Palo Alto Networks Inc (PANW) 2015 Q1 法說會逐字稿

Good day and welcome to the Palo Alto Networks first-quarter FY15 earnings conference call.

Today's conference is being recorded.

(Operator Instructions)

At this time, I would like to turn the conference over to Kelsey Turcotte.

Please go ahead, ma'am.

Great.

Thank you.

Good afternoon and thank you for joining us on today's conference call to discuss Palo Alto Networks' fiscal first quarter FY15 financial results.

This call is being broadcast live over the web and can be accessed on the Investors section of our website, at Investors.

PaloAltoNetworks.com.

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

This afternoon, we issued a press release announcing our results for the first fiscal quarter ended October 31, 2014.

If you would like a copy of the release, you can access it online on our website.

We would like to remind you that during the course of this conference call, management will make forward-looking statements, including statements regarding our revenue and earnings per share guidance for our fiscal second quarter, continued strength in our business, our expectations regarding our gross margins, seasonality, revenue growth, future investment in Traps, CapEx and non-GAAP operating margin for Q4 of FY15 and Q4 of FY16, our ability to accelerate growth in our market share, demand for and adoption of our products and services, expected availability and efficacy of new products, and our competitive position.

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 a more detailed description of these risks and uncertainties, please refer to our annual report on Form 10-K filed with the SEC on September 18, 2014 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 provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the supplemental financial information that can be found in the Investors section of our website, located at Investors.

PaloAltoNetworks.com.

Before I turn the call over to Mark, we'd like to inform you that we will be presenting at the Credit Suisse 18th annual Technology Conference on Wednesday, December 3 in Phoenix, the Raymond James 2014 Systems Semiconductor Software and Supply Chain conference on Tuesday, December 9 in New York City, and the Barclays Global Technology Conference on Wednesday, December 10 in San Francisco.

And with that, I'll turn the call over to Mark.

Thank you, Kelsey, and thanks, everyone, for joining us this afternoon.

I'm pleased to report that we had a very strong start to our FY15, and I'd like to thank our customers, partners and the Palo Alto Networks team for their contributions and support.

As the leading provider of end-to-end enterprise class protection and prevention, we are delivering growth rates well above the market and the competition by consistently demonstrating the differentiation and sustainability of our platform, the scalability of our model and our team, and our ongoing growth potential.

This was evident in our Q1 results, which is exceeded our own expectations; and I'm especially pleased that we were able to demonstrate strong sequential growth off of our record fourth quarter.

In Q1, billings and revenue reached records again, with billings growing 52% year-over-year, to $240 million, and revenue growing 50% year-over-year, to $192 million.

In the quarter, we also expanded our non-GAAP operating margin to 10.6% and delivered Q1 non-GAAP EPS of $0.15 per share.

Our growth is primarily being driven by three things.

First, at the most basic level, security continues to be a critical business imperative that must be addressed by every business in the world and this is driving increased security spend.

Second, in the security battle, prevention is the ultimate objective and Palo Alto Networks' integrated and automated Next Generation security platform is unique and delivers unparalleled prevention capabilities in this $16 billion addressable market opportunity.

And third, we believe we successfully scaled a global sales coverage model with a powerful sales team and key distribution relationships in every geographic theatre, providing our customers with security subject matter experts that are best-in-class, both before and after an order.

Our Q1 results reflect these long-term factors at work and also reflect the power of our land and expand strategy.

On the land side, we continue to acquire customers at a very fast pace and are now pleased to serve approximately 21,000 customers worldwide.

Examples of new customer wins in the quarter included replacing Cisco, Blue Coat and Websense for perimeter security at a Fortune 10 company, replacing CheckPoint and Cisco in an enterprise-wide global deployment in one of Asia's largest financial institutions, and replacing CheckPoint and Cisco as the primary data center firewall for one of the nation's largest insurance companies.

The expand side of the business also continues to grow quickly.

To make our Top 25 customer list in Q1, a customer had to have spent a minimum of $6.1 million in lifetime value, up from $5.6 million last quarter; and almost all of those customers made a purchase in the quarter, as they replaced legacy technology and point product solutions in favor of our Next Generation enterprise platform.

Customers are switching to us and continue to make repeat purchases at a rapid pace because of our technology.

We believe our platform provides customers with the most comprehensive protection and prevention in the market for all their security use cases, while each individual aspect offers best-of-breed capabilities.

For example, in the data center use case, we continue to see broad adoption of our high end PA7050 chassis.

In the quarter, we saw sizeable purchases, such as a global service provider buying more than a dozen chassis and one of the world's largest oil and gas companies significantly expand their current deployment with eight additional chassis.

Also, to continue to provide the world's best prevention capabilities at all points in the network, two weeks ago we launched our newest appliance, the PA3060, for our mid-sized enterprise customers data center use cases.

In the advanced persistent threat solution space, we believe we are now the largest provider by customer account, with approximately 4,000 customers paying for Wildfire's integrated and automated prevention capabilities.

And in late September, we made realtime exploit and malware prevention at both the network and the endpoint a reality, with the integration of Traps and Wildfire.

This is extremely compelling for all customers who understand how vulnerable endpoints are to attack.

While it will take time for Traps to ramp into a meaningful revenue contributor, we're off to a good start and closed multiple Traps deals in the quarter, including a mid-six figure win in a highly competitive bake-off within a large US-based energy company.

We are seeing a lot of enthusiasm for this disruptive offering.

New product announcements like the PA3060 and Traps place us at the forefront of solving some of our customers most complex security needs and we continue to innovate, helping them to safely and securely embrace technology trends like cloud and mobility.

We continue to be pleased with the high degree of interest in the Palo Alto Networks addition for NSX, and are engaged in a large number of POCs.

Also, in October, we expanded our partnership with VMware to provide our advanced security to VMware's public cloud platform, VCloud Air.

Enterprises can now apply the same rich set of security services available through VMware NSX and Palo Alto Networks across both public and private cloud environments.

We also enhanced our GlobalProtect mobility offering, helping organizations control access to enterprise applications and data based on key policy criteria, such as application, user and device, and we announced the latest release of our VM Series, with support for Amazon AWS and KVM.

Our customers can now take advantage of the productivity and cost benefits of the cloud without compromising their security.

We were able to achieve all of this in the quarter, while at the same time delivering bottom line results and cash flow generation that continued to demonstrate the leverage we have in the business and the ability to expand it over time.

Given the strong start to the year, we remain confident in our continued growth and our ability to gain market share at a rapid rate.

Security is the top IT spending priority across organizations of all sizes and our solution to customer security problems is unique in the market.

We believe our highly integrated Next Generation firewall, subscription services, and Advanced Endpoint Protection deliver best-in-class security at each point of the kill chain and, when used together, provide superior security at a superior total cost of ownership.

With that, I'll wrap it up and turn it over to Steffan.

Thank you, Mark, and thank you for joining us on our call today.

Before I get into the details of our results and guidance, I'd like to note that except for revenue figures that are GAAP, all financial figures are non-GAAP, unless stated otherwise.

We're off to a strong start in our new fiscal year.

In the first quarter, we built upon the record billings and revenue we delivered in Q4 FY14, demonstrating the continued traction we have in the market with our powerful platform; and we continue to drive leverage, with both operating margin and free cash flow increasing on a sequential basis.

The power of our hybrid SaaS revenue model, combined with our land, expand and retain sales strategy, are key components of our business model.

Once again, we saw new customer acquisition and expansion at existing customers drive robust growth in both the product and services side of our business, which led to out performance in billings, revenue and deferred revenue.

Existing and new products are performing well in the market, as our enterprise security platform continues to drive market share shift in our favor.

Now let me turn to the numbers.

In Q1, total revenue grew 50% over the prior year and 8% sequentially, to reach a new record of $192.3 million.

The geographic mix of revenue for Q1 was 69% Americas, 20% EMEA, and 11% APAC.

Compared to the prior year, the Americas grew 53%, EMEA grew 61%, and APAC grew 21%.

As in previous quarters, we saw broad strength across a wide range of verticals and we do not have any end customer concentration.

The three components of our hybrid SAS model, product, subscription and support, all grew very well in Q1.

Q1 product revenue of $101.5 million increased 34% over the prior year and 2% sequentially.

We saw particular strength in the contribution from our highest end appliances, including the PA7050, which continues to provide greater opportunity in the data center market.

Our recurring services revenue of $90.9 million increased 72% over the prior year and 16% sequentially and accounted for a 47% share of total revenue.

Looking at the two components of recurring service revenue, the first component is our SaaS-based subscription revenue of $43.7 million, which increased 76% over the prior year and 16% sequentially.

Support and maintenance revenue, the second component of recurring services, was $47.2 million, an increase of 69% over the prior year and 15% sequentially.

Billings in Q1 were 240.5 million, an increase of 52% year-over-year and 3% sequentially.

Growth in recurring services billings positively impacts deferred revenue.

Total deferred revenue in Q1 was $470.7 million, an increase of 69% year-over-year and 11% sequentially.

Short-term deferred revenue increased to $286.7 million, an increase of 67% year-over-year and 10% sequentially.

Total gross margin for Q1 was 76.8%, an increase of 180 basis points compared to last year and 10 basis points sequentially.

Product gross margin was 75.1%, a decrease of 150 basis points year-over-year and 60 basis points sequentially.

The sequential modest decline was due in part to investments we're making in manufacturing operations; and we expect there will be fluctuations in product gross margin, primarily due to product mix.

Services gross margin for Q1 was 78.6%, an increase of 580 basis points year-over-year and 60 basis points sequentially, due in part to ongoing growth in the contribution from subscription services.

For the quarter, research and development expense was 11.9% of revenue, increasing approximately $2.1 million sequentially, to $22.8 million.

This was primarily due to headcount growth.

Sales and marketing expense for Q1 was 46.8% of revenue, decreasing approximately $2.5 million sequentially, to $90.1 million.

This was primarily due to a decrease in sales commissions related to our strong FY14 year-end performance.

General and administrative expense for Q1 was 7.5% of revenue, increasing approximately $5.4 million sequentially, to $14.4 million.

This was driven in part by consulting and outside services related to projects in the G&A organization.

Total headcount at the end of the quarter was 1,900, up from 1,722 at the end of Q4 FY14.

In total, Q1 operating expenses were $127.3 million, or 66.2% of revenue.

Operating margin grew 310 basis points year-over-year to 10.6%, and increased sequentially 250 basis points.

Net income for the quarter was $12.8 million, or $0.15 per diluted share, using 84.7 million shares, compared with net income of $6.2 million, or $0.08 per diluted share in Q1 FY14.

On a GAAP basis for the first quarter, net loss was $30.1 million, or $0.38 per basic and diluted share.

This compares with a Q1 FY14 GAAP net loss of $7.9 million, or $0.11 per basic and diluted share.

We finished October with cash, cash equivalents and investments of $1.1 billion.

Cash flow from operations, free cash flow, and free cash flow margin for Q1 were $74.9 million, $69 million, and 35.9%, respectively.

Capital expenditures in the quarter totaled $5.9 million.

Consistent with the strength we saw in the quarter, linearity in Q1 tracked better than the prior year period.

Our accounts receivable balance was $116.2 million for this quarter, down from $135.5 million in Q4.

DSOs decreased sequentially and year-over-year by 4 days, to 59 days.

Turning to guidance, as we enter Q2, we feel good about the strength in our Business and our ability to capitalize on expected year-end buying patterns.

In Q2 FY15, we expect revenue to be in the range of $200 million to $204 million, which represents 42% to 45% growth year-over-year.

We expect non-GAAP EPS to be in the range of $0.16 to $0.17 per share, using 85 million to 87 million shares.

Before I conclude, I'd like to highlight a few considerations for modeling purposes.

Due to strong growth, seasonality has been difficult to forecast, but we believe that over the longer term, fiscal Q2 and Q4 may show our strongest revenue growth.

As a reminder, in Fy15, we expect to invest approximately $25 million, or $0.18 to $0.19 per share in Traps, our advanced endpoint protection offering, with the level of investment skewed to the back half of the year.

Consistent with what we said last quarter, we expect CapEx for FY15 to be in the range of $45 million to $50 million for the year; and as we said previously, we continue to expect to exit Q4 FY15 with a low teens non-GAAP operating margin and to exit Q4 FY16 at a 22% to 25% non-GAAP operating margin.

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

Thank you.

(Operator Instructions)

Raimo Lenschow, Barclays.

Thanks for taking my question and congrats on a great start to the year.

I just wanted to talk a little bit about Traps.

Can you talk a little bit about the -- you mentioned some early wins there -- a little bit about the reception you got from the market?

And also the opportunity you do have then when you combine it with Wildfire and how the sales force is able to up sell and cross sell that?

Thank you.

Yes.

Hello, Raimo.

It's Mark.

Thanks for joining us.

We're very excited about Traps.

As you know, we brought that back to market in late September.

So we had it in the market for about 6 weeks in the quarter and the reception has been very strong, just from an interest level.

And like I said, we closed a number of deals in the quarter, in October.

And also one that I just wanted to note, just because it was a good sized deal, mid-six figure deal.

It was highly competitive, where the customer had already given the PO to somebody else, took it back and gave it to us, once they saw it at work.

That customer, to your point about Wildfire integration, was an existing Palo Alto customer running Wildfire.

When they saw that work together with Wildfire, they were extremely impressed with that.

So I think that it's a great completion to the platform concept that we've been talking about and selling for awhile.

It's primarily geared towards prevention, and now we can demonstrate that on the endpoint, as well.

And like I said, the early indications seem very positive.

Perfect.

Thank you.

Thank you.

Matthew Niknam, Goldman Sachs.

Hello, guys.

Thank you for taking the question.

Just a little more broadly, I have a question on customer activity.

Can you talk about whether you're seeing any pull forward of demand from calendar 2015 into calendar 2014?

And then secondly, how you're starting to see demand among customers shape up as you head into the next calendar year?

Thanks.

Yes, sure, Matthew.

I think it's a little difficult to say if there's a pull in.

The security market is very strong right now.

You can see that in our results, other folks results.

It's a good market to be in.

We span the end of the year in this quarter, so we don't have an impact of folks trying to pull spending in.

But as a general matter, what we're seeing is increased attention, increased spending from folks, and definitely a desire to have prevention capabilities.

And I think that's why we're selling so well.

Got it.

And then just one follow-up on international.

Any color you can provide on what's driving the acceleration in growth in EMEA and APAC this quarter?

Yes, you know, if you look at how our revenue breaks down across the theatres, you can see that North America, our most mature theatre, continues to grow at a very, very healthy rate.

And as we've said in the past, we invested in the theatres outside the North America, after North America, not surprisingly, as we grew and matured the Company.

And I think some of those investments are paying off now over in Europe.

We've done a lot of things there under Mark Anderson's leadership with major accounts, global accounts, the play book we've been running in North America he's been running now in Europe with some good success.

Also just wanted to note, as well, we had talked before about increasing our distribution relationships with some of the best folks in the world.

We mentioned West Con before in a previous call where we expanded our relationship globally.

And the real focus of that, to start off, was in Europe.

And early indications on that are really great, growth well in excess of 300% in just a short period of time on a year-over-year basis.

So we're happy with that relationship and other major global players like that, that we're working with on a global basis.

One follow-on point, Matt, is with international being about a little bit over 30% of our business this quarter, we see that there's a very big continued growth opportunity across both EMEA and APAC.

And we feel like we're still in the very early innings of getting to that growth.

(Operator Instructions)

Keith Weiss, Morgan Stanley.

Excellent.

Thank you guys for taking the question and very good quarter.

I was wondering --I'll turn two questions into one -- but if you could just talk about how you're doing with sales into your existing customer base, in terms of going back and getting existing customers to take on more product?

Whether it be more subscriptions, like Wildfire, or maybe using a virtualized appliance, like where you have VMware?

And then question number two, as you guys start to get more mature and you start to actually refresh your own customer base, maybe you could talk just a little bit about how those refreshers are going, how well you're able to sustain value or add value on the refresh of guys already within your customer base?

Yes, sure, Keith.

They're somewhat related.

On the first point -- and I'll call that the wallet share question -- we're seeing a couple things there.

The first is a continued increase in subscription rates and attach rates across the board, as our customers continue to understand the value of using everything that the platform brings to bear in the battle for security.

So really healthy, as you can see from our subscription services business, attach rates continue to go up.

And then in addition to that, we also are bringing to market, from a product perspective, things that can satisfy folks' need all up and down the chain, if you will, inside their enterprise.

So the PA7050 at the high end, selling well.

We just introduced the 3060 for data center use cases for mid-sized enterprises, and then the addition of Traps, as well, to complete the platform.

So I think that's all taking effect.

But at the end of the day, people are really buying into the platform concept and the prevention capabilities it brings.

On the second portion of your question, the refresh opportunity, we watch our customer base very closely.

And all of our customer cohorts are growing in lifetime value over time.

And in the earlier ones, which we look at in 2009-2010, we can see the indications of refresh cycles beginning there.

And the ability to upsell those folks, as well, when they're usually buying a bigger piece of hardware, to upsell them on more subscription services, because they're understanding that platform story.

So I think all that's working very well for us.

Excellent.

Thank you, guys.

Thank you.

Shaul Eyal, Oppenheimer.

Thank you.

Good afternoon, guys.

Great quarter.

Congrats.

Two quick questions on my end.

Mark, just your thinking about FishNet and Accuvant's recent teaming up, how does that impact your business?

Sure, I think we'll continue to see consolidation in that part of the industry.

I don't think it's a bad thing for us.

Both of those are very good partners of ours, and have increased their business over time combination brings more to bear from what they can do for us as a large vendor in the market.

So I think that's probably a good thing.

Got it.

And Steffan, thanks for reaffirming the operating margin targets as you exit FY16.

But as we think about further means of lifting up EPS down the road, what's with the current thinking about tax rate?

How could that be maybe lowered down and in turn lift up EPS?

Well, currently, we have a static non-GAAP tax rate of 38%.

What we've done over the past couple years is we've committed to an international cost sharing structure for our IP.

And with that type of structure in place, as we become a full taxpayer longer term down the road, we would expect to see our tax rate most likely be in the high 20% range, which would be a lift to EPS.

And as it relates to non-GAAP in the near term, over the next year or so, we'll evaluate the static tax rate of 38%, and we'll probably revisit that a year from now, now that we -- and at that point, we'll have had that static tax rate for about 2 years.

Brent Thill, UBS.

Thanks.

Just a question on the relationship between product and services there.

You had good upside in services on the product side and you were just a little bit ahead of the Street.

I'm curious what you're seeing there as it relates to the services side?

And there's another question as it relates to that, as you look at this managed defense as a service and how you think you'll benefit, as that seems like it's early but there's a big opportunity for you in that segment of the business?

Yes, sure, Brent.

On the product services side, we came off of a screaming fourth quarter, as you may recall, and very happy to see sequential growth across the board, Q4 to Q1, so very happy with how that turned out.

The services side of our business is about 47% of our business right now, continues to grow over time.

We like that a lot.

The services show stickiness with the customers.

It has higher margins.

So we really like that trend.

And at the same time, we continue to grow the product revenue at a very high rate, as well.

So I think both of those cyllinders are firing very well on our hybrid model.

On the services side, your managed services question, we love services, obviously.

It's 47% of the business and growing.

We really like the idea of providing what used to be hardware-based security as subscription services, and we like that model a lot.

We're not in the MSS business today.

Lots of people are in that business and know how to run our products and provide it on a managed services basis.

So we think we understand that segment of the market pretty well.

Karl Keirstead, Deutsche Bank.

Thank you, Steffan.

I've got a question about the cash flow performance, which was extraordinary in the quarter, and the operating cash flow margin tracked way above what your non-GAAP operating margin was.

So I'm just wondering if you could give us a little bit of guidance in how to model cash flow.

What kind of -- if you look out a year, let's say, FY16, or you can pick the period, what should the relationship be between the operating cash flow margin and your non-GAAP operating margin?

Thank you.

Good question.

Well first of all, our cash flows benefited this quarter by a great billing cycle in Q4 and very good linearity in Q1.

So the fact that we drove 35%, 35.9% free cash flow margin in the quarter was great.

Longer term, we've been giving folks a guideline around, at our target model of 22% to 25% non-GAAP operating margin, free cash flows, we estimate should be 5% to 8% above.

We'll continue to refine that down the road.

But that's something where we believe free cash flow margin will be above operating margins.

Mainly because operating margins, candidly, are a lagging indicator of profitability, because we have the hybrid SAS revenue model, where we take revenues ratably for a large swath of the business.

But we also take in period expenses for sales commissions.

So free cash flow is a very meaningful indicator of profitability for us.

We believe it's a differentiating factor, from a business model standpoint.

And the fact that we're able to post great positive free cash flow while growing top line revenue and billings way above market rate of growth, we feel very good about the power of the business model.

Great.

That's helpful.

And if I could ask my follow-up on another metric, and that's the attach rate for the subscriptions, obviously that was a big growth engine in the October quarter.

Are you able to bracket for us what the attach rates are for some of the more mature subscription modules?

Yes, so we've reported overall attach rates every 6 months.

The last time we talked about this during the last quarter, we said on an overall basis, it was 2.1, up from 1.9 the prior previous time we had spoken about that.

And attach rates continue to grow for us.

That's because all the subscription services continue to grow very nicely.

Some of the more mature ones in prevention are in the 80 something percent category of attach, and we think a number of these services can reach the high maturity rates.

Rob Owens, Pacific Crest Securities.

Great.

Thanks and good afternoon.

Curious, as we're seeing security clearly accelerate here the last couple quarters, not only for you guys, but the industry in general.

Where do you guys think the budget's coming from?

What other areas are seeing less spend at this point?

You know, Rob, it's hard to say what might not be getting funded.

We definitely see an increase in security budgets across-the-board, and that's on the global basis, as well.

The reports that I've looked at are pretty clearly indicating that people are figuring out that they have to spend money here.

And it sounds like they're going to continue to do that in the future, with security being one or two of the top priorities.

I don't actually track all the other stuff close enough to know who might be being maybe shorted for that, but somehow people are figuring out how they spend here.

And then as we look at your strong customer acquisition numbers the last couple quarters showing some acceleration here, who are you seeing most from a displacement standpoint?

With everyone adopting a Next Generation firewall marketing campaign, who are you seeing most competitively these days?

Thanks.

Yes, it really hasn't changed in quite some time.

I know everybody has jumped on the marketing band wagon for Next Generation, but there's a few things I think that are becoming increasingly evident in the market.

The first is, when it's time to show up and really prove that to folks, we've consistently been the only ones who have been able to show true Next Generation firewall capabilities.

And even more importantly now is the concept of Next Generation security platform that does prevention.

So, not only just Next Gen firewall, but really, really distancing ourselves from everybody else in the market who don't even have that first capability set and continue to fall further behind on the whole platform concept and prevention.

That is across the board.

When we look at our win rates across the board, we're taking business from everybody in the market today.

And that looks like that would continue for quite some time.

Thanks.

Thanks, Rob.

Phil Winslow, Credit Suisse.

Hello.

Thanks, guys, and congrats on another great quarter.

You guys talk about pretty good success and just getting larger and larger deals.

What's really driving that here?

Is it really the attach rates of more and more subscription services?

You mentioned the 1.8 to 2.1 that you guys talked about last quarter, or is it a high end appliance that you can actually go into more and more data center deals?

How do you think about the mix of that?

And then just one quick follow-up.

Yes, sure.

Congratulations on your baby, Phil, by the way.

Thank you.

Yes, it's actually a mix of a number of things.

The first, and probably the most important, is the acceptance of Palo Alto Networks as a major player in the enterprise security market and understanding that platform capability set as having end-to-end protection prevention capabilities.

So as a general matter, people are more inclined to just buy more from us, on size and scope, and do it at an earlier basis than they have in the past.

And then for the existing customers who have been working with us for a while, the ability to march them up from an attach rate perspective has been demonstrated over time.

So it's really a combination of those two things that are driving higher -- more times at bat, higher initial sales, and then increasing the ability to sell subscriptions in there, so the lifetime value continues to go up.

Great.

And then just one quick follow-up for Steffan.

The exit rate for FY16 that you talked about, maybe if you could just remind us about what that model looks like?

We have sales and marketing as a percentage revenue, gross margins, et cetera, so we can have an idea for how the model evolves in your mind?

Certainly.

Well, it starts with gross margin.

Our forecasted range exiting Q4 of FY16 is 73% to 76%.

Sales and marketing as a percentage of revenue is 33% to 36%.

R&D is 13% to 14%, and G&A is 5% to 6%, leading to a range of 22% to 25% non-GAAP operating margin.

And when you look at where we are today as a business, we're either at or within sniffing distance of all of those line items, except for sales and marketing.

As practitioners of the business, we constantly evaluate growth versus profitability.

The fact that we're growing at 10 times at the rate of the market and much faster than the rate of the competition, we are committed to delivering profitability over time.

But we don't want to strive to get to be as profitable as possible, because we would be leaving a great opportunity on the table.

So that's our viewpoint on it, and we've been pretty consistent.

We've been very consistent, since the time we went public, around the target model exiting Q4 of FY16.

Walter Pritchard, Citi.

Hello.

Can you talk about on the attach of subscriptions, you mentioned the threat prevention where it is, approaching 80%.

We can do the math on Wildfire.

As we think about Wildfire and other subscriptions that you have, could they approach the 80%, or how should we think about the potential peak of attach on those?

Hello, Walter.

It's Mark.

I think that particularly Wildfire, as an example, is a close cousin -- first cousin to threat prevention, when you think about what it does.

And then particularly, when those two things work together.

So I think we could see pretty high attach rates on the Wildfire.

The other ones are already selling very well and have very high attach rates.

And then we have GlobalProtect, which is doing nicely.

It's still our smallest one, as I think the market [sorts] through what mobile security is going to look like in the future.

We like that one a lot.

We think that maybe it's going to take some time for folks to come to the understanding of how mobile security should be done.

And then on top of that, we have Traps, as well, which is not an attach rate, as you know, but I think of it as our fifth service, from a financial perspective, and we have great expectations for that.

And just a follow-up to that, Mark.

Should we think about Traps as the next driver here in terms of attach, so to speak?

Or do you have in your back pocket other subscription services that might start becoming meaningful that we don't have released or may be fledgling in beta, something like that, over the next couple years?

I think about Traps as a fifth service here, even though it won't have an attach rate concept to it.

And we're always evaluating additional subscription services and we have a high bar in those many things that folks have had value in, in the past.

Ideally, are delivered with hardware, can be subsumed into our platform at a very elegant, graceful and highly integrated way.

So we're constantly evaluating things that could fit that bill, and I would expect us to have more services in the future.

Gray Powell, Wells Fargo.

Great.

Thanks for taking the questions.

Just a couple, if I may.

Maybe starting off with a bigger picture question.

I think in about 4, maybe 5 years, you've been able to take a high single digit share of the network security market and a much higher flow share of new growth.

How should we think about the opportunity in endpoint security and what do you see as the gating factors of driving share gains in that market?

Hello, Gray.

So we're still single digit players in a close to $19 billion addressable market opportunity, if you look out a couple years from today, as far as the size of the market is.

And that is for enterprise security, of which the endpoint is a portion of that.

For us, that's a completely untapped portion of that addressable market opportunity, and I think we have two things going for us there.

The first is that Traps itself is highly disruptive.

It is truly doing prevention on endpoints on things nobody has seen before and it's very, very effective.

And in addition to that, when it's working with the rest of the network security platform, it really gives you end-to-end protection and prevention across the entire network.

So we think it's the combination of those two things that will help us drive penetration into the endpoint market and be able to do so at high growth rates.

On the flip side, we love Traps, as well, because it also is a great benefit to our existing customers or folks who have looked at us just for network security.

So we think that it's also going to benefit us from a sales perspective on the network side of the business.

So those two things working in tandem are very nice for us.

Got it.

And one more, if I may.

Can you help us just think about the scalability of Palo Alto's management console, as we think about the potential for you guys to do larger deals?

And along those lines, how many appliances can customers manage in some of your largest deployments today?

So on the management platform itself, which we call Panorama, is very, very scalable.

I think a few years ago, some of our competition would like to say that was somehow a limiting factor for us.

We put a lot of time and attention to that over the last few years, both on the software side and also we introduced a hardware platform that Panorama can run on, as well, the M100, so that we can have lots of scalability around it.

I have not heard a customer in years bring up management platform as any buying objections.

As far as the capability set, they can manage thousands of devices right now and deployments out there today are 500-plus devices easily running on Panorama.

So I don't think there's any limitation at all.

Excellent.

Thank you very much.

Scott Zeller, Needham and Company.

Hello.

Thanks.

Just wanted to go back to the budget question from earlier.

Could you tell us how often you're now seeing line items called out for cyber security when you're competing for deals?

And if you do see that in an opportunity, does that typically mean a larger deal, I'm assuming?

Yes.

Hello, Scott.

I think we're seeing the transition that is in play, and this will take some time, into hearing the words cyber security used.

Generally hearing it used by C-suite executives on the technology side, so CIOs, CEOs, CISO conversations.

But at the same time dealing with people who are actually operating technology who talk in terms of the network and things that have to run in the network.

So that's an evolution of those two things over time.

When people are talking about cyber security, we like that a lot, of course.

Because we say in cyber security, prevention should be your ultimate objective.

And if you want to future proof your organization in order to do protection and prevention all the way from network down to the end point, then we've got the answer to that.

When they bring the operating guys into the room, to really dig into that, we're also able to have very fantastic conversations with them about each aspect of that.

So if they want to talk about the firewall, we can talk about the firewall.

If they want to talk about the end point, we can talk about the end point.

We can talk about IPS.

We can talk about all the capabilities after that, both at a C-suite executive level, as well as people who actually have to run stuff at the end of the day.

So it's working well.

Thank you.

Andrew Nowinski, Piper Jaffray.

Okay.

Good afternoon.

I think last quarter, you had about 3,000 Wildfire paying customers.

Just curious to know what that changed to this quarter and whether Traps could be driving some of that demand for Wildfire.

And I just have a quick follow-up.

Sure, Andrew.

We are just shy of 4,000 paying customers.

So a great quarter for us in customer addition on paid Wildfire.

I think Traps has not been in the market long enough to be influencing Wildfire sales, probably the opposite, so some of the deals we saw around Traps in the quarter.

But those two things working in conjunction should help each other out over a long-term basis.

Okay.

And then can you just talk about whether Wildfire's predominantly had any success when the customer's already a Palo Alto customer?

Or whether it's drawing you into some new deals where the customer doesn't already have a Palo Alto firewall?

Thanks.

It's both, both situations.

We found that if you're an existing Palo Alto Networks customer not yet using Wildfire, the idea that you can do realtime malware prevention for known threats and then very, very fast detection and downstream kill chain impacts for malware that is zero [deg] is a very compelling conversation.

And of course, we also get to say, you already bought the infrastructure to support that capability set, so you should use Wildfire.

In addition to that, when we go into new opportunities and nobody -- they're not using our technology at all yet, we very much talk to the platform and the prevention capabilities of the platform.

And when people hear that, if they're going to purchase Palo Alto Networks for the first time, they're inclined to buy Wildfire along with that first purchase, because they want that advanced persistent threat protection right up front.

Thanks.

Thank you.

Aaron Schwartz, Macquarie.

Good afternoon.

Thank you.

On the target operating margins, I know you just mentioned, and you talked about it before, the sales and marketing is really the area for leverage.

The question I have is how do you think about the mix between indirect and direct sales?

Presumably, indirect is going to play a part there in the greater leverage.

And historically, a lot of channel partners might be a little bit more network-centric with security.

Are there things -- or what are the milestones to continue to ramp the indirect side with your target margins?

Or are the target margins just a factor of top line growth and you can get there independent of any mix in the channel?

There are definitely two things at play there, two of which what you just said.

The first is, we are continuing to build out our channel infrastructure.

We have a great partner ecosystem.

And as we invest in the channel, train the channel, the percentage of deals that the channel can close with as little touch from Palo Alto Networks as possible, that will be more leverage for us in the model.

We will be getting more revenue growth by virtue of having more channel partners out there.

We've always described our sales model as a high touch indirect fulfillment type model.

So literally, close to 100% of deals get to filter the channel.

But we have a great direct touch sales force that sells side by side with the channel.

So what we've done in the past, under Mark Anderson's leadership, is we've done account segmentation with looking at Global 2000 accounts and major accounts.

And in those instances, we have very nice, high touch direct sales folks sometimes working in concert with the channel partners, as well, doing those deals.

For deals that are outside of the very large enterprises, we're going to be looking more towards our indirect partners to take more of that business from beginning to end.

Additionally, how we get to that target sales and marketing line is we'll have more ramped salespeople than ramping salespeople over time.

That's a key component.

And the fact that we have such a great lifetime value concept, where once we acquire a customer, we're able to sell more to the install base, those repeat sales that happen come at a lower cost of sale to the Company.

So strategically, we have the direct and indirect function, but we also have more ramped people than ramping in other elements that I just covered.

Terrific.

Thank you.

Hendi Susanto, Gabelli and Company.

Good evening, and thank you for taking my questions.

Question for Steffan.

Your R&D was 11.9% in Q1 and 12.3% in FY14, which are below your midterm target of 13% to 15%.

Could you give some insight on whether we can expect R&D as a percentage of revenue to be below that target in the near future?

Additionally, service gross margin was very strong.

I'm wondering whether we are seeing the uplift of favorable mix, toward subscription, and operating leverage and surface business that we can expect to continue?

Thanks.

Well, for R&D, we keep the filter very tight around the folks who we're bringing into the Company, and we are committed to making the best investments that we can.

And our commitment to innovation within R&D has translated very well into new product introductions and really changing the game on the competition.

Over time, we feel like in order to sustain the innovation engine, we should be around, call it, 13-ish, 14-ish percent.

So there's going to be some lumpiness as we get there.

Additionally on R&D, we're starting to really build out the Traps team in Tel Aviv.

That was a product of our Cyvera acquisition.

So we are going to be seeing more investments in that business, as well.

I can't really comment on the specific near term, but we feel good about our target model.

And we feel like to adequately be committed to innovation, you have to be in, call it, the 13% to 14% range.

On the topic of services gross margins, there are two elements to services gross margins.

The first is we are definitely getting the benefit of increasing attach rates to the subscriptions.

And remember, subscriptions are software-type gross margins.

So as we get more subscription revenue, that will definitely translate into higher services gross margins.

The other part of the services gross margins is the customer support organization.

And that's really people and systems intensive.

What we are starting to see are, like early days of getting some scale in that group.

And you could imagine with the amount -- the sheer number of customers we've acquired, we've been adding well over 1,000 customers per quarter, for now 12 quarters in a row.

We need to be investing in that customer support organization.

But we're doing it prudently.

So we believe pound for pound, we have the best customer support organization on the planet.

And now we're starting to see some leverage, so we're getting two positive tail winds in services gross margin.

Erik Suppiger, JMP Securities.

Good afternoon.

Congratulations.

Thanks, Erik.

On Traps, I was wondering, can you give us a sense for how that might scale, and maybe give us a sense relative to Wildfire?

You've talked about that market size as being significantly bigger, but I think you have a different sales model for that.

So you've started to see the elements there.

When could we see Traps maybe start to exceed the size, the customer base that you have for Wildfire?

Yes, sure, Erik.

So a couple thoughts around that.

The first is that by having Traps in the first place and entering into the end point security market.

The addition to the addressable market opportunity is anywhere between $4 billion to $5 billion, depending on news numbers you look at.

Though the end point security market is a larger market than what we've seen folks who have tried to triangulate on the market called staff, where Wildfire specifically may fall into, which I've seen anywhere from $1 billion to $2 billion of market opportunity.

So they're just different addressable market opportunities in the first place, with Traps being a broader one, just as far as what the market looks like, in terms of size.

Given that, we like that market a lot.

And as I said a little earlier, when those two things are operating together, it's a killer offering for folks.

Because you're getting realtime exploit prevention, you're getting realtime malware prevention for known threats, and you're getting very, very fast turnaround for unknown threats, both at the network and the enterprise.

So we're thinking about those two things together.

As far as what we expect to see from Traps, we like the early interest in the market.

We like the fact we're closing deals already.

We think, given the subscription model and the time it will take to ramp the sales and a few other things, that we'll see meaningful revenue contribution in FY16 or sales building throughout the back half of FY15.

But we're very excited about this opportunity.

Michael Turits, Raymond James.

Hello, guys.

One on Wildfire and Traps, and thanks for taking the question.

First of all, in each of those two products, who are you specifically going up against in deals with each of those products?

So on the Wildfire situation, it's -- when people think about that, they usually think about advanced persistent threats.

And there's some folks who would position themselves in the market as more comprehensive.

So that way all the standard network security competitors we've seen, Cisco, Juniper's end point, who have offerings in that space, as well.

So that's more of our platform will beat them on a head-to-head basis, relative to many of their point solutions, as they have.

And then the most direct competition we see as far as the standalone player there, will be [Fire Ring].

And what about on Traps?

I'm sorry.

And on Traps, the big players in that market are the legacy folks, Semantec, Trend, and McAfee.

And ultimately, a big part of the market opportunity is in that legacy space.

There's a host of quote, NextGen end point folks out there today, as well, that we're competing with who are trying to land next to, as a complement to some of those legacy guys, is the first step.

So we're competing in both cases, legacy, but probably today more and more on the NextGen guys who are competing for the space in the end point to do something there.

Jeff Kvaal, Northland.

Yes.

Thank you.

I have two questions.

And Steffan, they may both be for you, actually.

I'm wondering if you could comment on number one, the linearity in the quarter.

It looks like it was great.

Could you talk about why linearity is improving and should we expect it to revert to, let's say, last year's level, at some point?

And then secondarily, Steffan, if you wouldn't mind, could you tell us more about what was in the consulting element of the G&A uptick, and particularly if it's going to be recurring?

Thanks.

So linearity in the quarter was very good.

Why it's happening is we are getting a broader pipeline heading into each quarter, which is nice.

The close rates have been very robust.

So we're able to close deals earlier because of the technological differentiation and the power of the platform that we have, in addition to great sales execution.

So we've had the differentiation that we've always had, but now we have more feet on the street, more fire power and we're able to close deals earlier.

It's too soon to tell whether or not the linearity will continue to be at these levels, but certainly in our fiscal Q2, one of the interesting things about a company like ours that has a quarter end in January is December, typically, is a strong month because of calendar year-end budget flush.

So we would expect to do a very good portion of our business through month 2, and we'll see if that holds up this year.

And there are no indications that it won't.

As far as consulting services, at the end of the last fiscal year, we had a couple consulting projects roll off.

And in this Q1, we had some come back on.

And mainly in the tax area, that we started to make some investments in.

As we build out that organization, we're relying on some external consultants.

And then also we have some other, I'll call it, discrete projects that we're working on, all with the intent of helping us get more scale going forward.

So think about finance and accounting projects, as well, in order to get more future leverage.

So there's a little bit of quarterly perturbations around projects rolling off and some projects starting, and that's what you really saw.

As far as, will it increase at the same rate?

Certainly not over time, because we're looking at a target model of 5% to 6% for G&A.

So directionally over time, it should come down.

But there will be quarterly perturbations.

And ladies and gentlemen, that does conclude our question-and-answer session.

I'll now turn the call back over to Mark McLaughlin for closing comments.

Great.

Thanks, everybody, for being on the call this afternoon.

We had a great start to the year and we're really energized for the opportunity we see as we move into FY15 and beyond.

We think we're at the right market at the right time, with the market leading protection prevention technology.

I'd really like to thank Palo Alto Networks team for their hard work and support for all of our customers and partners, as we continue our march to be the leading enterprise security provider in the world.

And I wish everyone a happy and healthy Thanksgiving holiday.

Thanks for being with us.

Ladies and gentlemen, that does conclude today's conference and we thank you for your participation.