Palo Alto Networks closes gap in network security

Cisco has been the long-standing leader in network security but is close to being surpassed by Palo Alto Networks on the back of sustained strong growth. Palo Alto Networks has raced to second place with a strong product portfolio and dedicated channel, and is making significant investments in sales and marketing. Network security remains a highly competitive market with no dominant leader. The top four vendors (Cisco, Palo Alto Networks, Check Point and Fortinet) account for more than 60% of the market, which in Q2 2018 was worth US$3.4 billion and grew 11.4% year on year.

Palo Alto Networks invests its way to second place

Palo Alto Networks’ growth has been underpinned by investments in research and development but, more notably, in sales and marketing, which alone represents 45% of revenue. Building a brand and a salesforce has been instrumental in helping it gain both awareness and market share. While its firewall range remains core to its business, like most security vendors it has expanded its suite of offerings to enable a multi-vector approach to security. Traps, Aperture, WildFire and its GlobalProtect cloud service are just some offerings that take Palo Alto Networks beyond the network security appliance and into other parts of the cyber-security stack. Network security is a mature segment, and so gaining share requires competitive displacement. Driving value for customers plays a key role in this as well as reducing churn. Its investment in cloud-based services will help it progress further.

With its high cost structure, Palo Alto Networks is not yet profitable, which competitors are keen to point out. Looking at its latest fiscal Q4 2018 results, operating margin was 1%, while its net loss was US$2.3 million, with accumulated loses approaching US$1.0 billion. Yet its free cash flow (and free cash flow margin) is strong, helped by two important factors: its ability to sell long-term service and subscription contracts (deferred revenue grew faster than revenue in Q4), and the amount of stock-based compensation used in paying its workforce.

Its new CEO, Nikesh Arora, was appointed in June 2018 and will have to master a balancing act of investing in continued growth (which has been the primary driver of its stock price gains to date), while also bringing the company to profitability. Its ability to expand into adjacent sectors, such as endpoint and cloud security, will be important growth drivers over the next 24 months. It raised significant cash throughout its fiscal 2018, a big portion of which came from its recent US$1.5 billion convertible notes offering, presumably in part to help fund future growth.

Key competitors need to react

Cisco, Check Point and Fortinet need to be aware of Palo Alto Networks’ potential to become the outright leader in network security and react now. Each has a different vantage point on the market, with its own set of opportunities and challenges. Cisco has size, a large customer base, a dedicated channel ecosystem and financial strength due to its dominance in networking. It is the only security vendor with significant cash reserves to make big acquisitions and has bought some notable security brands over the years, such as Sourcefire, ScanSafe and IronPort Systems. It recently announced its intent to acquire Duo Security for US$2.35 billion. Yet despite its position as market leader and increased focus on the sector, security is often seen (by customers and partners) to be a secondary business for it. Cisco should consider what it can learn from its Meraki business unit, which is kept as a somewhat separate entity to foster a distinct culture, a separate brand and a nimble competitiveness.

Check Point has been Cisco’s main challenger for many years and is one the pioneers in unified threat management, but it has lost significant ground to Palo Alto Networks in the first half of 2018. In Q2 2018, its share of the network security market was 14.3%, down from 15.6% in the same period last year, according to Canalys estimates. An overly centralized management team has left it too slow to react to the competitive landscape, with deals taking weeks to approve according to one top partner. It has been much slower than either Cisco or Palo Alto Network in moving customers to subscriptions. Overall channel sentiment has declined in the past 12 months, according to the Canalys Vendor Benchmark, in contrast to that for Palo Alto Networks, which maintains an industry-leading score (see chart below). Despite slow growth rates, it is important to highlight that Check Point is profitable and has been financially stable for a long time. A stock market crash would likely hurt its competitors more, especially Palo Alto Networks, which relies heavily on its share price to finance growth. But being cautious can be costly in a competitive market.

Fortinet has invested to keep pace with Palo Alto Networks, spending 44% of revenue on sales and marketing (based on its latest quarter reporting). But it has managed overall costs to achieve an 11% operating margin and a net income of US$49 million (based on the quarter ending 30 June 2018). It maintained a strong growth rate in its latest quarter, but behind that of Palo Alto Networks (and more so when comparing growth of deferred revenue). Fortinet has a strong mix of international business, where it is the market leader in network security (outside of the United States). It also has a strong service provider business, which delivers large deals but is affected by seasonality. Companies that cater for the carrier space can be more conservative, which does not bode well for the fast-moving security sector.

The channel matters for growth

All four network security companies are channel-centric – each has more than 90% of revenue going indirect. Channel sentiment, therefore, is critical to a healthy selling ecosystem. According to the Canalys Vendor Benchmark, this is an area where Palo Alto Networks leads. It is seen as channel-friendly by its close-knit partner ecosystem but, moreover, its partners are also reaping the benefits from its growth. Growing via the channel should be a priority as Palo Alto Networks seeks profitability and geographic expansion – its market share position drops to fourth when looking at international markets (outside of the United States).

As security takes center stage in corporate priorities, the stakes become critical for network security vendors that are not only vying for market share positions in this specific sector, but also brand perception in the overall cyber-security space, which remains crowded. Network security accounts for 39.9% of total spend on security products and creates a strong base from which vendors can build cross-sell opportunities into other layers of the security stack.