Palo Alto Networks Inc (PANW) 2016 Q4 法說會逐字稿

Good day, everyone. Welcome to the Palo Alto Networks fiscal fourth-quarter and FY16 earnings conference call. Today's conference is being recorded, and at this time, I'd like to turn the conference over to Kelsey Turcotte, Vice President of Investor Relations. Please go ahead, ma'am.

Great, thanks, Matt. Good afternoon, and thank you for joining us on today's conference call to discuss Palo Alto Networks fiscal fourth-quarter and full-year 2016 financial results. This call is being broadcast live over the web, and can be accessed on the investor section of our website at Investors.PaloAltoNetworks.com. With me on today's call are Mark McLaughlin, our Chairman and Chief Executive Officer; and Steffan Tomlinson, our Chief Financial Officer.

This afternoon, we issued a press release announcing our results for the fiscal fourth quarter and full year ended July 31, 2016. If you'd 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 financial outlook, the impact of a change in accounting policy, the spending environment and market opportunity for our products, subscriptions, and services, trends and certain financial results and operating metrics, our revenue, billings, deferred revenue, and free cash flow growth rates, sales productivity, seasonality, ability to expand market share, scale the business, gain leverage, and deliver profitability, benefits of our partner ecosystem, innovations in our product subscription and services capabilities, our competitive position, and our plans with respect to our share repurchase authorization.

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 factors that could cause actual results to differ, please refer to our Quarterly Report on Form 10-Q, filed with the SEC on May 27, 2016, and our earnings release posted a few minutes ago on our website and on the SEC's 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. For historical periods, 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 investor section of our website, located at Investors.PaloAltoNetworks.com.

For planning purposes, we expect our fiscal first quarter 2017 earnings conference call to be held after the market closes on Monday, November 21. We would also like to inform you that we will be presenting at the Citi 2016 Global Technology Conference on Thursday, September 8; the 2016 Deutsche Bank Technology Conference on Wednesday, September 14; and the Dougherty & Company Institutional Investor Conference on Wednesday September 28.

And finally, for your reference, once we have completed our formal remarks, we will be posting them, and a related slide deck to our investor relations web site under Quarterly Results. With that, I'll turn the call over to Mark.

Thank you, Kelsey, and thank you, everyone, for joining us this afternoon. I'm happy to be here with you to share our results for the fiscal fourth quarter and full FY16.

Our fiscal fourth quarter capped off another record year for Palo Alto Networks. In the quarter, we grew revenue 41% year over year to $401 million, billings were up 45% year over year to $572 million, free cash flow was up 72% year-over-year to $171 million, and we reported non-GAAP EPS of $0.50. In Q4, we saw better macro sentiment than what we witnessed in Q3.

For the FY16 we reported revenue of $1.4 billion, up 49% year over year, billings of $1.9 billion, up 56% year over year, free cash flow of $586 million up 85% year over year, and non-GAAP EPS of $1.67, up 94% year over year. In our industry these growth rates at our scale are unprecedented, and I want to thank our customers, our team, and our global partners for these results, their hard work and their ongoing support.

We've been driving a paradigm shift toward a real platform, which customers are adopting in record numbers. As a result, we continue to outpace the competition and rapidly capture market share. Financially, the paradigm shift is providing us with sustainable benefits, evident in our strong product sales, significant growth in attached and non-attached subscription services, and very high renewal rates.

In particular, the rapid growth in recurring services provides sustainable growth in both short and long term deferred revenue, increasing visibility into future revenue, higher operating margins over time, and high free cash flow generation. As a result, we are confident that we will continue to deliver high revenue growth at scale for years to come.

This paradigm shift is inevitable in an age where attacks are increasingly automated and sophisticated. Historically, the answer to the attack growth and sophistication had been to attempt to detect an attack through a combination of best of breed technologies, often delivered as individual hardware appliances or disparate software agents, and then have the customer be responsible for acting as a back-end integrator to try to gain some leverage from the products.

It is increasingly obvious that this approach is failing, and instead of providing leverage against the automated attacker, it's resulted in security defined by the least common denominator in the security stack, increased complexity of network, increased cost to deploy the technology, and increased reliance on manpower which is hard to find, and the least leverageable resource the Company has. As a result, customers are moving away from point product to do detection and drive manual responses, to real platforms, that provide high degrees of prevention through native integration of best-of-breed capabilities, which are increasingly delivered in services, high automation, increasing ecosystem leverage, and seamless deployment in all environments, including the cloud.

Vendors today are being judged against these requirements, and we can clearly see a few things occurring. First, customers are making purchasing decisions based on strategic architectural considerations, as opposed to the more transactional one of each hardware model seen in the past. Customers want better security, a reduction in the number of vendors, and better value for their spend. They are being more thoughtful about their decisions, more open than ever to transition from legacy technology, and awarding larger deals to fewer vendors.

Second, those vendors that have traditionally served the follow-on market are relying primarily on price, bundling of free services, or promises of future road map to try to stay in the network. And third, point product vendors are finding it increasingly difficult to justify their standalone value proposition, when their capabilities are being subsumed into the platform. As the primary driver of this paradigm shift, we are benefiting disproportionately compared to the rest of the industry.

Our next generation security platform prevents threats across the entire attack life cycle, simply and seamlessly, by automating security in a way that transcends individual capability, and it's easily deployed as either hardware or software, in the network, on endpoints, and in the cloud. Customers recognize and embrace the uniqueness of our approach, and our metrics show we are delivering on these requirements.

In terms of customer growth, in the fourth quarter, we had the highest rate of new customer adoption in our history, adding over 2,000 new customers, and are now proud to be serving approximately 34,000 total customers globally. This includes over 85 of the Fortune 100, over 70% of the Fortune 500, and 55% of the Global 2,000. In terms of capabilities of the platform, we continue to see rapid adoption, real usage, and very high renewal rates.

At the end of the fourth quarter, we now have more than 29,500 customers using threat prevention, more than 24,000 using URL filtering, and 3,500 using GlobalProtect. We added the highest number of quarterly WildFire customers in our history, to bring our total WildFire customer base to over 12,500. Our Traps offering and our VM Series offering each are on mid eight-figure run rate in sales, growing at triple digits.

Specifically, we grew our number of VM Series customers to over 1,700, up from the approximately 1,000 we reported recently at analyst day, with hundreds of these customers deploying in the public cloud. And Traps continues to ramp quickly. We now have well over 500 Traps customers, up from the approximately 300 we discussed at analyst day. Finally, we had approximately 100 customers using AutoFocus and Aperture, resulting in a combined eight-figure run rate in sales for these offerings, growing at triple digits.

Platform adoption is driving record lifetime value growth across the board. For example, all of our Top 25 lifetime value customers again made purchases in the fourth quarter, and to make this list, a customer had to have spent a minimum of $14 million in lifetime value, a more than 50% increase over the $9.2 million in Q4 of FY15.

With the markets only true platform, our technology, ecosystem, and competitive advantages are increasingly evident. Some examples of wins in the quarter include a checkpoint replacement at a large US financial services company to secure their data center with our PA-7000 Series chassis; a competitive win against Cisco in the defense industry, for significant IoT use case, utilizing VM Series; a perimeter and data center Cisco replacement with PA-5000s, threat prevention, URL filtering and WildFire in one of Europe's largest retailers with over 6,000 stores; a checkpoint replacement including dozens of devices across product lines, threat prevention, URL filtering and GlobalProtect, where we became the standard security platform for one of Europe's largest media companies; aCisco replacement of the internet operations of one of the world's leading SaaS vendors, with our PA-7050 chassis, threat prevention and URL filtering; and we closed a seven-figure Traps deal for 30,000 endpoints with a US-based integrated healthcare organization, where we replaced Symantec for Antivirus.

We are also increasing leverage and return on investments for our customers, with additional partnerships designed to reduce the burden on our customers to integrate technology. For example, earlier this month, we teamed with Accenture, Splunk and Tanium to develop an integrated security offering, wrapped with Accenture services, that includes our next generation security platform. This unique combination will help organizations better defend their network, product their endpoints, gain insight into the security behavior within their Enterprise, and effectively automate breach detection, prevention, response, and recovery efforts.

We are always working to further extend our technological advantage by consciously fostering a culture of innovation, and continually enhancing the capabilities of our platform. Most recently, we announced the release of Traps version 3.4 with new functionality, including increased significant machine learning capabilities for realtime unknown malware prevention, and quarantine of malicious executables. These updates further strengthen the malware and exploit capabilities of Traps, and alleviate the need for legacy antivirus technology to protect endpoints.

We also introduced the WildFire EU cloud. Customers will now have the option to submit unknown files and e-mail links to a WildFire cloud within the EU for analysis, where the customer submissions will be fully analyzed and stored, without ever leaving EU borders. Data privacy and protection is paramount when it comes to cloud-based threat analysis, and with the WildFire EU cloud, it's now much easier for global and European customers alike to fully utilize this critical threat prevention capability. Response to our recent platform releases and road map continues to be very positive.

On the go-to-market front, we just completed sales kickoff for 2017, where more than 2,000 enthusiastic sales, marketing, and product team members sat side by side with over 800 partners hearing about our objectives for the fiscal year, as well as participating in the same training programs and certifications as our own sales professionals. This event is a great way to kick off the year, and I can assure you, the team is fired up.

We are in a very large addressable market, with high single digit market share. We have significant runway ahead of us, and we have been continuously optimizing the team across all functions in the Company, for deep bench strength, to ensure we can seamlessly scale with unprecedented growth rates.

I was very pleased to announce the next step for us in that regard at our sales kickoff, with Dave Peranich, joining the team as EVP of Worldwide Sales, and Mark Anderson being promoted to President. Dave, who will be reporting to Mark, will focus exclusively on sales and channels, while Mark will retain ownership of sales, lead our go-to-market strategy as well as customer support and business development. I'm very pleased with these appointments, and look forward to working with Mark and Dave for a long time to come. Congratulations to you both, and welcome to the team, Dave.

As we look forward, we have confidence that we are the leading beneficiary of the move to real platforms, and we are anticipating another exciting year of high growth for the Company. With that, I'll turn the call over to Steffan.

Thank you Mark, and thank you all for joining us. Before I start, I'd like to note except for revenue and billings figures, all financial figures are non-GAAP, unless stated otherwise.

As it's the end of the fiscal year, I'll be covering more material than a standard quarterly call. This includes Q4 and FY16 financial results and key metrics, a discussion on the model and related mix assumptions, and I'll conclude with guidance and modeling points.

I'll start with the results. For both the quarter and the year, we delivered industry-leading top line growth at scale, and increased profitability. Our platform and our unique hybrid SaaS financial model provide a combination that translates into sustainable growth, and structural leverage, both now and in the future.

Turning to the numbers, in Q4, total revenue grew 41% year over year to a new record of $400.8 million. For the fiscal year, we reported total revenue of $1.4 billion, a 49% increase over the prior year. The geographic mix of revenue for Q4 was 72% Americas, 17% EMEA, and 11% APAC. Compared to the prior year, both the Americas and EMEA each grew 41% and APAC grew 42%.

Q4 product revenue of $191.1 million increased 24% year over year, and growth was healthy across our product portfolio. Recurring services revenue of $209.7 million increased 61% over the prior year, and accounted for a 52% share of total revenue. SaaS-based subscription revenue of $106.5 million increased 66%, while support and maintenance revenue of $103.2 million increased 57%.

Q4 billings were $572.4 million, up 45% year over year. For FY16, billings were $1.9 billion, up 56% year over year, product billings were $670.1 million, up 35%, and accounted for 35% of total billings. Support billings were $579.6 million, up 70%. Subscription billings were $655.9 million, up 72%. Support and subscription billings accounted for 65% of total billings in FY16, compared to 59% in FY15.

Total deferred revenue was $1.2 billion, an increase of 74% year over year and 16% sequentially. Short-term deferred revenue of $703.9 million increased $280 million year over year, and accounted for 57% share of total deferred revenue. Long-term deferred revenue of $536.9 million increased $247.1 million year over year and accounted for a 43% share of total deferred revenue.

On a semiannual basis, we update a number of metrics, which give insight into the drivers of top line performance. In Q4, customer adoption of our eight subscription services continued to be strong. The attach rate of the four attached subscription services increased to 2.6 subscriptions per device sold in the quarter, up from 2.3 in Q2, and 2.2 in Q4 of FY15. Of note, these services are being attached to higher price devices, which has consistently been increasing the dollar value of transactions over time. And finally, renewal rates for subscriptions and support continue to be high, at greater than 90% and approximately 100% respectively.

With the top line details covered, I'll now turn to margins. Our Q4 gross margin was 79.4%, an increase of 110 basis points compared to last year, and 150 basis points sequentially. The year-over-year increase was driven by improvements in recurring services gross margins.

Total Q4 operating expenses were $245.7 million, or 61.3% of revenue. Operating margin was 18.1% in Q4, representing a 400 basis point increase year over year, and 100 basis points sequentially. The year-over-year improvement was primarily comprised of gross margin improvement of 110 basis points, and sales and marketing margin improvement of 210 basis points. For the full FY16, operating margin was 17.3%, representing a 440 basis point increase year over year.

Net income for the quarter was $46.2 million or $0.50 per diluted share using 91.7 million shares, compared with net income of $25 million or $0.28 per diluted share in Q4 2015. For FY16, we reported net income of $152.6 million or $1.67 per diluted share, compared with net income of $75.2 million or $0.86 per diluted share in FY15.

On a GAAP basis for the fourth quarter, net loss was $54.5 million or $0.61 per basic and diluted share. This compares with a Q4 2015 GAAP net loss of $46 million or $0.55 per basic and diluted share. For FY16, we reported a GAAP net loss of $225.9 million or $2.59 per basic and diluted share, compared to a GAAP net loss of $165 million or $2.02 per basic and diluted share in FY15.

Turning to cash flows and balance sheet items. On a GAAP basis in Q4, cash flow from operations was $187.5 million, up 68% year-over-year. Free cash flow was $171.2 million, up 72% year over year, and free cash flow margin was 42.7%.

We finished July with cash, cash equivalents and investments of $1.9 billion. DSOs were 69 days, an increase of one day on a sequential basis and 11 days compared to Q4 last year, reflecting a strong July, and an increased mix shift towards subscriptions and support.

With the Q4 and fiscal year recap complete, I'd like to provide some insights into the continued evolution of our hybrid SaaS model, and the mix shift in the business. In the execution of our model, we're driving a shift towards more products being delivered as SaaS-like services, resulting in more recurring revenue. This is a natural outcome of selling all elements of the platform, and is beneficial from a financial standpoint, because it makes us more strategic and sticky with customers, is higher margin business, provides increasing visibility into future revenue streams, and drives sustainably high free cash flow generation.

As customers commit to our platform, a natural outcome is increased scope and duration of contracts. In Q4, duration for new contracts both on a quantity and dollar-weighted basis were 2.1 and 2.7 years respectively. Of note, when we look at our Top 25 customers, we can see that all of them have made multi-year purchases, and all of them continue to make many and frequent additional purchases during and after these multi-year commitments.

This behavior is unlike traditional SaaS models, and is consistent across our customer base. The result is that the lifetime value of each customer cohort continues to increase significantly.

And also unlike traditional SaaS models, we bill and collect the cash for deals up front instead of annually, which is driving high deferred revenue growth and strong free cash flow. Over the past three years, our short-term deferred revenue has grown more than 60% year over year, and long term deferred revenue has grown more than 70% year over year. This of course provides us with increasing visibility into our high growth expectations on future revenue.

I'd now like to move to an update on the deferred commissions project, guidance and modeling points. As discussed at analyst day, we've been working on a project that allows us to better match commission expense to our ratable revenue. Starting in Q1, we plan to move from our historical approach of expensing all commissions during the period in which the related revenue contract was booked, to the accounting policy used by many other companies, where commissions related to ratable revenues are amortized over the term of the revenue contract.

With our business evolving to more of a recurring revenue model, this method provides a much better match between revenue and expenses on the income statement. Guidance provided this afternoon reflects this anticipated change of accounting policy. It's important to note that the contribution of this change is not linear over the year, and that the vast majority occurs in the second half of the fiscal year when accelerated commission payments are in effect.

Accordingly we anticipate the change will have less than $0.01 contribution to fiscal Q1 non-GAAP EPS, and approximately $0.25 contribution to full year non-GAAP EPS. And for reference purposes, if the anticipated change had been in effect for FY16, the estimated incremental contribution to non-GAAP EPS would have been approximately $0.12 to $0.15 in Q4 and $0.19 to $0.23 for the full year. And the corresponding operating margin would have been 22.6% to 23.6% in Q4, and 19.3% to 19.8% for the year.

Now, turning to guidance. For fiscal Q1 of 2017, we expect revenue to be in the range of $396 million to $402 million, which represents 33% to 35% growth year over year, and we expect non-GAAP EPS to be in the range of $0.51 to $0.53 per share, using 92 million to 94 million shares.

While we don't provide annual guidance, and will not be updating this information in the future, in order to assist in modeling the deferred commissions plan impact for the fiscal year, we want to provide a one-time, full year view on non-GAAP EPS. Using current FY17 consensus of $1.827 billion for revenue, our outlook for the full year non-GAAP EPS is expected to be in the range of $2.75 to $2.80 per share, using 94 million to 96 million shares. This range includes the benefit of at least 100 basis points of organic non-GAAP operating margin improvement, and approximately 150 to 200 basis points from the deferred commissions change.

Before I conclude, I'd like to provide a number of modeling points. First, it's important to note as a percentage of total revenue in FY17, we expect that recurring services revenue will be approximately 60%, and product revenue will be approximately 40%. We expect total recurring services revenue to grow at least 50% year over year, with about $700 million of short-term deferred revenue coming from the balance sheet as of July 31. This represents approximately 65% of total recurring services revenue for the year.

We expect year-over-year annual product revenue growth of approximately 12% to 13% in the full year 2017, taking into account the challenging year-over-year comparables, particularly in the first half. We expect product revenue to grow sequentially from fiscal Q1 through the remainder of the year, and we would expect the lowest year-over-year growth in Q2, and the highest year-over-year growth in Q4. Additionally, we expect higher product revenue growth rates in FY18, given lower comparables relative to FY17.

We are planning for DSOs to be in the range of 70 to 80 days for the year, as the mix of business shifts towards more subscriptions and support. The effective non-GAAP tax rate for FY17 will be 31%.

CapEx for FY17 is expected to be in the range of $160 million to $170 million for the year, taking into account the one-time $100 million investment associated with the construction of our new headquarters. Normalizing for this one-time event, CapEx would be in the range of $60 million to $70 million for the year, and we expect total CapEx will be more heavily weighted toward Q2 and Q3, with approximately 60% of capital expenses falling in these two quarters. Excluding the one-time $100 million CapEx investment in our headquarters, free cash flow margin is expected to be at least 40% for the fiscal year. Including the CapEx for the new headquarters building, free cash flow margin is expected to be in the range of 35% to 40%.

And finally, I'd like to note that our Board of Directors has recently authorized a stock repurchase for $500 million, effective through August 31, 2018. With that, I'll turn the call back over to the Operator for Q&A.

(Operator Instructions)

At this time we'll take our first question from Keith Weiss with Morgan Stanley.

Thank you for taking the question. Mark, you talked about a better macro environment this quarter versus what you've seen in prior quarters. I was wondering if you could expand a little bit on that? And then in terms of the guidance into next year, when we think about a low to mid-teens product revenue growth, should we think about that as a unit volume growth expectation for the overall business that's made up with ASPs, or how should we think about that type of growth rate in terms of garnering incremental share within the broader market opportunity?

Yes, Keith, thanks. So the first question, on the macro side, as we said last quarter, and I think we saw this broadly across the whole technology industry, there was fairly negative sentiment out there, and we saw that improve in Q4. We're very happy to see and hope that would expect into the future. We had mentioned a couple soft spots last quarter as well, one being Australia, we saw very good performance there in the fourth quarter, (technical difficulty) and the team was able to do a great job for us there, and we see increasingly nice revenue growth rates in APAC as a result.

On the product revenue side, when I think about what's happening in the industry with the paradigm shift, I'm really looking at the growth of the platform, right? So we are attempting sell the entire platform. I think when you look at the success of that, and total top line revenue growth of the Company, we are outpacing everybody in the industry by very wide margins, and that's true in every aspect of the platform, including the product portion of it, as well. We're coming off some pretty tough comps through FY17 compared to FY16 but we still expect we would outpace all the players in the industry by a wide margin in product, as well as for the total platform.

Got it so from a competitive standpoint, no change in your view on competitive positioning, versus some of the incumbents?

No, not at all. I think there, we're doing very well competitively, and doing better and better as time goes on. It's pretty evident, I think, as you look at the results that customers are really rallying around the idea of a platform, for the reasons I mentioned on the call there. This is evolutionary in nature, but it's picking up steam. They're really fed up with the cost expense, complexity of point products and legacy technology, and I think the platform concept, a real platform is resonating very well with them. When you look across the board at some of the statistics that I noted and Steffan noted about the growth in not only in the hardware side of the business, but the attached and non-attached subscription services, they're all growing at very high rates.

Just also to add to that Keith, is this was the highest new addition of customer logos in the quarter that we've had. Which demonstrates that we are taking market share in a meaningful way. And the other point I'd like to make is, we're able to monetize our customer base and platform much better than the competition, and if you look at any metric on a revenue per customer basis, and you stack us up against any of the competitors out there, we are multiples ahead of them, which demonstrate the fact that the customer base wants the entire platform, both the hardware and the eight attached -- or the eight subscriptions that we sell, the four attached and four non-attached.

We'll move along to Brent Thill with UBS.

Good afternoon. Steffan, just on the bottom line, you posted 440 basis points this year, and you're guiding to 100 organic for next year. Just given the recurring subscription, which seems like it's going to come at a pretty high margin, why such a delta this year from what you put up this year, versus how you're thinking about FY17 on organic basis?

Well, we're running the play book that we've been running for a long time now, and we updated it at our analyst day, we have a growth and profitability framework, where, when we're in high-growth mode, where revenues are growing greater than 30%, we are focused on growing that top line but also increasing operating margin. And what we committed was we would be in the 100 to 200 basis point range of annual operating margin improvement, which is exactly what we're calling for with our guide, and then we have the incremental benefit from the deferred commissions project, which gives us another 150 to 200 BPs on top of that. But this is the play book we're running, and we have, call it, high single digit market share in what will be a $22 billion TAM, and the platform is resonating so well with customers, we are not trying to stretch for profitability at this point.

The other point I'll make is, operating margin is a lagging indicator of the business. People need to be looking at free cash flow as an indicator of profitability in addition to operating margin, and we're looking at posting free cash flow margins of greater than 40% on an adjusted basis for the fiscal year, and that goes back to the power of the model. And I don't know of many other companies who are able to post that type of top line growth and those types of free cash flow growth and margin structure.

Okay, and real quick for Mark, just on the transition to Dave as the new Head of Sales, clearly Mark is still there, so it's not necessarily a traditional sales change that we've seen. But there is also some that are nervous any time a change like this goes down. Can you just walk through the hand off, and in terms of the transition here, and how you see that going?

Yes, sure, it's completely understandable, Brent, as well. So as we've grown the business and we're running at a pretty big scale right now, or as you can see from the billings side of well over $2 billion and growing very quickly, we have to keep trying to invest in advance everywhere in the Company to maintain seamless growth. And we've been doing that for a long time from a people process and business perspective, and we're going to keep doing that into the future.

At this size, we thought it would be very good for us to have a great professional who has been around the block a number of times, to pay attention exclusively to sales and channels, working with Mark in that regard, who has done a great job for us for the last four years, and has built up a great rapport with the customers, and the team as well. We also wanted to give more focus and capacity, capabilities to Mark for some very important things that we need to do in the future, like driving relationship with strategic systems integrators, he's going to take on the bulk of the strategic relationships with our cloud partners and business development as well, so we can get more focus and capacity in those areas, which are going to be important for us to grow in the future. And of course, benefit of that as well as that gives me some more focus and capacity to work on the most strategic things in the Company, so I would just look at this as a continued increase in focus and capacity, and we're really glad to have Dave on the team.

We'll now move to Saket Kalia with Barclays.

Thanks for taking my questions. First, maybe just to start off, very nice to see the capital return, with the share repurchase authorization. Mark we haven't historically seen share repurchase from Palo Alto, so maybe touch on why the change in direction? And more importantly to the extent you can comment, is this something that you think could be done a little bit more regularly?

Good question. So we look at our business model and where we are as a size of the Company today. We've got a great model with the platform, Steffan mentioned it has very high free cash flow generation, we expect that to continue in the future, so we benefited a lot from that, we have about a $1.9 billion in cash, primarily onshore. We're throwing off very high numbers from a free cash flow perspective, and we're going to keep doing that into the future as people adopt the platform.

So with all that in mind, we talk about use of cash regularly at the Board, as you'd want us to, and expect us to do. There's always three objectives in that, right? One is to make sure we can invest well into the business, which we're doing, and you can see we've put a lot of money into the business appropriately, to continue to get market share at these rates.

We also want to make sure we have appropriate amounts of cash that we could action any M&A that we might find interesting at any given time. We certainly have the capability to do that. And then also if possible opportunistically, to return some cash to the shareholders, we could take that into account as well. So at this size or the cash flow generation, we think we can accomplish all these objectives.

Got it, very helpful. And then for my follow-up, for you Steffan, just on the accounting change, and you touched a little bit on this earlier, but as we go beyond 2017, and as you hopefully continue to be in high growth mode, should we normalize the 100 to 200 BPs of expansion that we talked about at analyst day, or does the accounting change maybe adjust that range with that given growth rate, if that makes sense?

We feel committed to the ranges we talked about at analyst day, and so when you look at what we are delivering for FY17, we're a little bit above that stated range, because of the impact of deferred commissions. Post FY17, because of the amortization, you're going to have some of the FY17 expense hitting in FY18, et cetera. So we're still committed to the 100 to 200 BPs post FY17, provided we're in high growth mode. When we -- at some point in the future, as the model indicates, we'll start delivering more operating margin expansion, if and when revenue growth moderates a bit. But we remain confident that we're going to be in high growth mode for years to come, and we have a framework that we're running the business to, and we want to be very transparent with investors on both the organic improvement and the improvement from the deferred commissions change.

Sterling Auty with JPMorgan has the next question.

You talked about the improved macro in the quarter. Can you talk a little bit about what you saw in terms of linearity in the quarter, relative to what you saw in the third quarter?

Sterling, we had a strong July. We would expect that, when everybody is into their accelerators in the fourth quarter, so not unusual to be the case. We did say in the third quarter, we saw a more loaded third month in that quarter, I think that was really sentiment related, but really nothing unusual from a fourth quarter perspective.

Okay, so maybe a bounce back to what you normally see in the quarter? And then just a follow-up, in terms of looking to FY17, what changes have you made around either sell structure, quotas, et cetera, to think about driving some of the subscriptions, especially the standalone stuff like Traps?

Sterling, I'm going to hand it over to our new President, Mark Anderson.

Sterling, how are you?

Good.

Yes, so really not a ton of changes. I think we've got a really good solid play book, that drives really good productivity across the board. We expect to continue to run that. We did a lot of segmentation last year, by bringing in a new service provider organization, and adding a commercial tier to our Enterprise go to market. Both of those are tracking well ahead of plan, and feel really good about stabilizing FY17 and beyond with this organizational structure, that can really scale for years, I think.

Next question?

Next question will be from Walter Pritchard with Citi.

You gave us some color on the Aperture and AutoFocus revenue run rate. I'm wondering on this if you can give us any update around Traps, or any just view as to how you're thinking how the unattached billings performed in FY16 and how you look at them performing into FY17? The unattached subscription.

Yes, great question. They're all doing very well. We put out some slide materials as well, which I'm not sure if you're able to reference, or if you have them Walter or not, but if you get a chance, you can take a look at them. One of the slides that we dropped in there is really showing the customer adoption rates of all of the services, so that's slide 12 in the deck, if you're looking at it.

So we're trying to show a number of things. One is, you can see where the services were introduced from availability perspective, right? And you'd see historically over time, after we've done introduction of a service over the years, it has grown very nicely from a customer adoption perspective, and it certainly looks like the newer services are tracking in that regard.

I mentioned Aperture and AutoFocus have about 100 customers, at the year after launch, and that's growing very nicely. Traps, we're well over 500 customers now, I think for sure we hit an inflection point in that business in the second half of FY16. We're hearing very good feedback from customers and partners on that now and we expect it to be a major player in that business, and on VM Series it's growing very well too. We have over 1700 customers in VM Series and it continues to grow at high rates.

One of the interesting things about the VM Series as well is we took what we did in business and I mentioned some of the magnitude on that and looked at that in FY16, product wise it's not product revenue of course. It is subscription services revenue but that would add a few more points of product revenue in FY16. And then finally, I gave this on the call in the script, but we're running Traps business and VM Series business, each of them are multiple mid eight figures right now, growing at triple digits. So we're very happy with the progress of all of the unattached services, and we would expect that to keep growing over time.

Great, thank you.

At this time, we'll take a question from Gabriela Borges with Goldman Sachs.

Thanks so much for taking the question. Maybe just a little bit of follow-up on the commentary on product revenue growth rates, if you don't mind. In particular on the comment that FY18 product revenue could accelerate a little bit, I understand the dynamic here with tough comps and easier comparisons, but if you could just give us a little bit of color on how you are thinking about industry growth rates normalizing over that time frame?

Yes, sure when we look at the nature of the industry, if you took like a 10 year view, particularly in the follow on market, it's cyclical in nature, and with various ups and downs over time. But regardless of the cyclical nature, and you look at our performance over that period of time, we continue to significantly outperform the market on all aspects of the platform, including the hardware portion of that, as well. We're looking at FY17 over FY16, we've got some pretty tough comps, as you can see, particularly in first half.

We do expect to grow the product revenue sequentially every quarter after Q1, as we said, and we also believe the we've got the benefit of our own internal refresh, which is good and increasing over time, and when you look at a cohort analysis of the number of customers in the cohorts, almost 29,000 of the 34,000 customers are after 2012. So it's a very significant uptick post the 2012 cohort as well, and we expect to see that continue to add steam towards the back half of the year and into FY18 and beyond.

And in putting things in context, our guidance indicates that we're running a $0.75 billion product revenue business in FY17, which is by far and away the largest from a product revenue standpoint, versus the competition. And the other thing is, we are driving a platform sale. So product is an important component, but it's not the only component. We've been driving the business, and you're seeing the impact of recurring revenue coming into the mix in a meaningful way. So it is a platform approach and we're calling for high growth mode for this year, so the product is one component of the analysis.

That's very helpful color, and as a follow-up if I could, maybe just on the platform approach and the capital allocation, an update on how you're thinking about M&A and what criteria you're screening for, as you think about building that platform, and engaging with customers more deeply over the longer term? Thank you.

Sure, that's a great question. We're very convinced that the platforming is the winning strategy, it's been the case for years now. And our view of the platform is that it's very important that the capabilities are doing a number of things. One is that they are actually doing something from a security perspective to try find and stop an attack, somewhere in its life cycle.

The second thing is that they're as native to each other, and what I mean by that is they actually work very closely together, so that you can get a high degree of automation. And from that, you can get leverage when you add a new customer in there, right? So every single customer helps every other customer. So that's really the simplest definition of a platform.

And it is way more possible to get that outcome, when things are actually under your control, and you have built them yourselves. We -- our motion here is to get into a more than $2 billion run rate in billings, it's been primarily to do those things ourselves, because we get all three of those very important points from a platform perspective, right?

Now that doesn't mean there can't be M&A in the future. It's possible, we've done a few deals like that, we would action that, if we thought it was important from a platform perspective, and we put something seamlessly into the platform, if it met all those definitions into the future.

But customers really know the difference. They know the difference when you're trying to smash things together that you purchased in the market, and try to call it a platform, or pseudo platform. They don't like the fact that those things don't really get integrated and they have to be the integrator of those technologies over time. They are really just rebelling against that. So the native concept of the platform, we think, is very important, and our primary motion would be to make things ourselves, when we can.

We'll now move to Rob Owens with Pacific Crest.

Great, and thanks for taking my question. With regard to Traps, you mentioned the inflection that you've seen in the back half of FY16. What do you think is driving that? Is it broader market acceptance of the technology, was it the last rev, just the market maturation overall?

Yes, Rob, it's a good question. It's a mix of all those things, but if I had to weight them, I would say that primarily, we're getting better and better and better at this. So we've got some competitive advantages here on Traps, in and of itself, like every one of the capabilities in the platform. Our bar we use for that is it has to be as good if not better than any best of breed capability, and we're definitely doing that with every release of making it the best possible end point protection you can get, and AV replacement, right, and 3.4, which we just released, is a major step forward to this being a head-on AV replacement, right?

The second thing is we want to make sure we leverage those best of breed capabilities from an end point perspective into the network itself, so a unique competitive advantage we have here is that they are very tied into, for lack of a better term, the networks, so the network and the endpoints are learning from each other, and actually being able to do prevention with each other in a highly automated fashion. And the third point is the very native integration into WildFire, so we get the leverage from a threat intelligence perspective, both at the end points and to the networks.

Customers really understand that, and when they're comparing them to either a legacy solution that really isn't working, and they know it, they are choosing Palo Alto more often than not. And when they compare us to the multitude of next gen endpoint providers in the market, those providers really can't stand up to the platform, the power of the platform, and we're seeing that, like I said in the second half of FY16, the team did a fantastic job of growing the customer base, growing the bookings on that, and I expect that will continue in the future.

Great, and then second, some of your competitors started discounting and frankly discounting maintenance in this quarter, as things have become more competitive. So curious what you're seeing, either in terms of what customers are asking for, or a rational competitive behavior out there? Thanks.

It always been a very competitive market that we live in, and I expect that's going to continue, and maybe even heat up as we go into the future. I mentioned in my prepared remarks that if you are a legacy firewall vendor, they are getting down to the last cards you can play. Increasingly, one of those is price. If you're a point provider, that's maybe the only card you could play at this point. So we're definitely seeing very aggressive behavior in the market.

Nonetheless, we continue to win at very high rates, you can see from our gross margins, they continue to be very good. We're able to sell value, we are not intentionally, we're not selling on price, we're selling on value. And we expect we'll be able to continue that into the future, but people were getting desperate out there.

We'll move to Pierre Ferragu with Bernstein.

I have actually a question on like the color you provided on guidance. You started by making reference to where consensus expectations are at the moment, so am I right thinking you have beat your earnings guidance, based on that revenue number of $1.8 billion or so? And then if that's the case, my question would simply be how do you feel about that number? What would be your own perspective on what revenue you can achieve in 2017? Is it a stretch, or like an easy mark? That would be very helpful.

Yes, great question. So, as you know, we don't provide annual guidance, right? We would not be doing that in the future, but we want to be as helpful as we possibly can from a modeling perspective here. And with the impact of the deferred commissions, it has a good positive contribution to EPS on a full year basis, but it lags itself in over the full year, right? So we really want to make sure we could be helpful on the models on thinking about what the impact would be over the year, so that's why we wanted to give a one-time full year view on what the EPS range could look like. And of course, if you're talking about EPS and you don't have revenue in mind, that's not very helpful as well, so we just anchored that into current consensus, which we're comfortable with, and that's why we did that.

Then I have a quick follow-up which is an on the product revenue gross number you gave. Is that like in the same picture, so is that like backing off from this $1.8 billion consensus revenue number, your revenue growth in products would be 12% to 13%, or is that something on which you have better visibility, and it's more of a statement this is what you expect for next year, just on product revenues?

We considered in the commentary to give some guidance on the EPS related to the current consensus on revenue, what we talked about from a product revenue perspective of the 12% to 13% growth rate.

We'll now move to Karl Keirstead with Deutsche Bank.

I've got two related questions about the product revs. Maybe I'll start with Steffan. Not to be too short-term here, but it looks like you're guiding to something below 12% to 13% product revs growth for the October quarter. You mentioned it would be lowest in Q1 and increase thereafter.

What is it about October that might result in a slowdown in product revs growth from 24% this past quarter to 12% to 13%, because it doesn't appear as if the comp gets that much more difficult. So is there anything else happening, that's causing that? And secondly for you, that's giving you confidence that in January, that trend can increase?

And then for Mark, I've got a related question. This mix shift away from product to subscription and recurring is not just a Palo Alto Networks phenomenon. We're hearing it across the industry, and it's really picked up in the last six months or so, and I'm wondering if you could give us some perspectives, given your client conversations, as to what fundamentally is driving that shift? Thank you very much.

So on the first one Karl, in the prepared remarks, I had mentioned that actually the January quarter, not the October quarter, was going to have the lowest year-over-year growth from a product standpoint, and that's because Q2 of last year, we posted our highest year-over-year product revenue growth in that quarter, at close to 47% year over year, a year ago. So it is largely due to the comp. We're looking at growing revenue sequentially after Q1. And the other thing is, when we look at our pipeline view for the first half and the full fiscal year, we see pipeline very strong, comps get easier in Q3 and Q4, and we look to accelerating product revenue growth in the back half of the year, and into FY18.

Karl, the second point, I think you're spot on for sure. The whole industry is talking about what we're talking about here, and that's because of this paradigm shift that I mentioned, and not to give ourselves too much credit, I think we're the main driver of that over time. We created the concept of a real platform, we're subsuming services into that platform at a rapid rate and very seamlessly. And I think if you're a point provider in the market today, and your capabilities are going away from a hardware perspective, one direction to go is to try turn them into services, which people are trying to do, but at the same time, you're facing those things just being subsumed into the platform.

And if you're a legacy firewall vendor, you don't have a real platform, of course you're all coming up with the services, as far as I can tell. I don't have all of the details, it looks like a lot of those folks are trying to bundle them in for free, as a way to maintain the firewall position. But if they are not used, they aren't very useful.

In our case, we know that people are using them, they're paying us full boat for those things, they're renewing them at very high rate, which is great, and they're buying them at very rapid rates. We can see that across the board from a purchasing perspective. Steffan mentioned that, in our prepared remarks, in our Top 25 customers on lifetime value, and I don't know if you have those charts, but if you get a chance, check out number 17, which really is the view that you've seen for some time on lifetime value.

But we went back and took a look at customers with multi-year purchases as well, because multi-year purchases mean they're committing to Palo Alto Networks, and more and more capabilities, and for longer periods of time. But also people were a little worried about if we're making multi-year purchases are they gone? And what's happening from buying perspective.

And slide 17 there, even if people are making multi-year purchases, they are making frequent purchases inside that multi-year period, excluding renewals. So they are continuing to come back and adopt more and more of that platform. And if we look out over our top 1000 customers, and look at all of those who have made a multi-year purchase just to expand this view for a second, they made a multi-year purchase, over 90% of them has made a subsequent purchase after they made a multi-year purchase.

So anyway sorry, I'm going on at length here, but this whole paradigm shift you're seeing, and you noted in the entire industry, is very important, and there's definitely a move into more of these capabilities being delivered in services. And like I said, not to give ourselves too much pat on the back here, I think we actually invented that, and we're disproportionately benefiting from it.

We have time for one more question. This will be from Michael Turits with Raymond James.

Granted the tough comps on product and also mix shift, but is there anything inherent in the market, even if we think of it on a unit basis, in terms of the amount of let's call it boxes to be sold, that would be slowing that growth rate now, in terms of penetration, or greater [competition]? It's still quite a significant decel.

Yes, Michael, no. I don't think so. I think we're looking at the overall numbers that we're driving, if we start with that for a second, just what's happening from wins in the market. We're always going to start with and try to drive the total revenue rates on the platform. So you can see we're very committed to continued high growth in this, and that includes the product component. And like I said to the earlier question, to the extent that there's cyclical natures in product purchases over time, we have outperformed that very handily, in any of those environments as well. But mostly we're just dealing with tough comps here as we look at FY17 to FY16.

And also Steffan, you had talked about still being on plan for the 100 BPs of organic expansion on plan of 100 to 200, but that's still at the low end of that range. So why this year are we at the low end of that range?

Because the market opportunity is so great. We have single digit market share in a $22 billion market, we're posting top line growth that's far in excess of all of the competition. There's no reason to stretch to maximize operating margin in the near term to slow down the revenue growth. We've been driving from the date of the IPO to balanced growth and profitability. We've been growing way faster than the rate of the market, and we've been expanding operating margins. So our plan is to continue to do that on a go-forward basis, we're committed to that, and we look forward to continuing to take market share and increase profitability.

I think that's all the time we have, so I'd like to thank everybody for being on the call this afternoon. Just to reiterate, FY16 was a very good year for us, and I want to once again thank the Palo Alto Networks team and our partners for all their hard work and their support, particularly our customers as well for the trust they continue to put in us. As we look ahead, we're more convinced than ever of our ability to continue to take market share and distance ourselves from the competition. We look forward to updating you on that progress on the next call. Thanks, everybody.

Again, that does conclude today's conference call. Thank you all for your participation.