hardware firewalls while building new cloud and AI business.

To continue this transformation and strengthen our financial profile, we feel that we can create more focus by aligning the teams in our NetSec and ClaiSec. So we are officially going from three speed both at aligning our efforts around these two business areas with six focused efforts as we force into our next fiscal year.

Next, we are focused on transformation from hardware to software and delivering a best-of-breed hardware solution as required. As you saw, this transformation is actually financially neutral to net positive for us and always beneficial to our customers. The speed – firewalls, including virtual firewalls, SASE, and our growing security subscriptions.

ClaiSec, the business area where we drive cloud security and our Cortex efforts have proven that with focus and an opportunistic, organic and inorganic strategy, we can create an industry leading self solution for cloud security and solutions like XSOAR and XDR and AI and ML.

Here we need continued investments for us to drive customer scale and for us to continue to invest in both continued product development and customer launch. We will do so by continuing our focus on Cortex, Prisma Cloud and Palo Alto Networks incident response services. The newly formed team combining Crypsis and Unit 42 which Wendi Whitmore has joined to help lead.

We are also excited to announce that with the Board’s consent, we have finalized in the filing needed for an equity structure for the ClaiSec business. Our goal is to make sure that the value of the ClaiSec business is more transparent.

In addition, the Board has approved the development of a vehicle from voice to invest in such ClaiSec equity, strengthening the alignment of shareholders and the interest of employees regarding success of our ClaiSec business.

Lastly, I am also proud to say that Palo Alto Networks recently made a commitment to address climate change. As Luis will go over in more detail around how we will be carbon neutral by 2030.

With that, let me turn the call over to Luis.

[Luis Visoso, Chief Financial Officer]

Thank you, Nikesh. Climate change is an existential threat and at Palo Alto Networks we are all-in to do our part to address this crisis. We have done some important work up to this point including led certifications, recycling and community involvement. We plan to step up our efforts and contribute even more.

I am proud of our commitment to be carbon neutral by 2030. We have already activated renewal energy on high quality carbon offset strategies. We will be reducing our emissions aligned to science-based targets and we will work across our value chain to have lasting impact and advocate stewardship.

The Paris Agreement calls on all of to limit global warming below 2 degrees Celsius by 2050. We plan to reach our commitments by 2030. We will keep you informed of our progress along the way. We will continue to participate in the Carbon Disclosure Project as per sharing plans and progress using protocols set by the Task Force on Climate-Related Financial Disclosures.

During the World Economic Forum’s Davos Agenda last month, we committed to increase transparency by reporting on the International Business Council’s Stakeholder Capitalism metrics over time.

It will take creativity, collaboration and visionary thinking to protect our planet and we are up for the challenge. We call n others to join us, consider aligning to the Paris Agreement and make your commitment to do your part.

Now turning on – turning to our financials. As Nikesh indicated, we had a great second quarter and we continue to deliver winning innovation and adding new customers at a fast pace. This strength gives us confidence to raise our guidance for the year. I would like to start with our performance in Firewall as a platform or FwaaP, which had a great quarter as we continue to grow faster than the markets.

FwaaP billings grew 21% in Q2 as we continue to transition from hardware to software and SaaS form factors. As you can see, FwaaP billings declined 3% in Q2 2020 and over the last four quarters, we’ve been able to drive sustained execution and growth in this area to 21% in Q2 2021.

Next-Generation Security or NDS continues to expand and now represents a quarter of our total billings of $309 million, growing 59% year-over-year. In Q2, we added over $120 million in new NGS ARR reaching $840 million.

Let me remind you, at our last Analyst Day in September of 2019, NGS was a gleam in our eye and we called for $1.75 billion in billings by 2022. We are on track to beat those numbers.

In Q2, total revenue grew 25% to $1.0 billion. Looking at growth by geography, the Americas grew 27%. EMEA grew 24% and APAC grew 14%. Q2 product revenue of $255 million increased 3%, compared to the prior year. Q2 subscription revenue of $462 million increased 35%. Support revenue of $300 million increased 32%.

In total, subscription and support revenue of $762 million increased 34% and accounted for 75% of total revenue. Excluding revenue from Crypsis and Expanse, subscription and support revenue increased 31%.

Turning to billings, Q2 total billings of $1.2 billion, net of acquired deferred revenue increased 22%. Strength was broad based as we continue to see strong execution across the company. The dollar weighted contract duration for new subscriptions and support billings in the quarter was slightly down year-over-year, but remained at approximately three years.

For the first half of fiscal 2021, billings of $2.3 billion increased 21% year-over-year. Product billings were $495 million, up 3% and accounted for 22% of total billings. Subscription billings were $1.2 billion, up 23%. Support billings were $733 million, up 34%.

Total deferred revenue at the end of Q2 was $4.2 billion, an increase of 30% year-over-year remaining performance obligation or RPO was $4.6 billion, an increase of 41% year-over-year. In addition to adding approximately 2,400 new customers in the quarter, we continue to increase our wallet share of existing customers.

Our top 25 customers, all of whom made a purchase this quarter spent a minimum of $59 million in lifetime value through the end of fiscal Q2 2021, a 27% increase over the $46 million in the comparable prior year period.

Q2 gross margin was 75.3%, which was down 110 basis points, compared to last year, mainly driven by a higher mix of our NGS products which are less mature. Q2 operating margin was 19.8%, an increase of 190 basis points year-over-year. The operating margin expansion is driven by operating expense leverage, behind operational efficiencies, lower travel and event expenses due to COVID, which more than offset the incremental investment in headcounts.

We ended the second quarter with 9,038 employees including 176 from Expanse at the close of the acquisition.

On a GAAP basis, for the second quarter, net loss increased to $142 million or $1.48 per diluted – per basic and diluted share.

Non-GAAP net income for the second quarter increased 28% to $154 million or $1.55 per diluted share. Our non-GAAP effective tax rate for Q2 was 22%.

Turning to cash flow and balance sheet items. We finished January with cash, cash equivalents and investments of $4 billion. On December 4, 2020, our Board of Directors authorized an increase to our share repurchase program and extended the expiration date to December 31, 2021.

As of January 31, 2021, $1 billion remained available for repurchases. Q2 cash flow from operations of $365 million increased by 19% year-over-year. Free cash flow was $332 million, up 29% at a margin of 32.7%. DSO was 60 days. An increase of three days from prior-year period.

Turning now to guidance and modeling points. For the third quarter of 2021, we expect billings to be in the range of $1.22 billion to $1.24 billion, an increase of 20% to 22% year-over-year. We expect revenue to be in the range of $1.05 billion to $1.06 billion, an increase of 21% to 22% year-over-year.

We expect non-GAAP EPS to be in the range of $1.27 to $1.29, which incorporates net expenses related to the proposed acquisition of Bridgecrew, using a 100 million to 102 million shares.

Additionally, I’d like to provide some modeling points. We expect our Q3 non-GAAP effective tax rate to remain at 22%. CapEx in Q3 will be approximately $30 million to $35 million.

As Nikesh reviewed earlier, for the full fiscal year, we are again raising our guidance across most metrics. We expect billings to be in the range of $5.13 billion to $5.18 billion, an increase of 19% to 20% year-over-year. We expect Next-Generation Security ARR to be approximately $1.15 billion, an increase of 77% year-over-year.

We expect revenue to be in the range of $4.15 billion to $4.20 billion, an increase of 22% to 23% year-over-year. We expect product revenue to be flat year-over-year. We expect operating margins to improve by 50 basis points year-over-year. We expect non-GAAP EPS to be in the range of $5.80 to $5.90, which incorporates net expenses related to the proposed acquisition of Bridgecrew using 99 to 101 million shares.

Regarding free cash flow for the full year, we expect an adjusted free cash flow margin of approximately 29%.

With that, I’d like to open the call for questions.

[Operator]

[Operator Instructions] Our first question comes from Keith Weiss of Morgan Stanley.

[Keith Weiss, Morgan Stanley]

Excellent. Thank you guys for taking the question and very nice quarter. I was hoping to dig in a little bit into Solarstorm and if you could talk to us about any impacts that you saw in this quarter or and more expansively, how do you expect the impacts of that has been to play out as we go through the year? Is there more on the comment? And what parts of the product portfolio do you think are going to get most impacted by that event?

[Nikesh Arora, Chairman and Chief Executive Officer]

Hey, Keith. Thanks. Look, as we said in the call, we launched a series of initiatives to make sure that our customers are protected vis-à-vis Solarstorm. That was a sustained attack which was planned or a series of quarters if not years. And what we realized that, once you get into the supply chain, and start being able to respond to 18,000 customers, the impact is going to be far reaching.

What’s happened is people were first reacting to that and started to make sure on an emergency basis there is nothing in their infrastructure which is already infected and they have not effectively been compromised. Now with that slowly and steadily behind us, what’s happening and we are noticing people doing cybersecurity assessments.

Every board is out there saying, take a look at good box, make sure that there is no breach as to make sure that we won’t be breached. The first question was, are we breached? The answer was, no, we are fine. Could we have been breached to be if we had Solarstorm? The answer is, yes. So, what we are noticing, we are noticing a rethinking of the cybersecurity architectures.

In that context, our Crypsis acquisition was very helpful, because that’s where we had the field force to be able to go out and address these situations that kind of sort of came to light and I don’t know if you know Wendi Whitmore at IBM X-Force until now and she is going to come and join us. She had a stint of CrowdStrike and FireEye and Mandiant as well.

So she is going to come and drive that effort even more aggressively for us. We also saw that in our own case, XDR protected us, which again becomes an important distinction for because it was a zero day attack, and we found it because of behavioral alarm release that were happening on the endpoint, which is effectively easy to arrest the outsourcing a lot more conversations around that and Expanse’s ability to be able to look at what assets are exposed to the outside, which in this case of Solarstorm servers, we’ve also used Expanse and looked and saw that there were hundreds of customers have open Solarstorm servers sitting on their network. So it’s generally been useful for us in the XDR part, the XSOAR part, the Crypsis part, but more importantly from a board focus on cybersecurity hygiene is been critical.

[Keith Weiss, Morgan Stanley]

Excellent. Thank you.

[Nikesh Arora, Chairman and Chief Executive Officer]

Thanks.

[Operator]

Our next question comes from Philip Winslow of Wells Fargo.

[Philip Winslow, Wells Fargo]

Great. Thanks for taking my question and congrats on another fabulous quarter. I really want to focus in on Prisma Cloud in the VM and CN-Series. Obviously, you saw massive uptick in the amount of workloads that you protect in the cloud with Prisma Cloud and then obviously a massive uptake year-over-year, I think more than 4x in terms of the number, firewall Software customers. So, I guess, kind of two related questions in here.

First, I mean guys, why hearing the customers are choosing Prisma Cloud, obviously sized a large deal on that product this it seems to be this quarter? And then the follow-up to that, when you think about Prisma Cloud plus the success you are seeing in the VM and CN-Series, are those two in combined kind of changing the customer dialogue that you are having as you are seeing these customers see accelerate their shift to cloud?

[Nikesh Arora, Chairman and Chief Executive Officer]

Yes. Philip, thank you. Look, if you look at it, you have to strike yourself. We grew our Firewall as a Platform 21%, right. And we’ve been talking about kind of get that to 15% range. You can see all that growth has come from Firewall in the cloud, i.e. Prisma Access 2.0 and has come from our VM and CN-Series Firewalls.

And it’s kind of – it’s hard to understand if you are not sitting with the customer, we have seen a few deals flip from hardware to software in the last week, literally, customers in to buy which a hardware and said wait, hold it on. ER has launched its Firewall FLEX one which is go into this flexible credit program where we can spin up as many firewalls we want to spin them down if we don’t need them.

I think you can carry those credits to the cloud. So, I think what is something very important to understand, we are going through a targeted to cloud transition now in the industry is that don’t mean it’s the demise of the hardware industry. It just means that the incremental shift is beginning to happen. It’s gathering momentum.

You can’t keep posting tens of billions of dollars on billings AWS GCP and Azure and not see a decline in datacenter over time. It’s going to happen. So if you look past the quarters and in that transition, it becomes very important how you are going to protect yourselves in the future. So, we are beginning to see customers go from hardware to software and honestly we are encouraging it to the extent the customers wants our opinion.

We have the ability to sell the hardware the best in the industry to ability to software firewall, and the ability to sell them Prisma Access throughout in the cloud. We are sitting now and now I am going to say, you pick the best architecture. You want, we’ll service it. You ask us, we’d rather, you went other software out.

And that’s where all of you guys have asked us, do you able to get a software deal with money, we’ve put up our slides, saying look, we don’t lose money. We make more money. We are not saying that, not that loudly because that’s not a good thing to say loudly. It better security solutions for the customer, reduced total cost of ownership, but we are seeing that transition and I think that’s the most important part of this story and as we highlighted, we did a big deal in the telecom space where certainly security matters in 5G, right.

Because in – you and I walk around with our iPhones or android device, they’ve got malware on them, stuff a lot buddy. But if you are in a car, driving on the highway and that can be infected malware, that’s a problem. So, the 5G enterprise networks have to be secure. All 5G networks are being built on the cloud.

[Philip Winslow, Wells Fargo]

Okay. Great. Thank you very much.

[Nikesh Arora, Chairman and Chief Executive Officer]

Thanks, Phil.

[Operator]

Your next question comes from Sterling Auty of JPMorgan.

[Sterling Auty, JPMorgan]

Yes. Thanks. Hi, guys. So, in the context of the guidance increase, I did noticed that the next-generation security ARR staying the same despite what looks like good results in the quarter, was there any pull-forward? Or what additional commentary can you give us around that NGS ARR outlook for the year?

[Nikesh Arora, Chairman and Chief Executive Officer]

Honestly, there is no hidden meaning in there. We are not trying to tweak it in such a way that – look, we’ve seen strength in the cloud firewall. We’ve seen phenomenal strength in Prisma Access. And I have to tell you that this pandemic has forced the network conversation about how do I make sure Sterling access every application at home, not just the ones that I will let him access.

It’s gone from a – it’s good to have remote access, so you have to have remote access. And then, the security certainly paying attention on the network architecture and then and Lee and his team have delivered this phenomenal next upgrade where we can look at both web-based and non-web based apps. So we are seeing phenomenal success. And so, there is tempering of our expectation and ambition on NGS. It’s just how the math works right now.

[Sterling Auty, JPMorgan]

Thank you.

[Operator]

Next question comes from Saket Kalia of Barclays.

[Saket Kalia, Barclays]

Okay. Great. Hey, thanks for taking my question here guys. Nikesh, maybe for you. You touched on this in your prepared comments. Can you talk about the cloud and AI equity structure? What’s the reason for setting up that structure now? And how was it going to work mechanically?

[Nikesh Arora, Chairman and Chief Executive Officer]

So, you know what, Saket, two-and-a-half years ago, when I came here, we talked about building a cloud security business and we talked about building an AI ML-based business. Last quarter, we started showing you the two pieces of NetSec and ClaiSec. You’ve seen there is volume to get $735 million of ARR in cloud AI security.

We also shared our left-hand side, our Network Security business, actually it has phenomenal cash flow margins, 38% going to 41%. So that’s a cash-generative part of our business whilst we go through a hardware to software transformation. On the right-hand side, we are competing with them outset there today like three current sites of the world and in the XDR space and a bunch of startups in the cloud space. That’s an area for investment.

We think that the market inherently values both those businesses fundamentally differently. It values the Network Security business and cash flow. It values the cloud AI business and ARR. So we want to be able to create the opportunity for the market to value our businesses differently to create more transparency for the shareholders and it would also allows us to keep investing in the cloud AI business and in the interest of driving more ARR.

So, what we’ve done is, as you saw, we have separated our financials, show you both NetSec and ClaiSec. Luis and team have worked hard to get them audited and make sure that we could reporting them on a more regular basis going into next fiscal year and we are looking at various equity structures that allow us to create incentive plans, as well as potentially in the future monetize the ClaiSec business for different set of investors compared to the Palo Alto investor.

[Operator]

Our next question comes from Fatima Boolani of UBS.

[Fatima Boolani, UBS]

Good afternoon. Thank you for taking the questions. My question is around the firewall business and the metrics there. I appreciate the deals sort of change flavor. So, what are some of the core assumptions we should read with around the installed base refresh opportunity, as well as the R&D pipeline for hardware and appliance refresh is within the product portfolio on the Strata side?

[Nikesh Arora, Chairman and Chief Executive Officer]

Lee, do you want to talk about the hardware refresh, because what I am saying is there is we are not taking our pedal of the metal. What we are going aggressively trying to continue to build the next the addition of hardware and focus on refresh. I will tell you, in absolute dollars, we still sell the largest number of hardware firewalls in the industry.

We get lost some percentages, it doesn’t matter. If other vendors are out there generating 18% growth, we still sell more absolute dollars of product in a quarter than anybody else. But Lee, if you can talk about the hardware.

[Lee Klarich, Chief Product Officer]

Yes. We are always working on the next generation of hardware since the beginning of the company until now and we have some amazing new platforms coming. I won’t tell you too much in terms of that, but we are always working on that really exciting stuff there. The software side as well with – and new security capabilities and other set of amazing things we are working on.

One thing I’ll point out in that is the leverage we get across hardware, software and cloud delivery. Part of what really resonates with our customers is, not that they get to pick which one, they use from us. But their ability to actually use hardware where they need hardware, software form factors where they need software, cloud delivered where they need that with a set of consistent security capabilities, easy to manage and operationalize. That’s something that only we can deliver to our customers.

[Fatima Boolani, UBS]

Thank you.

[Operator]

The next question comes from Brian Essex of Goldman Sachs.

[Brian Essex, Goldman Sachs]

All right. Great. Hi, thank you. Thank you for taking the question. I was wondering, Nikesh, if you could dig into a little bit Firewall FLEX in your credit based licensing model for next-gen firewall, what was the timing on that roll out? How long is it been marketed and how much adoption is that in terms of the way it’s impacting your model?

[Nikesh Arora, Chairman and Chief Executive Officer]

So, I’ll give you the preface of it and then Lee can jump in and give you the details. But when we hadn’t refreshed our VM pricing policy, it was set up more like a hardware business, where you had to tell us which particular model of software you wanted and you are basically stuck to that model. And if you think about software deployment, it’s a key.

I can give you a key with more capacity or key with lower capacity. So, we just felt that we were being too pedantic in our approach and selling software in a very hardware-centric model where you can only buy five subscriptions of it.

So, we worked hard over the last 18 months to get this all done into a new credit based model where we can right size the requirements. You can spin them up or spin them down. But if I say it, I wish Lee doesn’t get the same. We say, why do you say you are going to help to have me. Answer, when you don’t stop. So, we have stopped.

[Lee Klarich, Chief Product Officer]

In my defense, when we came up with the model, that was sort of, I call it the normal model and ask what others were doing. I am – actually, our customers are very excited about this new Firewall FLEX model, because it is the first of its kind to the industry giving your customers the flexibility and the customer saying to choose how many CPUs do they need?

At what subscriptions do they want? Where they want it to put, cloud, on-prem, et cetera. That level of flexibility and to doing a credit model where individual deployment can actually be different. So, we’ve actually – it’s one of those unique cases where we’ve given the customer a lot more flexibility and options yet made it simpler at the same time.

The last piece I’d address was, in the old model it was getting too cumbersome on how to offer all the security subscriptions. This model allowed us to easily scale up to all of the current security subs, plus any future subscriptions we come out with.

[Nikesh Arora, Chairman and Chief Executive Officer]

We working more subscriptions.

[Lee Klarich, Chief Product Officer]

Sorry. We just launched the beginning of February. So, it’s only been out for a few weeks. We are already having customers respond incredibly positive to it.

[Brian Essex, Goldman Sachs]

All right. Very helpful. Thank you.

[Nikesh Arora, Chairman and Chief Executive Officer]

Thanks, Brian.

[Operator]

Next question comes from Gray Powell of BTIG.

[Gray Powell, BTIG]

Hey, great. Thanks. Can you guys hear me okay?

[Nikesh Arora, Chairman and Chief Executive Officer]

Yes.

[Gray Powell, BTIG]

All right. Congratulations on the good numbers. So, yes, last week, you all announced how secure was gateway features of Prisma Access. How important is that functionality to your customer base? And do you think it creates an opportunity to gain incremental share from legacy players like Symantec or even some of the companies like Zscaler?

[Nikesh Arora, Chairman and Chief Executive Officer]

Sorry. Okay. He changed his definition on legacy. Never mind. So, I am just kidding. We get punchy after coffee on our earnings call day. So, Lee, go ahead.

[Lee Klarich, Chief Product Officer]

Okay. As I think all of you have seen and heard us from before we used to set up this sort of either or approach, either it was next-gen firewall approach to security or is it proxy approach and you’ve heard us talk a lot about the challenges associated with the proxy approach. Limited application support.

Some of the challenges with applications and breakage and performance, but at the same time we recognized as, there are certain used cases out there where there is a right way to do it and it is a – it could be very complementary to what we do from a next-gen firewall perspective.

And so, with this release, we basically integrated that into Prisma Access such that we can now give our customers the ultimate of flexibility on how they connect to the cloud through both the secure web gateway model, plus next-gen firewall natively integrated and provide all the great security capabilities we have.

[Nikesh Arora, Chairman and Chief Executive Officer]

So, I think, Gray, what Lee is saying is, we came near looks religion on proxy. Now we also support proxies in front of our product and we also support the app-based approach, so now you can go after web-based apps and non-web based apps and we said 53% of your breaches come from non-web based apps and proxies are used less than non-web based apps. But we cover both opportunities by doing it, the proxy way or the non-proxy way.

[Gray Powell, BTIG]

Got it. Okay. Thank you very much.

[Operator]

Next question comes from Patrick Colville of Deutsche Bank.

[Patrick Colville, Deutsche Bank]

Hey. Thank you for taking my question. I appreciate it. Just want to ask about Bridgecrew. So, is that deployed on-prem in the cloud. Is it the kind of developer buying it with the kind of credit card type payment model or just help us understand that product’s better please?

[Nikesh Arora, Chairman and Chief Executive Officer]

Yes, look, again, I’ll one two, punch here. But we’ve been making bets for the last two-and-a-half years whereas securities-wise in the cloud space, especially. We went from workloads, we went to containers, we went to micro segmentation, went to IIM and what we come with the realization is what’s happening is there is a bunch of – so what happens is, you do - you build an application with a developer.

You give it to your IT team and they deploy and say, hey, you silly guy, you got a bunch of security bugs and go fix it. The guys will work by these bugs. Why need tell me before? They have started going to opensource and trying to find security monitoring software to see let me just make sure, I don’t build stuff with security bugs in it.

So, what happens is, what virtual has is such if they open source free, no credit card needed. These are software that starts tracking the security bugs in your development site, the ICD site. So it tells the developer you are making mistake fix it. Now what happens is, you fix it, when you give it to the guy and security guy says, well, you still have bugs.

So wait a minute. I’ve checked it. So what he has done is, he bought Bridgecrew, we’ll will take the open source tool that they have, we’ll look at the policies there. We’ll map them with the policies in the enterprise site to make sure that if you need to find data, if they are going to check for it in real time and in production, you get to check for it for free as the developer.

So, there is 26 million developers developing this seamless security professional. If we can get 26 million people to start checking it while they are building the application, building the software, then it’s consistent to what they are going to be check out in the enterprise side. That’s the muscle we didn’t have. That’s a DevOps muscle.

Most DevOps companies don’t have security muscle. We have security muscle. We don’t have DevOps muscle. We just bought DevOps muscle.

[Patrick Colville, Deutsche Bank]

Okay. And so the monetization is, it’s via…

[Nikesh Arora, Chairman and Chief Executive Officer]

So, what happened is, they have an enterprise version of the free software they give away to developers. It going to like drop offs. There is a lot of people start using it, you want that to be in the enterprise section, because you don’t want to be checked against a different products or policies. So we are going to merge that enterprise capability into Prisma Cloud, because we’ve already checked it and we’ll say, whatever your developer checks for free is what we are going to check is production there consistent. So if they didn’t find a bug, when they were writing the quote, unlike they find it when we were running it.

[Patrick Colville, Deutsche Bank]

Thank you.

[Operator]

Next question comes from Tal Liani of BOA.

[Tal Liani, BofA]

Hi, guys. I want to go back and ask about the legacy or the hardware piece. I am trying to understand the competitive landscape now and trying to understand the customers’ reaction to the fact that market is migrating somewhere else. Are there still competitive replacements? Or is this a case where customers just keep the status quo whatever they have today because if they take a decision, it’s going to be a decision to migrate out of hardware into more modern solutions. So, I am trying to understand the dynamics, the underlying dynamics in the market and help me to understand what’s the competitive landscape looks like?

[Nikesh Arora, Chairman and Chief Executive Officer]

Yes. Tal, thanks for the question. Look, what’s going to happen in my version of the world is, you will still have 40% to 50% of the customers who will still stick to a datacenter hardware based strategy. I think what the markets are not fully embraced and understood is when you move to the cloud, the cloud can be expensive.

And many companies will say, wait a minute, I don’t need to do all the stuff in the cloud unless we’ll keep the datacenter and do some of the less expensive stuff here, why they want to take everything and make it real time bleeding edge in the cloud. So you are going to end up in a hybrid world where people are going to maintain datacenters and maintain cloud.

So, I don’t think every customer in the world is moving their cloud, but I think that, on the margin, yes, you are seeing a bigger shift to the cloud than people see out this. So, with that fact in mind, we do see competitor replacements when customers have end of life for existing hardware installs. Right, the second I am saying, I am coming end of life for legacy vendor A, B, C, D or E, should I go, replace this with new versions of legacy A, B or C or should I look at a new network architecture which allows the flexibility of having hardware and software and remote access.

The example we gave we entered a $20 million deal with a customer who built – who bought Prisma Access for half of their employees, who bought hardware firewalls for their datacenters and who bought virtual firewalls for their cloud and they made sure they were all consistent.

So, we do see customers end of life being legacy hardware which is dead ended which doesn’t have a software form factor or a firewall in the cloud capability and we do see them transitioning to a hardware and software model. It’s not zero sum. It’s not these are already sometimes ends up being this end.

[Tal Liani, BofA]

Got it. Thank you.

[Operator]

Next question comes from Brent Thill of Jefferies.

[Brent Thill, Jefferies]

Thanks. Nikesh, there is a lot of questions from investors about this proposed equity structure and the timing and what you are experiencing, I am curious if you could just double click on what you think this looks like and why you are doing this right now?

[Nikesh Arora, Chairman and Chief Executive Officer]

Thanks for the question. Look, it’s not – first of all, we have spent about six to eight months preparing for the financial visibility and constantly thinking that thing. It requires a lot of work on our accounting side, lots of rules to make sure how we do transfer pricing between the entries and how do we leverage our common sales force at Palo Alto Networks.

So, and again, we are not doing anything. All we’d have is we’ve presented to the Board and they’ve agreed that this is an area for us to go ahead and work further on, which means we are looking at seeing how can we make the equity more transparent if we believe the market value has got differently than the Palo Alto equity.

Now the market can say, this is great. We just love you Palo Alto equity and it will help it achieve all the price targets of the more enthusiastic and optimistic ones if you have in which case we may not have to do anything if not, we may actually – you’ll take a look at the ClaiSec equity and see how do we create more transparency, because, fundamentally, if you look at it, we’ve got one business generating $0.5 billion in free cash flow, which is fantastic.

We like it. 38% margins now going to 41% whilst we are going through the hardware software transition. On the other hand, we have a $735 million ARR business growing at 77%. That business has negative cash flows. And the market looks them together and values it one certain way, either the market will value it differently as we look at it differently. So we are just exploring the opportunity of being able to make that value more transparent.

We are not going to change the operating structure of the company. We are going to still run at as one company with two basically agile business units, if that makes sense.

[Operator]

Our next question comes from Michael Turits of KeyBanc.

[Michael Turits, KeyBanc Capital Markets]

Good afternoon, everybody and nice quarter. It was a really good quarter on firewall platform as a service and you raised Network Security. But the product itself was just in – slight be – so, what’s the delta? What really raised that guidance on networks for the year and drove the outperformance? What was the biggest piece? VM Series, Prisma Access, subscription attach, how would you rank those?

[Nikesh Arora, Chairman and Chief Executive Officer]

Access, VMs and Subscriptions, not because subscriptions aren’t doing well. It’s just a very large number. So, sustaining a large number going at 30% is a good thing.

[Michael Turits, KeyBanc Capital Markets]

Great. So it's really, Prisma Access was the big driver?

[Nikesh Arora, Chairman and Chief Executive Officer]

Yes. I mean, look at Access, it's gone to a – when I joined, it was called GlobalProtect Cloud service. It was barely $10 million in the quarter. Now it's going gangbusters.

I just said - now I just said, we did $20 million deal across a customer's entire enterprise, which included Cortex and Prisma Access in there. So, we can get up to $10 plus million deals in Access in one deal where we were doing $10 million in one quarter three years ago. So, that makes it interesting.

[Michael Turits, KeyBanc Capital Markets]

Great. Thanks, Nikesh.

[Operator]

Next question comes from Jonathan Ho of William Blair.

[Jonathan Ho, William Blair]

Hi there. I just wanted to get some additional color in terms of the subscriptions that you've been I guess, selling with the firewalls. Is there any way that you can maybe provide some additional perspectives on maybe which ones are doing well and what the average number of subscriptions being taken are? And, yes, that would be great.

[Nikesh Arora, Chairman and Chief Executive Officer]

Yes, Jonathan, that the - obviously, we had four when I joined and they are all had over 50% attach rates even before. The one which has gone from zero to 500 is DNS secured in the last two years. As we just announced, we crossed the 5,000 customer mark.

Many of the newer subscriptions were just launched as part of 10.0 with our software. So they are all very recent, which includes IoT, SD-WAN, DLP, those things. Yes, those things.

[Lee Klarich, Chief Product Officer]

Right.

[Nikesh Arora, Chairman and Chief Executive Officer]

And, sorry, I got Lee sitting next to me, socially distanced, I keep nodding, asking him what he – if I forgot anything. But, SD-WAN, you can see is combined with our CloudGenix efforts. So we see SD-WAN traction between the two of them. We are seeing a lot of interest in DLP, which is very early. It's only a few weeks old and IoT, we see situations, but that's more of an architectural sales, because not just at that subscription.

People want to look at the IoT architecture for the enterprise. But we are – we launched healthcare IoT. So it's part of the IoT effort. So, I have expectations from DLP. I have expectations from SD-WAN, obviously, with a combination of CloudGenix and IoT, but I think we'll see different approaches and different sort of trajectories in terms of adoption. IoT is a bigger ticket when we sell it. DLP is a simple attach and it’s easy to deploy like DNS security is. So they take different trajectories at different prices.

[Operator]

Our last question comes from Andy Nowinski of D.A. Davidson.

[Andy Nowinski, D.A. Davidson]

Great. Thank you for sneaking me in. So, you mentioned a number of eight figure deals for both Prisma Access and Prisma Cloud, which were record deals for the company. Just wondering if you could provide any more color with regard to your overall large deal activity for the quarter? Was the activity up year over year? And if you did see an increase in the overall activity, kind of what drove the growth? Thanks.

[Nikesh Arora, Chairman and Chief Executive Officer]

Yes. Andy, I think purely math. I am waiting for Luis to go look, but purely mathematically, we added the same number of customers we did this year than we did last year and our billings grew 20%. So we got – definitely got to have more bigger deals in there.

Hurry up, Luis. What are you doing? So, yes, we are seeing strength. But I would say, it's kind of interesting. If you look at the landscape, the higher end of the cloud sales see bigger deals, because you are comparing them to large GCP, AWS, Azure spend. So even if you get 2% to 5% of the GCP, Azure, AWS commitment, you end with the large deal, which is typically the seven plus figure range.

And you see similar activity in Prisma Access, because it ends up being a three-year TCV style deal with – if you get the top end, like 100,000-plus users, you end up with a seven and a half figure deal. XDR in the market typically ends up in the $1 million to $2 million range, because of competitive pressures and competitive activity. So you just need to do a lot more XDR deals to get there.

And so it's different depending obviously, firewall, again, depends on the installed base of the estate and the end of life and ELAs have their own characteristics depending on, again, how much estate is there and how much people are reupping and how much software they are buying. Luis?

[Luis Visoso, Chief Financial Officer]

So here is how I look at it. If you add up the billings of the last largest deals that we did this quarter and you compare that to a year ago, the total is 35% higher. So it just gives you a magnitude of how significant those large deals are for us.

[Andy Nowinski, D.A. Davidson]

Thanks, guys. That's really helpful.

[Nikesh Arora, Chairman and Chief Executive Officer]

All right. Well, see, Brad Zelnick, if you change your mind about us, you don't even get to ask a question. All right. Thank you, everyone. Thank you for joining us, and thank you very much for all your questions. We look forward to seeing many of you in our upcoming investor events. I also want to thank our customers, partners, and of course, our employees at Palo Alto Networks. Have a great day.