Palo Alto Networks Inc (PANW) 2014 Q1 法說會逐字稿

Good day ladies and gentlemen and welcome to the first quarter 2014 Palo Alto Networks earnings conference call.

My name is Britney and I will be the operator for today's conference.

At this time all participants are in a listen-only mode.

Later we will conduct a question-and-answer session.

(Operator Instructions).

At this time I would now like to turn the presentation over to your host for today, Ms. Kelsey Turcotte.

Please proceed, ma'am.

Good afternoon and thank you for joining us on today's conference call to discuss Palo Alto Networks' fiscal first-quarter 2014 financial results.

This call is being broadcast live over the web and can be accessed on the investors' 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 its 2014 fiscal first quarter ended October 31, 2013.

If you would 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 they will email 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; increases in market share and overall momentum in Palo Alto Networks' business; trends in its business and operating results, including customer growth, its services revenue, gross margin, services margins and DSOs; expectations regarding investment research and development and the introduction of new products; and Palo Alto Networks' revenue and non-GAAP estimated earnings per share for the second fiscal quarter of 2014 ending January 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 Annual Report on Form 10-K filed with the SEC on September 25, 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 provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the investors' section of our website located at investors.

PaloAltoNetworksAltoNetworks.com.

Before I turn the call over to the team, I'd like to inform you that Palo Alto Networks will be participating in the CSFB Annual Technology Conference on Wednesday, December 4, in Scottsdale, Arizona.

And with that, I'd like to introduce Mark, Chairman, President and Chief Executive Officer of Palo Alto Networks.

Mark?

Thank you, Kelsey and welcome to the team.

And thanks everyone for joining us today.

Q1 was a strong start to our fiscal 2014.

Our results continue to prove that our next generation enterprise security platform is quickly becoming the mainstream market choice for enterprises around the world.

And it uniquely positions us as a leader in the fast-growing cyber security market segment.

The combination of these market drivers, our Land and Expand strategy, and the power of our fast-growing subscription services model drove record revenue and strong bottom line results the first quarter.

Revenue in Q1 grew by 49% year-over-year to over $128 million and we delivered high gross margins, significant operating leverage, and non-GAAP EPS of $0.08 per share.

We are very pleased with what we've accomplished this quarter, and believe that the reasons for such high growth positions us well for continued growth.

Today global enterprises are facing an extremely difficult environment in which protecting their networks against the ever-increasing threats is paramount.

The risks are very high and include lost revenue, loss of customer data, loss of intellectual property, and loss of customer trust.

At the same time, it's more and more evident that the legacy security technologies at that enterprises have relied on for a long time are incapable of addressing their security needs.

This has led to a major market disruption in favor of Palo Alto Networks.

Our platform is at the forefront of next generation enterprise security and is now being rapidly adopted by the Global 2000 as their mainstream solution at the expense of the legacy vendors.

In addition, were uniquely positioned as a firewall, the main protection point for network security, with the next generation platform which provides a highly integrated and automated level of visibility and intelligence around detection and prevention.

This allows us to benefit from the drive for advanced cyber security solutions.

The mainstream adoption of our platform as the firewall of choice, as well as our unique ability to provide the most integrated and automated cyber threat detection and prevention capabilities in the market, is fueling our growth.

And we can see this playing out in the numbers.

Our adoption as the primary network security platform by global enterprises continues to grow.

In the first quarter, we saw continued penetration of the largest companies in the world with over 65% of the Fortune 100 and 35% of Global 2000's customers.

And we saw larger initial orders and deployments from our bigger customers.

Also in the quarter, our wins against legacy competitors included one of the largest oil and gas companies in the world, where we were replacing CheckPoint and Cisco; a major Canadian bank; a large healthcare organization that we'll be deploying our full solution, including WildFire and other subscriptions; one of Russia's largest oil transporters; and a leading international credit card company, where we are deploying the largest virtual firewall in Europe.

In addition we demonstrated last quarter how we are well-positioned to rapidly expand our customer base.

For example, we expanded within a Fortune 50 manufacturer based in the United States with a seven-figure deal to be their primary firewall.

And we also expanded within a US federal agency where our platform is displacing large amounts of legacy technology.

These results show that we continue to rapidly move into the mainstream with the largest companies in the world.

This trend is further evidenced by the climb at our lifetime customer value.

For example, in Q1, a top 25 customer had to spend a minimum of $4.1 million with us in lifetime value to make the top 25 list.

And our lifetime value measured by the increase from their initial purchase rose to 19.6 times.

This compares to $3.6 million and 15.4 times in the immediately preceding quarter, and $2.1 million and 9.5 times at the beginning of fiscal 2013.

If I expand this list to our top 100 customers, they have all spent a minimum of $1.5 million on our solutions, which is double from what it was a year ago.

We believe our continued increase in wallet share will enable high growth over the long-term.

Our position as the firewall and our innovative approach to increasingly sophisticated attacks also sets us up well for high growth in the market for cyber security solutions.

This has been a big factor in our platform adoption that I mentioned earlier.

And we can also see it in the rapid growth in WildFire, the market's most highly automated and integrated detection and prevention solution.

In Q1, WildFire customer adoption grew to approximately 2400 customers, up from about 2000 in the prior quarter, with approximately 1000 paying customers using the platform, up from around 600 customers in Q4.

The WildFire attach rate was over 20% in the quarter and WildFire continues to act as a driver and differentiator for our core network security platform.

WildFire is an example of our high growth hybrid revenue model, where we leverage our unique hardware platform to sell SaaS subscription services to meet our customers' evolving enterprise security requirements.

The hybrid SaaS business model means that we are able to benefit over time with recurring revenues as we build our installed base.

In a constantly evolving and complex threat landscape, we continue to deliver solutions that solve our customers' toughest security problems.

This is an approach that makes sense, as our core platform sits in the single most important spot for network security is the firewall.

And of course we continue to invest in innovation and aggressively grow our go to market capabilities.

On the innovation front, in early calendar 2014 we expect introduce our high-end 120 gig chassis for the data center and service provider market, deliver significant enhancements to our WildFire service, release our next major OS revision, and bring our joint virtualization solution to market with VMware.

Expect more innovation throughout the year as the technology gap between Palo Alto Networks and our competitors continues to widen, as it has every year since we began providing solutions to our customers.

In terms of our go to market focus, the growth of our sales force, continued growth in investment and channel partners, penetration in emerging markets, and building out our alliance ecosystem are accelerating delivery of our solutions to the market and growth in the business.

We'll continue to pursue all of these focus areas to grow into our large addressable market.

Before concluding, I want to mention that we completed the summary judgment and claims construction hearings and our litigation with Juniper on November 15.

We remain confident in our position in that case.

To wrap up, our first-quarter results continue to demonstrate that we are on the right track.

We have reached over $0.5 billion in annualized run rate revenues, and continue to grow at almost 50% as we rapidly gain share in a very large addressable market.

We'll stay focused and do what we do best: delivering highly differentiated enterprise security solutions that solve our customers' most difficult challenges.

I'd now like to turn the call over to Steffan for a detailed look at our financial results.

Steffan?

Thank you, Mark.

I'm pleased to report that first-quarter results for fiscal 2014 exceeded our guidance.

We continue to demonstrate rapid revenue in billings growth, solid bottom line performance and healthy free cash flow generation.

Before I get into the details, I would like to note that except for revenue figures that are GAAP, all financial figures are non-GAAP unless stated otherwise, and exclude IP litigation expenses for both the first quarter and historical comparisons.

New wins from customers in the quarter, our expansion within our existing customer base, and our hybrid SaaS revenue model were the catalysts for revenue, billings and deferred revenue growth.

In Q1, total revenue was a record $128.2 million, growing 49% over the prior year and 14% sequentially.

The geographic mix of revenue was 67% Americas, 19% EMEA and 14% APAC.

All theaters posted solid growth year-over-year led by the Americas, which grew 58%.

From a vertical and custom standpoint, we saw broad strength across a wide range of verticals, including federal, and we had no end customer concentration.

All three components of our hybrid SaaS model grew well in the quarter.

Product revenue of $75.5 million increased 36% over the prior year and 15% sequentially.

Growth was driven in part by demand for our midrange 3000 and high-end 5000 PA Series of appliances.

Our recurring services revenue of $52.7 million increased 73% over the prior year and 12% sequentially, and accounted for a 41% share of total revenue.

Looking at its two components, support and maintenance revenue of $27.9 million increased 75% over the prior year and 10% sequentially.

Our SaaS-based subscription revenue of $24.8 million increased 71% over the prior year and approximately 15% sequentially.

As a result of our Land and Expand strategy, and the recurring nature of our support and subscription businesses, we expect the services revenue will continue to grow at a faster pace than product revenue as we continue to monetize our incumbent position in the network.

Every time we sell a new subscription or renew an existing subscription, it's equivalent to selling a product, except that we've chosen the SaaS model to deliver and monetize it.

Increases in services revenue as a percentage of total revenue will improve our gross margins as well as increase visibility into future revenue streams.

The strength of our business model was evident in the growth rate in billings, deferred revenue and free cash flow.

Compared to the prior year, billings in Q1 grew 43% to $157.9 million.

Total deferred revenue increased 74% to $279 million and short-term deferred revenue increased 69% to $171.6 million.

Turning to gross margin, total gross margin of 75% increased 50 basis points sequentially.

Product gross margin was 76.6%, increasing 140 basis points sequentially due in part to favorable product mix and continued focus on material and manufacturing cost reductions.

As a reminder, there will be fluctuations in our product gross margin, primarily due to product mix and the timing of new appliance shipments.

Services gross margin of 72.8% declined 70 basis points sequentially, due in part to investments in our customer support organization as we continue to add systems and personnel to accommodate the rapid growth of our customer base.

Moving on to operating expenses, as Mark discussed, we believe there is considerable opportunity for us to drive growth and capture market share.

And we continue to invest in both product development, and our sales and go to market organization.

Research and development expense was 12.9% of revenue, increasing approximately $2.1 million sequentially to $16.5 million.

Headcount additions and project-related expenses supporting our development activities contributed to the increase.

Sales and marketing expense was 47% of revenue, essentially flat with the prior quarter as a percentage of sales and increasing approximately $7.3 million sequentially to $60.3 million.

New headcount additions at the beginning of the fiscal year, partner conferences, and our worldwide sales event that we held to kick off the new fiscal year contributed to the increase.

General and administrative expense was 7.6% of revenue, increasing approximately $2.5 million sequentially to $9.8 million.

The sequential increase is attributed to higher personnel and infrastructure-related costs as we continue to support the growth of the business.

On a GAAP basis, IP litigation expense in our G&A line was $1.9 million in Q1 2014, $0.6 million in Q1 2013, and $1.4 million in Q4 2013.

We have provided a supplemental schedule on our IR website that shows the historical impacts of the IP litigation costs.

In total, operating expenses were $86.6 million or 67.5% of revenue.

Operating margin increased 70 basis points year-over-year to 7.5% and declined 50 basis points sequentially.

Our effective tax rate for Q1 was 38%.

Net income for the quarter was approximately $6.2 million or $0.08 per diluted share, using 77.2 million shares, compared with net income of $3.3 million or $0.05 per diluted share in Q1 2013.

On a GAAP basis for the first quarter, net loss was $7.9 million or $0.11 per basic and diluted share, compared to a Q1 2013 GAAP net loss of $3.5 million or $0.05 per basic and diluted share.

Turning to the balance sheet, we finished October with cash, cash equivalents and investments of $470.4 million.

Cash flow from operations, free cash flow and free cash flow margin were $38.9 million, $23.2 million and 18.1% respectively.

Capital expenditures in the quarter totaled $15.7 million and were related to facilities purchases and acquiring intellectual property.

The accounts receivable balance was $91.4 million, up from the prior quarter balance of $87.5 million.

Linearity in the quarter improved, which helped improve average days sales outstanding to 63 days, down from 72 days last quarter.

This is below our DSO target range of 65 to 75 days.

Let me now move to our guidance.

As a reminder guidance excludes IP litigation expenses.

In Q2 2014, we expect revenue to be in the range of $132 million to $136 million, which represents 37% to 41% growth year-over-year.

And we expect non-GAAP EPS to be approximately $0.08 to $0.09 per share using 77 million to 79 million shares.

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

(Operator Instructions) Greg Dunham, Goldman Sachs.

Yes, thanks for taking my question.

I guess Q4 was a good quarter for you guys.

You improved your execution.

But this quarter actually jumps out as better than that, with accelerating product revenue growth.

Can you decipher between how much of that is just increased tenure of the reps that you hired last year versus just a generally improving macro?

Any way to distinguish that?

Hey Greg, it's Mark.

The answer is, more likely than not, all of the above which is -- I think the security market continues to be very robust.

You can see that not just from ourselves but other folks who have reported.

The needs out there are very strong.

Customers are buying to solve those needs and then, on top of that, we have a unique platform.

So we are benefiting disproportionately from that.

As you know we put a hell of a lot of focus into the major global accounts and the sales organization over the last year.

And I think that is paying off very well as you can see from the numbers, too.

So we think a lot of these things are moving in our direction.

Some are macro and some are about the solutions.

Some are about the things we're doing on an execution basis at the Company.

And then one quick follow-up, if you may; where are we in terms of customers migrating to 5.0 on an OS basis?

Yes, a bit over 60%.

Okay perfect, thanks guys.

Keith West, Morgan Stanley.

Thank you for taking the question and very nice quarter.

I was wondering if we could talk a little bit about -- going into any Q1 there's some level of sales changes that take place.

Maybe you could mark to market for us the level of changes that were enacted this year compared to prior years, and how comfortable you feel with everybody kind of marching to orders for the rest of the year from where we are standing today?

Sure, Keith.

Well, as you know, over the last year we made a number of changes at sales organization, about 18 months ago with Mark Anderson joining us, under an assumption that he would do a certain amount number of things, which he has done very well from a team perspective starting with leadership.

And also getting the reps who know how to service and close large accounts.

That's really worked itself out through the better course to the last year and all those changes have been made.

And we think people are really humming now.

We mentioned it last call that this would be the first year, by the end of the year, we'll have more ramp than ramping sales people in the organization, which we think is a good thing for us as we continue to march down the field.

Excellent, excellent.

And then maybe on the -- from a potential overhang perspective, if you could give your comments on two aspects.

One, just in terms of the litigation, we are sort of into the thick of it past the Markman hearing.

Anymore flood in the market in terms of kind of sales cycles, any impacts on the actual fundamentals from that litigation?

It doesn't appear to be the case.

We said before that we haven't seen any impact in the market that we can discern from a selling perspective.

You know, we continue to grow at extremely healthy rates and we continue to beat all the competition handily whenever we face them.

So I don't see it really playing out in the market.

Excellent.

And just one last one in terms of the competitive environment.

Cisco obviously made a pretty big acquisition of Sourcefire.

What is the initial indication on sort of how that is impacting you guys in terms of the competitive environment?

Are people taking Cisco more seriously or is it just disruption in the near term?

I think to the extent that there's been any impact at all it's been positive for us.

And that's primarily because we handily beat Cisco when we face them.

We have beat Sourcefire in head-to-head competitions as well.

And taking an IPS technology and bolting it on a [state full] inspection firewall is not a fundamental disruptive technology change.

So I don't think it changes anything from a technical solution perspective.

We've also seen confusion the market from Sourcefire customers about what that means, what's going to happen to them over time.

We've been able to develop hundreds and hundreds of leads from dissatisfied or confused Sourcefire customers.

So, at least from our perspective, it's been a positive.

Excellent, and again, a very nice quarter guys.

Rob Owens, Pacific Crest Securities.

Great, thanks for taking my question.

Mark, you mentioned how the spending in security markets were robust.

I think if you go back a couple of quarters, you know, it was a little more choppy.

So maybe just talk about general demand, how the space is firming.

Are we in front of that perceived firewall replacement cycle that I think a lot of folks have been talking about for the last year?

Yes, Rob, it's little bit hard to come by hard data around the refresh cycles as far as anybody who would know for sure.

But I've heard a number of anecdotal points that a big refresh cycle is upon us in the next 12 to 15 months.

We think we can see that from what we're seeing from a pipeline perspective, close rates.

I mean, it all points that direction that there is a big refresh cycle in front of us.

On the big picture about security, I know that there was a one quarter bump in the road before, not just security but all networking.

There were various reasons for that.

But it appears as though, at least from a security perspective, that that has rebounded very nicely and that security is a top of mind issue and is likely to remain that way for some time.

Great.

And as we look at some of your incremental services and those SaaS capabilities in WildFire or the URL filtering or threat prevention.

Any sense of where renewal rates are running on those services?

Yes, we had said earlier that the renewal rates were better than 85%, and more likely [than not], higher than that.

One of the reasons we were less exact on the higher number was that when a customer upgrades from an equipment perspective for us, it looks like a new sale, not a renewal.

So we're highly confident it's higher than that, but that's what we reported last time.

Jonathan Ho.

Good afternoon and great results.

Just wanted to start out with the EMEA and APAC regions.

What type of opportunity do you see to sort of accelerate growth there?

Are there any sort of things that restrict the growth from maybe being a little bit faster than what you're seeing, especially relative to your North American results?

Yes, so, if we look at the results in EMEA and APAC on the EMEA side, we saw good year-to-year -- year-over-year growth and a slight sequential decline of about 2%.

We like EMEA as a market.

We think that's a big growth opportunity for us.

There continues to be some concern in southern Europe.

I think that's going to last for a while from a macro standpoint.

But we are investing there and we think that's a good growth market for us.

Also, just as a general matter, coming from Q4 to Q1 it's not surprising to see sequential decline there.

In APAC we had a 2% sequential decline as well, but we had very strong year-over-year growth in APAC and we are coming off of an extremely high comp, last sequential growth quarter over quarter in APAC.

So, across the board, generally pleased with all the performance in the regions.

Got it.

And just in terms of the latest products that you're seeing released, what type of opportunity do you think that's going to drive in terms of accelerating growth, particularly relative to the high end of the market and the midrange?

And what could that mean in terms of your growth expectations?

Yes, so the ones we have talked about from a roadmap perspective coming up in relatively short order for a whole new category of a new version of WildFire coming out, which is going to help us to continue to even faster accelerate the need for cyber security solutions.

We've talked about our 120 gig chassis which is coming out, which will help us expand even faster than we are today in the data center environment and open up a new part of the addressable market for us, which is the service provider market.

And we've also talked about our -- a joint technology offering coming to market shortly with VMware, which is going to allow us to even penetrate faster in the virtualization space.

So those are a couple-three we've discussed a lot.

There is more obviously.

We are not going to get into laying out the entire roadmap.

But we think those allow us to get bigger opportunities in different deployment models like virtualization, and also get more than our fair share of the real fast-growing cyber security subsegment of the enterprise security market.

Great, thank you.

Phil Winslow, Credit Suisse.

Congrats on a great quarter.

Just wanted to focus in on your comments about attach rates and renewal rates of your subscription offerings, and particularly WildFire.

Just what are you hearing from customers as far as just the sort of the ability to adopt more subscriptions from you all?

In particular WildFire, what are you hearing from customers about why they're choosing WildFire versus some of the other offerings that are on the market?

Sure.

So from an attach rate in subscription services, they continue to go up for us, which is great, and as we've expected they would.

And as a reminder, the reason for that is these subscription services are generally taking the place of what a customer used to have to buy from us from a standalone product.

So this is best-of-breed functionality in a highly integrated, highly automated fashion at a much lower cost than what they would have to get by buying a standalone product.

On the WildFire side that's a very fast grower for us.

And the reason for that is it's solving a real important problem for customers right now, in this whole advanced persistent threat space.

And the reason they're going with WildFire is primarily three things.

The first is that, because we are the firewall in most customers' cases already, not only can we do advanced detection capabilities but we can also do prevention, because ultimately you have to beat the firewall in order to do that.

The second thing is from a deployment standpoint we are doing this primarily in the cloud.

So it's got infinite compute capacities and is wicked fast as a result of that.

As an aside, we also have a private cloud solution with our WF 500 Series.

And the third reason is you get the network impact.

Because we do it in the cloud and we have thousands of customers in all verticals in every geography, we're able to share on a highly leveraged basis what we're seeing across the customer base.

So you don't have to be attacked yourself in order to see something from an attack perspective.

You're getting the benefit of what we're seeing across the entire customer base that is using WildFire today.

So those are really driving the data adoption.

Great, thanks guys.

Catherine Trebnick, Northland Securities.

Catherine, are you there?

Sorry.

Congratulations, quick question is on WildFire.

You have two solutions, the cloud-based solution and then the appliance.

Is there any pushback from your clients at all regarding security in the cloud and not wanting security in the cloud?

And could you pretty much give us some more color around that if that's the case or not the case?

Thanks.

Hey, Catherine, so primarily what we've been providing the customers, which they like, is cloud-based.

And the reason for that is it's easy; it's very fast.

You get the leverage of the network and the sharing that goes on with that.

However, there's a subset of customers that can't or won't for various reasons send files to the cloud.

And because of that subset of the customer base, we developed the WF 500, which in essence allows you to create a private cloud solution.

So if you have those concerns, you can still have all the power of this technology without worrying about the public cloud aspect of it.

Are you also -- in some of your customers you also share FireEye is also a customer.

Can you talk a little bit about how the differences between your solution and perhaps their pure play?

Yes, what I was just mentioning a little while ago which was, first of all, you got to start with the ability to do highly integrated and automated detection and prevention.

And as the firewall we can do both of those, not just the detection capabilities.

We have the cloud aspect, which allows for very fast ability to process files and get answers back.

And then we're highly leveraged because we use the network, so that all the customers can get the benefit of what other customers are seeing.

So, generally, those are the high-level architectural differences that allow us to put these kind of growth rates up.

All right, thank you very much.

Brent Thill, UBS.

Good afternoon.

Steffan, your comment on linearity improvement, I'm just curious if you could give us a little more color.

Typically Q1, you wouldn't think you would see that.

What do you think caused that linearity improvement in Q1?

There are a couple of factors, Brent.

When you think about the sales mechanisms we have put in place around large account selling, we saw some nice traction from some of our larger customers in the first half of the quarter.

So that was one thing.

And then we have the other part of our sales engine which is keep the lights on business.

And we have a very robust, high-touch, and direct fulfillment model with our channel partners helping.

So we had a very nice quarter from a linearity standpoint.

It helped drive DSOs down nicely quarter over quarter.

So we felt really good about the quarter.

Okay.

And can you just comment on the impact of the federal market?

Yes, so we were pleased with the fed business in the first quarter.

We saw the end of the year fed spend -- I mean their end of the year as we expected we would, despite all the sequestration anxiety.

And I just think it's primarily the continued validation of our solution for a very discerning customer base.

We like that vertical a lot.

And given what their needs are and what we do for a living, we think that will continue very nicely for us.

Okay.

So that, in your perspective, exceeded your expectation or met or was below?

How would you characterize that business?

In the first quarter our expectations were met as we expected them to be with the end of the year flush.

Great, thanks.

Michael Turits, Raymond James.

Hey guys, Michael Turits, thanks.

One question on APAC, which is it strong year-over-year.

Any impact from the NSA's last political issues in China?

And how much China exposure do you have?

So could this be an issue going forward?

Hey Michael, not that we can tell.

So I understood from Cisco's reports that they had some anxiety around that.

The big picture for us, our emerging market opportunities grew very, very well in the quarter on a sequential and year-over-year basis.

So we haven't seen any of that kind of impact.

But we have a smaller base of business than those guys do, but it performed very well for us.

Okay, and then kind of a high-level question about the security market.

Obviously you did well overall and you did well with WildFire.

Some people have questioned what the impact is of APTs on budgets -- on security budgets.

In other words, is there any -- and taking oxygen out of the room relative to next-gen firewall with APT?

Or do you view this, especially since it's not a pre-budgeted line item, or was there something which is therefore expanding what you think the IT security budgets are like in the next 12 months?

I think it's a good thing for us.

The way we think about this is we have a platform, right, and that years ago was considered just primarily a next gen firewall.

But it's really a platform that has multiple solutions that are highly integrated from the firewall IPS and filtering and others.

And when additional security needs need to be met, we have a unique ability to add certain services into that platform.

So that platform, I think, is really in a mainstream adoption phase of getting taken in by Global 2000 and Fortune 100 companies across the globe.

And that's just starting, of displacing all that legacy firewall plus the disparate other pieces of technologies.

In addition to that, we've got something that has popped up in a relatively recent term on EPT or cyber security threats.

And that, for us, is a feature set of our platform.

So we get to wrap that in there as well.

And then the next thing that's coming after that, whatever that may be, we have the ability with our platform architecture to bring that to bear as well.

So we've got the mainstream adoption of our core platform plus another accelerator called APT, which is a feature of us on that platform.

So we think it's an additive opportunity.

Great, thanks a lot.

Jayson Noland, Robert W. Baird.

Great, thank you.

First, for Steffan, we didn't really see seasonality in FQ1.

Should we think about the rest of the year as FQ3 soft relative to a more positive FQ2 and FQ4?

That's a good question.

We've highlighted this in the past where our growth rates have been so robust it's hard to call the ball on seasonality.

So what we originally thought was in our fiscal Q2 and Q4 may be strongest in terms of year-over-year and sequential growth rates.

Q1 obviously we saw no seasonality, which was a good thing.

So what does that portend for the rest of the fiscal year?

I would still say that we would think that Q2 and Q4 would be very good quarters for us.

We think Q3 would be, too.

But if there's any historical pattern that's shaping up, last fiscal Q3 more from a macro standpoint had hurt us.

In that quarter, we were still able to grow 50% year-over-year.

So it's still too soon to call the ball on seasonality, but we feel good about the prospects of growth for the rest of the fiscal year.

Okay.

Thanks for that color.

And then just a follow-up for me on US Fed gov.

Was the growth there a specific deal or broad-based?

And, Mark, can you continue to grow in this vertical given the challenges that likely remain?

Yes, Jayson; no, it's broad-based.

The fed is a unique vertical in that it takes a long time to get yourself established there, but when you do it really starts to pay off for you.

So I think this is a specific example of the focus we put into the major account program we have been running for a while.

This is a very discerning customer, but once they start to adopt your technology they can start -- they do that in a broad base.

We are seeing that happen.

So it's across the board.

It's good growth in the vertical and we think that can continue in time.

Of course, we're always keeping our eye on the ball like everybody else about sequestration and all the budget swirl that's going on in Washington, D.C. That's not a helpful thing for anybody, ourselves included.

And obviously as we go into Q2, you don't have the end of the year fed flush that you have in our Q1, but that's all baked into our guidance.

Okay, thanks, Mark.

Gray Powell, Wells Fargo.

Hi, thanks for taking the question.

So I think you touched on this earlier, but I guess I'll ask again.

So, network security spending has been somewhat constrained in the last couple of years.

How do you feel about the potential for improved refresh cycle for the industry as a whole?

And then do you think that provides you a better opportunity to displace incumbents and take share?

A couple of thoughts on it.

The first is that the addressable market opportunity we're playing in is [$13 billion going to $16 billion, $17 billion] in the next three or four years.

Lots of studies out there suggest that grows anywhere on a 5% to 7% CAGR, so just from a greenfield opportunity, or new opportunity, 5% to 7% not a huge growth rate.

But it's on a really big number, right, so that's hundreds of millions of dollars that gets created every year.

And we think we do very well there.

More importantly than that, though, is the installed base you just mentioned and the refresh opportunities that come with that, that are measured in billions of dollars of addressable market opportunity.

And we can see just in the displacement of the competitors across the board.

It doesn't matter who it is.

We displace them at very high rates, that we continue to win these refresh opportunities.

You've heard from -- like I said earlier it's hard to be mathematically exact in this, but a number of sources of the refresh that comes up every three or four years, really big ones.

We think we're at the beginning of one of those.

Got it okay, that's helpful.

And just one more if I may.

Can you help us think about the opportunity with WildFire longer-term?

Do you see that subscription being meaningful as some of the other early ones like IPS?

And then just sort of life to date, how would you benchmark it versus some of the other subscriptions?

Yes, so, the one that it's probably closest akin to, just from the way it might be thought of in the market, is threat prevention.

So I'd expect over time that we could achieve rates in that ZIP code, which is pretty high.

And then from just a growth perspective, it's been growing at the rates that we saw some of the earlier subscriptions services grow at over time.

It takes time to get them going.

The customers have to adopt 5.0.

That's why -- I think it was Greg who asked before what the percentage of the customer base was on 5.0.

Right now that's a bit over 60% and growing every quarter, so that's good just for our installed base.

So there's a number of moving parts around that, that would lead that to grow over time.

But we have very high hopes for that.

Understood.

Okay, thank you very much.

Scott Zeller, Needham & Company.

Hi, I wanted to ask, just as a trend anecdotally over the last few quarters, how have the deals in the pipeline shaped up as far as breadth of service, point solution versus broad deployment of firewall?

Can you give us some anecdotal color, please?

Yes, a couple of angles on that, Scott.

First is recently we had said that over 75% of the deals that are coming through the pipeline for us that we are winning, we're the primary firewall on those deals and bit over 60%.

This is a number we gave a couple of quarters ago.

A bit over 60% of the installed bases we're the primary firewall.

So those continue to rise.

As I said, we take that is one angle on the question.

And then the second thing is our attach rates continue to rise as well, meaning every time we get a product in there, we continue over time to attach more and more services to it.

So the combination of those two things bodes well for us.

One follow-on point to that; it really goes to the versatility of our platform.

We can sell into any enterprise network security need that exists.

It could be for firewall, it could be for IDS, IPS, filtering, you go down the list.

And the platform approach that we have really gives us a unique position against all the other vendors that are out there.

Just a follow-up; is that 75% -- we have heard that previously.

Has that been a consistent number?

Yes, we said we were going to update on a semiannual basis.

That was the last time we gave that number, that's what it was.

Okay, thank you.

That's up from the last time we talked about it, yes.

Hendi Susanto, Gabelli & Co.

Thank you for taking my questions.

I have one question for Steffan.

Management is targeting exiting the fourth quarter with operating margin in the low double digits.

Considering the [term investment] how should we expect the timing of margin expansion and operating leverage in the current fiscal year?

Well, we think that exiting Q4 we'll be in the low double-digit operating margin on an exit rate basis.

And given the size of the market that we're going after, if you look at our revenue growth, our customer additions, you look at the power of our hybrid SaaS model, we've always said that we want to have more of a slow and steady approach to operating margin expansion throughout the fiscal year and in towards our -- over long-term target model.

So we feel like there's going to be room for incremental investment, but we are doing it in a disciplined way where we are generating positive operating margin right now.

You look at positive cash flow and free cash flow generation.

So, the model is working.

And when you combine all that together, exiting Q4, we feel pretty comfortable that will be in the low double digit operating margin.

Okay, ladies and gentlemen, we only have time for two more questions.

Shebly Seyrafi, FBN Securities.

Thank you very much, very nice quarter.

So your product gross margin has increased for about three quarters in a row, and is at 76.6% non-GAAP.

And your total gross margin is at 75%, above your previous long-term target of 70% to 73%.

So I'm just wondering, with this 120 gig product coming out next year, should we think about the product gross margin staying at this level or potentially even increasing?

Or do you think it's above where you think it should be longer-term?

There are a couple of parts to that question.

The first is, remember, any time we introduce a new product, we typically see a little bit of pressure on the product gross margin line because we haven't achieved full scale and volume in that product line.

So depending on the early level of traction, there is usually a little bit of a negative fluctuation for new platforms that we introduce.

To your broader point, we have target gross margin range of 70% to 73% total.

We've been operating above that, which is great, because of how where operating our business in terms of a disciplined approach.

Once we get to our target model of 22% to 25% non-GAAP operating margin, we are going to look at all the elements of that target model including the gross margin, and we'll revisit at that point.

But in the interim we think there is going to be some fluctuation.

We are still making investments in our services organization as an example, so you're going to see fluctuations there.

But directionally over time, we feel good about the targets and we'll revisit once we get to the target operating margin.

Okay, and your IP litigation expense picked up again to $1.9 million as you're past the Markman hearings, etc.

Where do you see that going over the next few quarters?

Unfortunately, we see it going up.

As we get closer to the trial we will definitely see increases in IP litigation expenses.

We are not calling the ball specifically on the specific dollar amount, but in order to provide full transparency, we'll break it out every quarter both on the call and in the supplemental documents that we post on our IR website.

Okay, thanks.

Tal Liani, BofA Merrill Lynch.

Hi, thanks for taking my question.

This is [Eric Grenatti] for Tal.

Just on the refresh cycle opportunity that you have ahead of you in the next 12 to 15 months, is the service provider included in that?

And if so, can you just give us a sense of what you're seeing there from a customer interest in your upcoming platform, and how soon you can convert that into I guess meaningful revenue from the time you introduce the product?

Thank you.

Yes, so, on the refresh that's specifically just call it the standard enterprise, meaning this is a firewall that's used in the standard enterprise environment.

That's where the majority of the money sits today and that's what I meant from a refresh cycle perspective.

In the service provider market, as we mentioned before, other than working with the service providers and systems integrators and also as a distribution channel, we've had decent penetration with them from a technology perspective in selling our technology to them.

Meaning they are in enterprise using our technology to protect their own environment, and also an increasing opportunity where they're using our technology to provide a service to their customers, specifically enterprise customers.

So we think the 120 gig chassis that we are coming out with this really going to go to that last one I mentioned, which is the ability to use our technology to provide services to their customers as a service.

And that is a new portion of the TAM for us as far as serviceability and we expect good things from that for the future.

And then just on your EMEA business for, basically if the math is correct, it's been kind of within a tight range the last three quarters; certainly up this quarter, albeit off of easier comps.

Give a sense on what you think is needed there, aside from a good macro of course, to drive the growth rate a little faster in that region?

Thank you.

What's needed is a good macro environment.

Unfortunately that's the answer.

We are doing very well on a relative basis competitively in the market.

But in the absence of I'll call it a more normalized selling situation, the macro environment, it is tough sledding for everybody.

Erik Suppiger, JMP Securities.

Good afternoon, congratulations.

Thanks, Erik.

First off, the 20% attach rate you said for WildFire, I think you said that it was consistent with that last quarter.

Where do you think that attach rate could go?

And can you also comment as to how much of that is going into your existing customers versus how much is going into new deployments?

Hey, Erik.

Yes, a couple things; it's over 20% in the first quarter is what I just mentioned.

And as I mentioned a little while back on a different question, we think the attach rates can attach the ones that we have today for, like, threat prevention, particularly in filtering.

So, much higher than they are today, so we have a lot of hope for that as a driver for us and a tailwind for us in the future.

And new customers versus existing?

On that, we don't break that out specifically but we are doing well in both places.

So we've got about 2400 total customers on WildFire today.

That's up from over 2000 last quarter.

So we are growing the total customer as well, and the paid customers are close to 1000 -- close to 1000, which is up nicely from last quarter as well.

So the more that we continue to grow the free customer base, the more opportunity we have to penetrate that base and we are doing that.

The other thing is just given all the concern about the advanced persistent threats, cyber security today, we find that WildFire is also a great appointment getter for us, just from a prospect perspective on getting into accounts in the first place, and then being able to sell them the full solution, not just that feature set about APT.

Okay and then last one, on the WildFire 500, do think that can become a meaningful revenue stream?

Or do you think that still going to stay a minority kind of customer base that's just looking to not use the cloud?

It was designed and has continued to be designed to solve the needs of customers who don't want to send or can't send files up to the public cloud.

So I think it is a minority segment of the customer base.

So our main driver for WildFire is not going to be WildFire 500.

But of course you want to make sure we have total market coverage for anybody who wants a private cloud solution as well.

Very good; thank you.

At this time we have run out of time for Q&A.

I will now hand the call back over to Mark McLaughlin for any closing remarks.

Great, thanks again for being on the call today.

I want to reiterate my appreciation for the hard work of the Palo Alto networks team in support of all of our customers and partners as we continue to define the next generation of enterprise security.

And we look forward to updating you next quarter.

Thanks everybody.

Ladies and gentlemen that concludes the presentation for today's conference.

You may now all disconnect and have a wonderful day.