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Palo Alto’s new focus on profitability is bad news for Israeli startups

Analysis

Palo Alto’s new focus on profitability is bad news for Israeli startups

The cyber giant spent over $3 billion on acquisitions in three years, which shot up its valuation. However, as it aims to increase profits, Israeli companies which hoped to be bought are likely going to have to wait

Sophie Shulman | 16:51  26.08.2021

The three years during which Palo Alto acquired more than ten companies seem to have been successful, strengthening the powerhouse’s position as the largest cyber company in the world.

Palo Alto founder Nir Zuk Photo: Palo Alto Palo Alto founder Nir Zuk Photo: Palo Alto Palo Alto founder Nir Zuk Photo: Palo Alto

Following the publication of its financial reports earlier this week, the company, which was founded by Israeli Nir Zuk, saw its share price rise by 19%, reaching a market value of $43 billion. This was the highest daily spike in Palo Alto’s history, putting it at three times the valuation of its competitor Check Point, where Zuk was one of the first employees.

The relationship between Palo Alto and Check Point is a strained one based on a historic conflict between the founders, which refuses to die down. In early 2020, just before the outbreak of Covid-19, both companies were trading at a similar value. Check Point, founded and managed to this day by Gil Shwed, was traded at $16 billion, and Palo Alto at $18 billion. In the year and a half since then, Check Point's value has plateaued, while that of Palo Alto has skyrocketed by 140%.

On Tuesday, Palo Alto's positive reports shined a bright light on the entire cyber sector and made clear how red hot the market is: SentinelOne added 7% to its value, trading now at $15 billion; Varonis rose by 3% trading at $6.5 billion, and even Check Point climbed 1.5% to a market value of $17 billion.

However, the star of the party was Palo Alto, which reported $1.2 billion in revenue for the quarter that ended in July, which was also the last quarter of the company's fiscal year. Surpassing expectations and showcasing a rapid growth rate of 28% compared to the corresponding quarter, Palo Alto even reported that for the first time it has a customer who pays $100 million a year, noting that it has several other customers closing on that figure. This is a huge sum considering that most of Palo Alto's revenue comes from software sales to protect various parts of an organization.

Against this background, Palo Alto raised its annual revenue forecast for 2022 to $5.3 billion, 25% more than the current year, and double Check Point’s, which for several years has been growing at a rate of only 4% per year.

$3.6 billion, 13 acquisitions

The strength displayed in all areas of Palo Alto's operations - from the traditional firewall, through cloud operations (SASE) to cyber crisis management (SOC) - shows that at least in terms of growth, the aggressive purchasing strategy it has adopted in recent years has paid off.

In the last three years, led by CEO Nikesh Arora, Palo Alto has invested $3.6 billion in the acquisition of 13 companies. Arora, who served as SoftBank President, brought his approach of “first growth, profits later, maybe” to Palo Alto when he joined in the middle of 2018.

Palo Alto CEO Nikesh Arora Photo: Bloomberg Palo Alto CEO Nikesh Arora Photo: Bloomberg Palo Alto CEO Nikesh Arora Photo: Bloomberg

Speaking with analysts, Arora summed up the strategy well. "When I came to the company there were many cyber trends in which we were not a significant player, and we had to become one. If we would have built these capabilities on our own, it would have taken us five years. With acquisitions and mergers, it takes much less".

Palo Alto's series of acquisitions - roughly half of which, both in the number of companies and the sum invested, were Israeli companies - also strengthened its local presence. About a year ago, the company moved all the startups it had acquired into one headquarters in Alon Towers in Tel Aviv, which already was home to more than 700 of the company’s employees. Zuk also moved his base of operations from Silicon Valley to Israel, while simultaneously working on establishing a local digital bank.

Good news for shareholders

Beyond the numbers themselves, Wall Street also loved what Palo Alto executives were hinting at between the lines. The main and surprising message was that the company is taking a time-out from acquisitions. If in recent years there has not been a quarter in which Palo Alto has not bought a company, then now it plans to engage in optimally operating of all the acquired companies.

This is in fact good news for Check Point, which did not acquire many companies, and when it has, then it preferred buying young startups at low prices. For the local startup ecosystem, on the other hand, this is less good news. Quite a few cyber companies have been set up in recent years on the assumption that Palo Alto will swallow them sooner or later, and now they are mostly left with Shwed, who is hungry for growth but does not like to pay high or inflated prices, as been implied about Palo Alto’s deals.

For Palo Alto and its shareholders, this is good news as well, since its constant Achilles heel has been profitability. In this aspect, Palo Alto stands out in its inferiority, both because of its past acquisition load and because it advocates a generous capital reward, also in comperacent to its competitors.

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As a result, there is a huge gap between Palo Alto’s profit, which is calculated not based on generally accepted accounting principles ($162 million), and the reported loss ($120 million). Check Point, on the other hand, earned $186 million on a turnover of $526 million, half that of Palo Alto. Part of the low profitability is also due to Palo Alto's huge number of employees, which reached 10,473 at the end of the quarter, almost double that of Check Point.

"Next year we will recruit fewer employees compared to the recruitments we have made in recent years. There may be acquisitions, but only taking advantage of point opportunities to purchase a product, and they will be less significant," some within the company said, adding that from now on the plan is to increase operating profit faster. At the end of September, Palo Alto will present its detailed three-year plan.

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