Palo Alto Networks Inc (PANW) 2013 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the third quarter 2013 Palo Alto Networks Inc.

earnings conference call.

My name is Taheisha, and I'll be your operator for today.

At this time, all participants are in listen only mode.

Later, we will conduct a question and answer session.

(Operator Instructions)

As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Ms. Maria Riley, Investor Relations with the Blueshirt Group.

Please proceed.

Good afternoon, and thank you for joining us on today's conference call to discuss Palo Alto Networks fiscal third quarter 2013 financial results.

This call is also being broadcast live over the web and can be accessed on the investor section of the Palo Alto Networks website at investors.paloaltonetworks.com.

With me on today's call are Mark McLaughlin, Palo Alto Networks' Chairman, President and Chief Executive Officer and Steffan Tomlinson, Chief Financial Officer.

After the market closed today, Palo Alto Networks issued a press release announcing the results for fiscal third quarter ended April 30, 2013.

If you'd like a copy of the release, you can access it online at the Company's website or you can call the Blueshirt Group at (415) 217-7722 and we will e-mail you a copy.

We would like to remind you that during the course of this conference call, Palo Alto Networks' management will make forward-looking statements, including statements regarding continued revenue growth and overall momentum in the Palo Alto Networks business, especially as a result of it's land, expand and extend strategy.

Expectations for deals to closing fiscal Q4 or future quarters, our ability to develop innovative and differentiated products ahead of the competition, transit improvements and operating results, including it's sales pipeline, customer acquisitions, gross margin, operating margin and non-GAAP effective tax rate and Palo Alto Networks expected revenue and non-GAAP earnings per share for the fourth fiscal quarter at 2013 ending July 30, 2013, as well as CapEx expenditures for fiscal year 2014 ending July 31, 2014.

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 and 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 these risks and uncertainties, please refer to our quarterly report on Form 10-Q A filed with the SEC on March 5, 2013 and our earnings release posted a few minutes ago on our website.

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.

We have provide reconciliation for these non-GAAP financial measures to GAAP financial measures in the investor section of our website located at investors.paloaltonetworks.com.

Now I'd like to current students Mark McLaughlin, Chairman, President and Chief Executive Officer of Palo Alto Networks.

Mark?

Thank you, Maria, and thank you, everyone, for joining us.

In our third fiscal quarter, we saw good revenue growth of 54% year-over-year, surpassing $100 million per quarter for the first time in our history, despite challenging macroeconomic conditions, particularly in the Federal vertical in Europe.

During the quarter, we had strong gross margin improvement, achieved non-GAAP EPS of $0.06 per share and grew deferred revenues by 17% sequentially.

Also in the third quarter, we continued to demonstrate that we are aggressively capturing market share against all of our competitors and establishing Palo Alto Networks as the global leader in next-generation enterprise network security.

This is the case because while security is not immune to macroeconomic factors, it is increasingly critical to enterprises.

Threat landscape is not getting any better and it seems nearly impossible to pick up the paper without reading a story about a criminal organization hacking into ATMs or possible foreign government-sponsored attempts to steal secrets from large companies.

In this environment, our leadership position is driven by our high-value disruptive technology, which we believe provides the highest level of security available in the market.

We now have over 12,500 customers using our next generation security platform, and our customer acquisition has continued for the sixth consecutive quarter at a pace of over 1,000 new customers added during the quarter.

In addition to landing new customers, we also continued to grow revenue with the installed customer base by expanding our device footprint through the enterprise and extending our value to customers with multiple services on the devices.

One view of our success in implementing this strategy is the lifetime value of our customers.

For example, during the quarter, the lifetime value of our top 25 customers averaged 14.1 times their initial purchase.

This is up substantially from 11.4 times last quarter.

And to make the top 25 list in the third quarter, a customer had to spend a minimum of $3.2 million with us, which is up from $2.8 million last quarter.

This metric illustrates our ability to capture more wallet share once we've penetrated an account.

Some specific examples of the success of our land, expand and extend strategy in the third quarter include us closing of seven-figure deal with a very large industrial manufacturer in the United States in which we beat CheckPoint and replaced Juniper as the new preferred firewall.

This deal also includes a paid for Wildfire service as part of the offering.

Also, we closed of seven-figure data center firewall deal with one of the largest banks in Japan where we replaced Cisco and in addition, we closed a large perimeter firewall deal with a leading German cable company in which we beat CheckPoint in functionality and performance.

And we also continued our expansion strategy into one of North America's largest financial services companies where we started in mid-2011 and where we now have replaced all CheckPoint firewalls in their network perimeter.

The reason why we are able to win so many new customers and expand so significantly within our customer base is that our technology is fundamentally different than all of our competitors, and this differentiation continues to grow.

Customer traction has been significant across all of our new products and services.

In the third quarter, our PA 3000 series sold very well, as expected, and we now have more than 1,700 customers using our Wildfire service, up from 1,200 from last quarter with the attachment rate on the paid version of that service comfortably in the double-digits in just five months from launch.

In addition, next week will start the marketing campaign for the Wildfire 500 appliance, a key new element of our Wildfire cybersecurity offering that implements on-premise APT detection as a private cloud service for use by customers that cannot share data in public clouds.

We will continue to aggressively distance ourselves from the competition as we further extend our technology lead.

Looking forward, while the macroeconomic environment remains uncertain, we entered the fourth quarter with a strong pipeline and competitive momentum.

Our land, expand and extend strategy continues to fuel our growth, and we are pleased to report a strong third quarter of growth, continued strong new customer acquisition, accelerating repeat buying from our install base and increasing operating leverage.

I'm also delighted to welcome Carl Eschenbach, President of VMware to our Board of Directors.

Carl's experience and expertise is highly valued, and we look forward to his input and his advice.

With that I'd like to do the call over to Steffan for a more detailed look at our financial results.

Steffan?

Thank you, Mark, and thank you all for joining us today.

I will first review our results for Q3 '13 and then conclude with our outlook for Q4 '13.

In Q3, total revenue grew to $101.3 million, an increase of 54.2% year-over-year and 5% sequentially.

Looking at our two main components of revenue, in Q3, product revenue was $60.8 million, grew 39.7% year-over-year and decreased 1.9% sequentially.

The sequential decrease was primarily and Europe and in our Federal vertical.

Services revenue of $40.5 million, which represented 40% of total revenue, grew 82.6% year-over-year and 17.2% sequentially, driven in part by an increase in the attach rates of our subscription services.

This growth in services revenue underscores the power of our hybrid revenue model.

The geographic mix of revenue was 62% Americas, 23% EMEA and 15% APAC, with all theaters posting growth on a year-over-year basis.

On a sequential basis, Americas and APAC posted solid growth while EMEA declined by approximately 4%, following two quarters of 23% sequential growth for both Q1 '13 and Q2 '13.

Total non-GAAP gross margin in Q3 with 74.1%, ahead of our target range of 70% to 73%.

Non-GAAP gross margin increased 220 basis points year-over-year and 190 basis points sequentially.

Putting a finer point on gross margin, Q3 non-GAAP product gross margin was 74.3%, an increase of 70 basis points year-over-year and 90 basis points sequentially.

The sequential increase was primarily due to cost reductions and product mix.

Our non-GAAP service gross margin was 73.7%, up 510 basis points year-over-year and up 360 basis points sequentially.

The sequential increase was primarily due to increasing services as a percentage of total revenue and higher attach rates for our subscription services, as well as leverage in our customer service organization.

Having added over 1,000 end customers in the quarter, we will continue to invest in customer support, and services gross margins will fluctuate depending on the timing of the investment ramp of our service organization.

Moving on to operating expenses, Q3 non-GAAP research and development expense was $12.9 million, a decrease of $0.7 million from the prior quarter, due in part to the timing of expenditures related to certain projects.

As a percentage of revenue, non-GAAP R&D expense was 12.7%, down 130 basis points sequentially.

Q3 non-GAAP sales and marketing expense was $45.6 million, an increase of $3.7 million from the prior quarter, due to the addition of quota carrying headcount and commission-related expenses.

As a percentage of revenue, it was 45%, an increase of 160 basis points sequentially.

Q3 non-GAAP general and administrative expense was $9.3 million, an increase of $1.5 million from the prior quarter or 9.1% as a percentage of revenue, up 110 basis points sequentially.

G&A was impacted by expenses related to setting up our international corporate structure, ERP implementation and litigation costs.

In total, Q3 non-GAAP operating expenses were $67.7 million, an increase of $4.6 million from the prior quarter or 66.8% of revenue, up 140 basis points sequentially.

Q3 non-GAAP operating margin was 7.2%, an increase of 40 basis points sequentially.

The sequential improvement this quarter can be primarily attributed to the gross margin improvement.

As we've stated previously, given our leading position in the market and the fact that we are growing revenue at a much higher rate than both the market and our competitors, our goal is to continue to invest while growing operating margin in a slow and steady manner, noting there may be near-term fluctuations in operating margin.

Our non-GAAP effective tax rate for this quarter was 38.5%.

This rate will continue to fluctuate throughout the fiscal year as it is dependent on our global pretax profit mix and potential discrete events such as the removal of our domestic valuation allowance.

Non-GAAP net income for Q3 was approximately $4.5 million, or $0.06 per diluted share, using 78 million shares.

This compares to non-GAAP net income of $3.9 million or $0.05 per diluted share in fiscal Q2 '13, and non-GAAP net income of $4.7 million, or $0.07 per diluted share in fiscal Q3 '12.

On a GAAP basis, net loss was $7.3 million, or $0.10 per basic and diluted share.

Turning to the balance sheet, we finished April with cash, cash equivalents and investments of $391.5 million.

In Q3, cash flow from operations was $15.2 million, free cash flow was $8.8 million and free cash flow margin was 8.7%.

While cash flow from operations and free cash flow where impacted by the quarter's linearity, deferred revenue and billings grew strongly, giving us increased visibility on future cash flows.

Capital expenditures in the quarter were within our anticipated range of $5 million to $10 million and totaled $6.4 million.

As I mentioned previously, in fiscal 2014, we'll see an increase of approximately $10 million to $12 million in CapEx related to the relocation of our headquarters facility.

Most of this increase will be in fiscal Q1 of 2014.

The annual operating expense starting in FY '14 for this new facility will be approximately $13 million for the year.

We ended Q3 with $91.5 million of accounts receivable, up from the Q2 '13 balance of $68.6 million.

The quality of our accounts receivable is excellent.

Average day sales outstanding were 71 days, up from 58 days last quarter, reflecting both a backend-loaded quarter and a higher mix of subscription and multiyear deals.

Moving down the balance sheet, total deferred revenue was $219.3 million, an increase of 88% year-over-year and 16.5% sequentially.

Short-term deferred revenue was $134 million, an increase of 14.1% sequentially.

We're continuing to see an uptick in multiyear deals.

Billings were $132.4 million, an increase of 56.8% year-over-year and 6.5% sequentially.

Let me now turn to our guidance for Q4 '13.

We expect revenue to be in the range of $106 million to $110 million, which equates to 40% to 45% year-over-year growth.

And we expect non-GAAP EPS to be approximately $0.06 per share using 78 million to 80 million shares on a diluted basis.

While we are mindful of the current macroeconomic uncertainty, we are continuing to invest in product development, sales and go to market functions, as well as discrete projects in G&A, and have factored all this to our guidance for Q4.

With that, I'll turn the call over to the operator to open the Q&A session.

(Operator Instructions)

Greg Dunham from Goldman Sachs.

Please proceed.

I guess I wanted to start on the macro and try to get a sense of how much that was an impact on the business.

You -- revenue growth was 54% versus your closest peers that are flattish to down 20%, or close to 20% in this quarter.

So, clearly a strong outperformance there.

But I just want to get a sense of, do you feel that you guys are more sensitive to some of the macro shifts going on, in terms of the growth numbers?

How much did they play a role in terms of this quarter, and can you talk about the trend in the quarter?

You mentioned it was a back end-loaded quarter.

Can you talk about how it progressed throughout the quarter and maybe what you've seen thus far this month?

Thanks.

Hey Greg, it's Mark.

Yes, let me take those in a couple parts.

The first thing is, I think there's no doubt that it's a challenging market right now, and we are seeing that.

As our quarter progressed, for us, we saw that play out towards the end of the quarter than the beginning of the quarter as sentiment sort of changed, I'll call it on the big picture basis.

I think you are correct.

You noted that other folks have seen this as well and had some in their performance.

Despite that, we grew 5% sequentially, 54% year-over-year, so we are pleased with that, in light of those macroeconomic conditions.

Particularly for us, the areas where we saw the impact around that were really in Europe, and specifically in central and southern Europe, and then in the fed sector with the continued sequestration.

In those cases we saw -- each one of those cases saw few million worth of deals in each one of those sectors getting pushed, deals that we select for but getting pushed to the right.

We saw that occur as the month -- as the quarter played itself out.

So, I think it's no doubt that it's a tough environment out there.

But, given all that, we are pretty pleased with where we ended up.

Okay.

Thanks, guys.

Brent Thill from UBS.

Just a follow-on on Federal.

Just in terms of what you are seeing in the back half of the year, are you getting any more sense, in terms of how those budgets are coming together?

And just a quick follow-up in Europe.

Do you believe that's more macro, or is there anything you are seeing from an execution or competitive issue?

Let me start with the second one, Brent, just big picture.

On a competitive basis, we haven't seen any change in the competitive market except us continuing to pull ahead, and I think the results show that.

Our results relative to everybody else in this sector, we've done very well, particularly in our relative basis.

We are not seeing that at all, not in Europe or anywhere else.

On the fed side of it, the sequestration thing is real, this is the first quarter anybody's had to live through that.

On a second half -- from a second half of the year basis, I would expect that sequestration would last through -- at least the end of the fiscal fed year, which is at the end of October.

There's really no reason to believe, at this point, that that's going to change.

I think that will be with us at least that long.

Great.

Thank you.

Michael Turits from Raymond James.

Two questions.

First, again, when we look at the guide for next quarter, which is a little bit below consensus, what's in that guidance in terms of your assumptions regarding both fed and Europe?

In other words, is that the source of the lower number there that you continue to expect those to be weak?

And also, just wanted you to comment on the deferred, which is actually particularly strong, as I calculate your billings all-in.

I know some of that came from long-term, but some grew faster than revenues.

Were there any rev rec issues where you were deferred more than expected?

From the guide perspective, I think we have to assume that the sequestration continues, like I just said.

So, we will take that into account.

And then on the Europe side, I don't think there's any reason to believe that right where we are sitting today, that the sentiment over there is going to change in any big picture regard from what we saw, I think particularly towards the tail end of our quarter.

We are thinking about those two things in particular, as we look forward.

So, we are cautiously optimistic.

The guide does provide a 5% to 8%-point something sequential growth and 40% to 45% on a year-over-year basis.

But, we have to take those things into account as we look forward.

I will let Steffan take the second question.

On the deferred revenue piece, if anything, it underscores the power of our hybrid revenue model.

We've been selling lots of subscriptions, the attach rates have been going up.

We've had very nice traction with Wildfire.

And when you look at the mix between short and long-term deferred, short-term deferred revenue grew 14.1% sequentially, long-term deferred revenue grew 20.6% sequentially.

And that long-term deferred, there is no rev rec issue in there.

It's more, we've seen an uptick in multiyear deals, which is a big vote of confidence from our customer base who are designing us into their networks for a long period of time.

Okay.

Thanks, guys.

Jonathan Ho from William Blair.

Just wanted to get a better sense of some of the deals that maybe got pushed out.

Would you expect those to subsequently get -- potentially recognized this quarter?

Or do you feel like there's just going to be sort of an increasingly cautious environment throughout the rest of the year?

That's a good question, Jonathan.

For the deals that we saw that got pushed to the right there, in those two sectors, are situations where we've technically won, meaning a customer wants Palo Alto, so we are confident that ultimately, were going to get these deals.

The win is a little harder to gauge, because like I said, the sentiment hasn't changed or if it does change, maybe that helps us.

But we would expect that at some point we get these deals, but it's just really hard to say whether we get them in the fourth quarter or Q1.

I really can't nail that down right now.

Got it.

Just in terms of your overall pipeline, are you taking with the guidance a more cautious approach across the board?

Or does this reflect only sort of concerns in the fed and Europe ongoing?

Well, two separate things there.

From a pipe perspective, we've got a strong pipe as we come into the fourth quarter.

We had a strong pipe coming into the third quarter as well, but we've got a nice pipeline as we -- as came into the fourth quarter.

I think for us, where we particularly saw things, like we said, was in those sectors, those two places in Europe and the fed space, I think is a general matter.

There's macroeconomic concern.

Maybe it's stemming from those two sectors, not really sure, but as a general matter, it feels like there's a macro concern.

For the us, that's where we particularly saw the impacts.

Great.

Thank you.

Keith Weiss from Morgan Stanley.

This is Melissa Gorham calling in for Keith Weiss.

I know that you mentioned Federal being weak, but was there any other verticals that came in below expectations?

I know some of your peers had cited the service provider segment being weak in the March quarter, and I know that it's relatively smaller for you all, but just wondering if you saw weakness there as well.

Service providers is a much, much smaller vertical for us than a lot of our peers in there.

So, we saw little bit of softness there, but it's a rounding error in absolute dollar terms.

So, I'd say it was consistent with other people saw, but it's just not nearly as impactful for us as other folks.

In other places we saw a really good growth, so, like in the -- not in the Federal space, but in the state and local government education space, we saw very nice increases sequentially in that space.

So, it's really -- there were puts and takes across all the verticals.

But the two that we -- were impactful to us really were the Europe and fed.

Okay, great.

And then previously you cited in and attach rate of 1.5 subscriptions per appliance.

Has there -- was there any change to that in the quarter, and where do you see that going over the next year or so?

The attach rate did increase.

We are not giving specific numbers on the attach rate.

We're going to be doing that on an annual basis anchored around our analyst day.

And at the last analyst day we said it was right around 1.6 for the prior quarter.

So, you can expect, and I would say it's a reasonable expectation that as we add more subscription services like a Wildfire, we should be able to see growth in that attach rate.

Okay.

Thank you.

Phil Winslow from Credit Suisse.

This is Harris Heyer, I'm calling on behalf of Phil.

Thanks for taking the question.

I was hoping you could comment on the price environment, just in general, versus the last couple quarters.

Hey, Harris.

Yes, we actually haven't seen much change in price environment.

The things that we've said in the past is that the competition has been for quite some time, continues to be aggressive on pricing.

That's expected, I think.

When have what we believe is the superior technology, that's a card that they can play.

We've been looking at that for quite some time and have extremely high win rates against all the competition.

That hasn't changed.

We don't see any impact in that.

One other thing, Harris, is our product gross margins have increased sequentially, and that demonstrates the value of the differentiated technology that we're bringing to the table.

Thank you very much.

(Operator Instructions)

[Ray Melincia] from Barclays.

A quick one.

If I look at the run rate, it looks a touch lower than we have modeled and potentially would have thought, given the reasons you discussed.

Will that cause any change in the thinking in terms of investment on the buildout of distribution capabilities or the Company as a whole?

Thank you.

The answer -- the short answer is no.

We are taking a very long view here on the business, and our goal has been and we've demonstrated the ability to grow the business way ahead of the market growth and way ahead of any of the competition.

So, we view this as a market share gain opportunity for us, and we intend to be aggressive about that.

You might have a quarter were you have some tough macro conditions and other ones that won't be that way.

We are taking a long approach on that.

What we continue to invest, we will invest aggressively and as long as we are able to post a significant market share gain, we will keep on doing that.

Perfect.

Thank you.

Rob Owens from Pacific Crest Securities.

Wondering if you could provide some color on just what your renewal rate on these subscriptions have looked like and how that's been trending over the last couple of quarters?

Renewal rates in general have been very robust.

From a subscription standpoint, they vary by length of time that the subscription has been out.

So, Wildfire is our newest one, obviously, and we've just started selling that.

Threat prevention in Europe filtering, it's better on the longest.

They have the highest attach rates, and the renewals on those are very high.

We haven't gone into specifics on what the exact attach -- renewal rates are, but they are very robust.

And then the renewal rates on maintenance is extremely high.

You can't really have -- you can't be in the position that we are in and customers not renewing their maintenance, because you need to have access to the updates and the upgrades that come through on the support side of the house.

So, if I -- not the maintenance side, but the subscription side, just drilling in a little bit, is this consistent with where other people would put blade renewals, since you're not giving specific comments?

Or is it in excess of some of those industry numbers that we see out there?

I would say it's either consistent or slightly better than what a typical blade renewal would be.

And then number two, with the new facility, I think you said an annual operating expense is $13 million a year, is that an incremental $13 million or is that total number?

It is the total number, but it is incremental because it's a new facility.

And we had flagged that back in October when we let everyone know that we had the facility, that we leased it.

It's not new news, it's just putting a finer point on it for you.

Great, thanks for that.

Thank you.

Greg Moskowitz from Cowen.

It sounded as though things really did tail off at the end of the quarter, and as we are essentially wrapping up the month of May, just wondering if you have any anecdotal commentary on how this past month has perhaps compared to the month of April.

Would you characterize it as status quo, or is it gotten a little bit better, a little bit worse?

Just curious if you had any color there.

We did see, as the last quarter tailed off, the sentiment was changing, eroding as the quarter progressed.

We thought about that as we looked forward in the guide and from a month of May perspective, May is where we thought it would be right about now.

Certain linearity perspective, so we are on track with where we thought we'd be and in line with the guide we're giving.

Okay, great.

And then Steffan, how many heads did you add in the prior quarter?

And going forward, should we still expect roughly 75 to 100 per quarter?

Last quarter we added 85 heads with an ending headcount of 1,034.

That net additions of 85 are right in line with the range of 75 to 100, which we've been talking about.

The could be fluctuations, both on the top end and the bottom and, but as a directional guide, that's consistent with what we've said before.

Perfect.

Thank you very much.

Scott Zeller from Needham & Company.

I wanted to ask about the evolution of deals and maybe the size of deals that you are competing for.

Is there any change in the field that you are seeing, where perhaps there are fewer opportunities that are point around application control and perhaps they are larger, sort of like a network security refresh type project that would be more complex and take a longer cycle?

Is this happening in the field?

Generally, what we've seen from a deal perspective is the continued realization from customers that the staple inspection technology that has been going on a long time just doesn't cut anymore because of the explosion of applications.

It's really the basis of the application technology we have here that's driving the continued growth and interest in the Company, as more and more customers realize that that's something they need.

So, actually, Mark Anderson are sitting right here with me.

I will turn it over to him too, see if you can add anymore color on that, Mark.

Thanks, Mark.

And Scott, so I'm just amazed continually what I've seen from customers in terms of how receptive they are to our technology.

We did see some cautious spending, primarily in Europe, and certainly saw some projects get pushed in Federal.

But really, I think the worst thing that we saw was large quantity deals, maybe eight unit deals were cut down to four unit deals.

So, it cut down our overall PO size, but we really, didn't lose any business and I don't think our proposition has ever been stronger than it is today.

I guess just to follow-up on that, are you saying that the average scope of a deal is larger and more complex than previously?

What we are seeing is that -- there's a number of factors we've paid interest to, they're all positive, but what we are seeing is that we are better known in generally in what our value proposition is.

We get to see larger deals at first as opposed to smaller deals built over time.

We get to see bigger deals, we are winning bigger deals, and then with our existing customers as well, the repeat buying patterns, as I noted in the top 25, continued at an accelerating pace, which is great, which means our follow-on orders get to be bigger as they rely on us more across their enterprise.

Thank you.

Aaron Schwartz from Jefferies.

Probably a question for Steffan.

With the deferred revenue outperformance here over the last couple of quarters, I know we talked about this historically, but it does seem like the revenue mix should change a little bit here going forward with the higher mix on services.

Is that a fair statement as we build out our models a little further out?

And then secondly, with the trend in multiyear deals that you've seen, presumably there is a pull forward in cash flow there.

Do you have any sort of directional trend of how cash flow should look next year?

Thanks.

On a higher mix of services going forward, you can see just in terms of how revenues have played out this quarter, services as a percentage of total revenue was 40%, last quarter it was 35.8%.

I don't expect to see that type of sequential increase in the near-term.

The fact that we are, call it 5% to 10% penetrated in the largest accounts, we expect this to be selling a lot more boxes.

And so with that as the dynamic, we should see nice growth in both product and services.

But with the subscriptions that we are selling, the attach rates are going up, and directionally, services as a percentage of total revenue should be increasing, but I would just caution to say it's not going to be increasing -- it shouldn't be increasing at the same rate it did over the last quarter.

As far as future visibility on cash flows is concerned, we are seeing an uptick in the multiyear deals.

All of our deals that are multiyear in nature our billed up front, the cash is collected up front.

So, that will be of benefit to cash flows.

We are not guiding on free cash flow or cash flow from operations, but we certainly should be seeing a benefit to cash flows.

How much that is, we are not going to be getting into the specifics.

Okay, and a quick follow-up, if I could.

Are there any concessions in the multiyear deals?

Thanks.

On the multiyear deals, there is a discount for multiyear.

And that's kind of in line with the industry practice.

Dan Cummins from B Riley.

I'll actually ask a follow-on to the last question before I get to what I wanted to ask about.

I'm curious if the overperformance on gross margin, is that helped at all by being a little bit short in Federal or in any large deals in any region in particular?

Thanks.

Yes.

The overperformance on gross margin had very little to do with being off on Federal or EMEA.

The overperformance on gross margin was really driven by both line items.

When you look at the product gross margin, we had nice cost reduction and favorable product mix.

And on the services side of the house, we had a benefit from higher attach rates, and those were the primary drivers as a basket and it really had nothing to do with being light in Federal or Europe.

Okay.

I wonder, maybe it would be helpful, I think some of us on the call tend to view some of your peers, at least right now in the current year, as maybe two or three stories.

When we look at commercial businesses versus Federal business versus global or a EMEA business, are you able to tell us a little bit more about your growth rate, your all-in growth rate in commercial markets?

And just helping us isolate some of these temporary effects modeling-wise, I think would be helpful.

And also curious if there were any 10% customers for the quarter.

I'm struck by the -- a lot of companies said, well, things got very weak in March and you had an April quarter, yet DSOs were very, very high.

I'm just trying to reconcile all that.

Thanks.

Dan, let me try to work through t hat.

First, the easiest one is, there are no 10% customers in the business.

Hasn't been, wasn't last quarter, so that's not a factor at all around this.

Does that include Federal?

Yes, it does.

Okay.

No -- we had mentioned before, no vertical at all represents more than 13% of our business.

Peer interest, though, is pretty well diversified business, right?

That's a general statement.

The first part of you question I'd say, specifically what we saw in, like I said, in central and southern Europe and then fed as well.

In each of those situations, we saw a $3 million to $4 million in each one of those, deals that we push out of the quarter.

So, that is the majority of the impact from where we expect it to be to where we landed.

That's not broader than that across the entire market for us.

So, as I said a little earlier, in a number verticals we saw very good sequential growth.

Across verticals, we hadn't broken a lot of those down, not because they're unimportant, just because, as I said, there's no single vertical that represents more than 13% of the business.

There were puts and taken in a lot of the verticals.

Generally strong, generally good quarter, except in those two places.

Jonathan Ho from William Blair.

Just wanted to ask about the linearity of legal expenses.

Would you expect legal expenses to peak around now during the discovery phase, or should we expect it to move up or move down over the next several quarters?

Thanks, Jonathan.

This is Steffan.

We expect that legal expenses will increase as we get closer to trial.

So, we are largely through the discovery phase, and that did come at a cost.

But as we've said previously, as you approach trial, which is scheduled for February of next year, legal costs related to Juniper will be increasing.

Great.

Thank you.

Shelby Seyrafi, FBN Securities.

Can you quantify your government or Federal exposure?

I think in the past it was around mid-teens percentage of revenue, EMEA is around 23%.

So, it looks like combined, you're faced with headwinds from segments consisting of basically 40% of revenues.

I think this lasts through the end of the October quarter.

Can you talk about whether you agree with that, that the October quarter itself is going to have a lot of challenges, particularly related to the US Federal?

And then what are the catalysts to look out for over the next few quarters, to counter some of these forces you are faced with?

Hey Shelby, it's Mark, so I'll take that in three parts, if I can.

The first part is, just to make sure we're all talking about the same facts and figures, EMEA represents in the last quarter 23% of our revenue, so that' Europe, Middle East and Africa, right?

What we are seeing from a sales perspective, what we saw in Europe, is not that percentage.

We saw, like I said, about $3 million or $4 million in mix between central and southern Europe from a sales perspective from weaker than where we thought it would be.

Just want to put that all in context.

On the Federal side of our business, we said no vertical is more than 13% of our business in total.

Fed for us is a high single-digit percentage revenue vertical for us.

So, put that in the context as well.

All that say, it's nowhere -- what you were saying, it's nowhere near 40% of revenue the way you just described it.

The second thing on the sequestration in October, specifically Federal government, they are on a fiscal year that ends in October.

So, my guess is, is that we probably wouldn't see anything change in sequestration.

I don't see any events that would get dictate a change prior to the end of that fiscal year.

It could be longer than that, but I think it would go at least till October.

And then on the drivers side, the drivers for us are generally continue to be very positive, meaning customers really like our value proposition, the differentiation of technology.

Security is a really big deal and getting to be a really big deal every day of the week when you see constantly stuff going on in cybersecurity.

That all plays to our favor.

I think the macro trends for us are very, very favorable about what we do for a living and at the time we do it.

And let's not forget, we are growing much faster than the market and our competitors.

So, we are going to continue that path.

Gray Powell from Wells Fargo.

Just had a couple here.

So, how should we think about the market opportunity with Wildfire, particularly now that you have an appliance available?

And then do you see that product cannibalizing the traditional anti virus market longer-term?

Generally, -- if we back up for a minute and say Wildfire is meant to serve the market that's dealing with detection prevention of advanced persistent threats, which is a pretty big deal today, and there's a lot of concern about that.

We think that's great.

That's good opportunity for us, and it's incremental opportunity for us as people are spending on that, which kind of goes to your second question, which is it's a little hard to tell where the budgets are coming from in there.

They could be coming from anti virus, they could be coming from IPS.

Some of them could be new budgets.

I'm not sure anybody really knows that yet, other than that there's a good amount of money being spent on that today.

And we are very well positioned with Wildfire with the cloud service, the private called service and now in appliance as well, to capture our share fair of that.

Got it.

Thank you very much.

Daniel Ives from FBR.

Please proceed.

A lot of questions I'm getting from accounts.

I just wanted to basically know, do you think that in terms of these larger deals, obviously, you guys carved out great firewall product.

But in some of these larger deals, it's tougher as you guys get into some of these end to end deals.

Is that accurate, or it's a mischaracterization?

I think that secure -- network security has been for a long time, and I think it will continue to be well into the future, a fairly discreet line item from a purchase perspective.

I know -- what I'm saying is I know there are other providers out there that our network providers that have a broader suite of services than we do because they have networking services and network security services.

The buyers of these things don't think that way about this, and that is becoming more pronounced with the worst situation with cybersecurity and all these threats that are coming in the networks.

I think it's a very hard sale if you're're a network service provider to say, take my so-so network security product because you're buying my networking gear.

They're just different buyers, and the level of interest around that is off the charts.

You just can't get by with that anymore.

You've got to buy the best stuff.

Okay.

As sort of a follow-up, do feel like competitors such as CheckPoint, that they have maybe, we'll say a year ago, took the eye off the ball from a competition standpoint, but you've seen more fierce competition in some of the big offs, maybe then you saw a year ago, now that they've kind of aggressively focused on this area of the market?

I think -- a couple things.

First, just from a technology differentiation standpoint.

We've been at this for going on seven years.

So, it's not new that we are doing something disruptive and fundamentally different than what everybody else is doing.

I think it's also fairly obvious that none of the competition, including CheckPoint, has done or indicated any desire to be able to compete with us, really, based on the technology.

So, when you are in those situations, the things that you do do competitively, you tend to be very concerned about keeping your existing customer base, you get very aggressive on pricing.

You do things that are really market driven as opposed to technology and value driven for the customer.

I believe at the end of the day, that doesn't work out for companies.

Because like I said a little -- a minute ago, Dan, the level of concern and anxiety over security is really high and getting higher.

And price doesn't get it for you anymore, right?

Bundling doesn't get it for you anymore.

You better just have the best network security solution in the market, and that's what we think we have.

Ladies and gentlemen, we have time for two more questions.

Catharine Trebnick, Northland Securities, please proceed.

You -- talking with several of the carriers, it looks like you're ramping up staff for that area.

I know that was one area you discussed quite a bit at the analyst day.

Could you talk about some of the use cases that you would be looking to win at the carriers?

Thank you.

Hey, Catharine.

Yes.

So, we view the carrier market as really the three opportunities.

One is to sell to the carriers as enterprises, meaning we are protecting their networks.

And in that regard, we are doing very well.

That's a direct sales effort, it's major accounts stuff.

Mark and his team are very focused on doing that.

Some of the investments we're making in that space from the people, personal standpoint are going towards that opportunity.

The second opportunity is to have those carrier use our technology to provide them on a managed services basis.

That is, two angles to that.

One is managed services to enterprise, which we are doing well with a number of the carriers on developing technologies -- developing the rollout plans within the user technologies to service enterprises that way.

And the second space is the SMB market, which we are not penetrated in with the carriers yet.

We believe who will be over time, there is some different products, software things we need to do there, but that's that opportunity.

The third one that we view is, there are large system integrators in a lot of cases.

Some of our largest commercial customers are using some big service providers as their systems integrators and in those cases, we are working with those service providers because the customer has chosen us for network security.

That's allowed us to start relationships with them and to go on a large-scale distribution partnerships that over time we think can pay dividends for us.

Okay, thank you very much.

Jonathan Ruykhaver from Stevens.

So, half the customer base uses Palo Alto as the primary firewall.

And looking at the five-year depreciation cycle on a firewall, what that implies from a growth standpoint, is there any concern that greater participation in that cycle, potentially prolonged sales cycles will -- I'm sorry -- weighs on activity?

Jonathan, so actually, I want to correct the statistics because we gave some new ones out at analyst day, which we said we would do every year.

Right now, 60% of our customers, or more than 60% of our customers for us, our whole base are using us as the primary firewall.

And the other statistic we updated at the analyst day was that in our fiscal year '13 so far, 75% of all of our new sales are going to us being the primary firewall.

So, just want to start with the right numbers.

And I'm not sure I understand the actual question, though.

Could you give me that again?

Well, just that if you look at the network firewall market, it's a single-digit type growth market, and we know that the process around displacing incumbents can be somewhat of a long sales cycle, historically.

So, if you are being baked into more of those potential firewall refresh cycles, does that impact in any way your sales cycles, relative to what you've seen historically as we move into the future?

Okay, I got that.

So generally, sales cycles for network security in particular, the firewall can be decently long because it's a really important piece of technology, and you take your time to make a decision on that.

So, when we think about the addressable market, it's in the multibillion dollar range, just for firewalls, let alone network security.

But that doesn't all happen at once.

So, there's always refresh cycles going on across this global buying base, and every one of those is the opportunity for us to come and compete and win, as we have been in those buying cycles.

Now, once we are in as well, it's very sticky.

We know how hard it is to throw the incumbent out, and you'd better have really, really different disruptive technology if you're trying to do that.

Once we are in the door, we know how hard it is to take us out, and you can get a sense of that as well, from the expansion that you've seen across the customer base.

The last thing I'd mention is, is that our largest customers continue to tell us that penetration levels in their accounts are maybe 10% of what we could possibly earn over time inside those accounts.

So, we are pretty bullish on what the opportunity here is.

Okay, good.

That's helpful.

Thank you.

Last question from Sterling Auty from JPMorgan.

Mark, you mentioned in your prepared remarks the success of the 3000 series.

Just curious where you are seeing the adoption?

If it's helping you expand your market presence or if it's going to branch offices of existing customers?

It's actually -- it's gone left and right, meaning that the 3000 series is right up the middle for us.

So, that is something that you'd probably see more -- and we are seeing more in the perimeter than you'd see in the branch office or in a data center.

As I think you and I talked about at one point, we'd said at the analyst day that we saw an opportunity there to put something in that point in the market, which would help us up sell off of the 2000 series for folks who just had throughput requirements as throughput needs continue to grow at their perimeter.

So, that seems to be working very well.

And when you look at the quarter, any segmentation in terms of where you saw the weakness, whether -- I think Mark talked about some of the bigger deals being segmented, but any sense if the weakness as the erosion as the quarter when on was uniform or a particular end of the market, meaning larger deals versus smaller customers?

Generally on the larger side.

So again, we saw just in Europe and particularly central, southern Europe and in the fed space, things that we saw that added up to $3 million, $4 million in each one of those across maybe like a dozen deals.

So, they tend to be larger in nature.

I think that's not surprising, given this sentiment that was changing over time.

Larger purchases would be of the ones that either get downsized or pushed to the right.

All right.

Thank you.

Ladies and gentlemen, I would now like to turn the conference back over to Mr. Mark McLaughlin for any closing remarks.

Thank you.

I appreciate that, operator.

I want to thank everybody for taking the time to be with us today, and also want to reiterate my appreciation for the hard work of all the Palo Alto team and support of our customers and partners as we continue to revolutionize the enterprise network security market.

We look forward to updating you all on our next quarter.

Thank you.

Ladies and gentlemen, that concludes today's conference.

Thank you for your participation.

You may now disconnect.

Have a great day.