Palo Alto Networks Inc (PANW) 0 Q0 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the fourth-quarter and fiscal year 2012 Palo Alto Networks Incorporated earnings conference call.

My name is Chris, and I will be your conference moderator for today.

Presently, all participants are in a listen-only mode.

Later, we will facilitate a question-and-answer session.

(Operator Instructions)

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

And at this time, I would now like to turn the conference over to your presenter for today, Ms. Maria Riley, Investor Relations with the Blueshirt Group.

You may proceed.

Thank you.

Good afternoon, and thank you all for joining us on today's conference call to discuss Palo Alto Networks' fiscal fourth quarter 2012 results.

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

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

After the market closed today, Palo Alto Networks issued a press release announcing the results for its fiscal fourth quarter and year ended July 31, 2012.

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

We would like to remind you that during the course of this conference call, Palo Alto Networks' management will make forward-looking statements, including statements regarding our ability to sell additional products and services to existing customers; our ability to extend our leadership position in next-generation network security and increase our market share; trends in connection with the duration of service agreements; plans regarding our short- and long-term target operating model, including targets for gross margins, operating income, research and development, sales and marketing, and general administrative expenses, and our long-term effective tax rate; expectations regarding our growth rate relative to the growth rates in our other markets and growth rates of other market participants; our effective tax rate for fiscal 2013; and our revenue and non-GAAP earnings per share for the first quarter of fiscal 2013 ending October 31, 2012.

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 final prospectus filed with the SEC on July 20, 2012, as well as 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 investor section of our website located at investors.paloaltonetworks.com and in our earnings press release.

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

Mark?

Thank you, Maria, and thank you all for joining us for our first earnings conference call as a public company.

I'm delighted to be here today to share with you our achievements in our fiscal fourth quarter and fiscal 2012.

Fiscal 2012 was a very exciting year for Palo Alto Networks.

We significantly expanded our customer base; were named a leader in enterprise firewalls by Gartner; released multiple new offerings to the market; continued to attract the world's best and brightest in network security to our team; successfully completed our IPO; and achieved impressive financial performance on both the top and bottom lines.

We also had a very successful fiscal fourth quarter, adding Mark Anderson as our new head of worldwide field operations; opening our new offices in Sao Paulo, Brazil, and Mexico City; earning NSS Labs' recommendation in their Next-Generation Firewall Group Test; expanded our technology partner program with Avaya for data center solutions, as well as with MobileIron and Zenprise for mobility solutions; and achieving the ICSA certification for our appliances.

We're very proud of all that we accomplished this past quarter and this past year, and I'd like to thank all the team members at Palo Alto Networks for their hard work and results.

I'll turn now to some highlights in our financial results.

We had a strong fiscal fourth quarter and fiscal 2012.

In our fiscal fourth quarter, we generated record revenue of approximately $76 million, which represents 88% year-over-year growth and approximately 15% sequential growth, and we delivered non-GAAP EPS of $0.03 per diluted share.

For fiscal 2012, we increased revenue by 115% year-over-year to $255 million, as we continued to demonstrate that we are rapidly growing share in a very large addressable market.

And in fiscal 2012, we generated approximately $18 million in non-GAAP operating income, which is a $24 million increase year-over-year.

Our technology differentiation continues to drive our customer growth.

During the fiscal fourth quarter, we added over 1,000 new end customers, bringing our customer count to over 9,000.

This is the third consecutive quarter in which we added over 1,000 customers.

These new customers were across all verticals and geographies as we continue to focus on our land, expand, and extend strategy to drive results and fuel our growth.

For example, in the fourth quarter, we replaced two of our major competitors with our PA-5000 series to become the primary firewall for a major European utility.

Additionally, we became the primary firewall for one of the leading US universities, replacing a different competitor, also with our PA-5000 series.

And for this customer, we also provided them with our real-time threat prevention engine and comprehensive URL filtering services.

We also expanded our relationship with a Fortune 100 global manufacturer based in the US.

At this customer, we won the primary perimeter firewall business eight quarters ago and this quarter, we expanded our presence to the data center, as well as to multiple additional sites.

And on the extend side, one of the leading consulting companies in the world bought us as a URL filtering solution about five quarters ago.

And in the fiscal fourth quarter, we expanded our presence as the customer deployed us as their global primary firewall, replacing one of the largest incumbent security firewall providers.

These examples illustrate that the lifetime value of our customer base continues to grow and provide future opportunity.

These deepening relationships result in our customers deploying Palo Alto Networks as their strategic network security vendor and is testament to our innovative and disruptive technology, which is transforming the enterprise network security space.

Security is a long-term growth industry, because of the ever-increasing and rapidly changing threat environment, which is in part due to the surge in applications used across corporate networks from macro technology trends like mobility, SaaS, cloud computing, and the consumerization of IT.

While these trends and associated applications can drive productivity, they can also greatly increase the threat landscape for enterprises due to the legacy network security technology's inability to safely enable the use of those applications.

Until the advent of Palo Alto Networks' next generation of network security, companies were forced to either allow the use of these applications and suffer the security consequences or block the applications and suffer the productivity consequences.

By using our technology, customers are not forced to make that tradeoff, and as a result, we are at the confluence of major technology trends that make our offerings timely, relevant, defensible, and highly differentiated.

This is unlike legacy stateful inspection firewall technology, which simply can't keep up with today's changing environment.

We're also uniquely positioned with a platform that addresses all enterprise network security requirements.

This allows us to address the entire enterprise network security market, which is over $10 billion annually and growing.

We believe that our competitive lead continues to grow with each new product introduction.

Palo Alto Networks has transformed network security, and customers all around the world are recognizing the benefits of our solution to solve their pressing network security needs.

As we look forward, we'll continue to be aggressive in maintaining our technology advantage, increasing our market share, and ensuring the highest levels of customer satisfaction.

We operate in a very large market and believe we can continue to capture market share with increasing leverage in the business over the next few years.

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

Steffan?

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

I'd like to mention that unless specifically noted otherwise, we're discussing all numbers except revenue on a non-GAAP basis, which excludes share-based compensation expense, and where relevant, its related tax effects.

In Q4 '12, total revenue grew to a record $75.6 million, an increase of 88% year-over-year, and 15% sequentially.

For fiscal 2012, we reported record revenue of $255.1 million, a 115% increase over the prior year.

In Q4 '12, product revenue of $49.4 million grew 70% year-over-year, and approximately 14% sequentially, driven by sales of our series of appliances.

Services revenue of $26.2 million increased 135% year-over-year and 18% sequentially.

Services revenue, which is comprised of both subscription and support, accounted for 34.6% of total revenue, an increase of 80 points sequentially and 690 basis points year-over-year.

This is in line with our expectations and underscores the power of our hybrid revenue model, as it provides enhanced visibility.

The geographic mix of revenue was 66% Americas, 21% EMEA, and 13% APAC, with all theaters posting growth on a year-over-year and sequential basis.

Total non-GAAP gross margin in Q4 '12 was 71.9%, a 10 basis point decrease year-over-year and flat sequentially.

A mix of higher-margin appliances contributed to Q4 '12 non-GAAP product gross margin reaching 74.8%, up 150 basis points year-over-year, and up 120 basis points sequentially.

Our non-GAAP services gross margin was 66.6%, compared to 68.6% in the prior quarter, and 68.4% in the same period a year ago, reflecting our continued investment in our support organization.

We'll continue to see fluctuations in both product and services gross margins due to product mix and investments we're making to support continued strong new-customer acquisition.

Moving on to operating expenses, we continue to invest in product development and expanding our sales and marketing organization.

Q4 '12 non-GAAP research and development expense was $10.2 million, an increase of $1.2 million from the prior quarter, primarily related to program spend and headcount additions.

As a percentage of revenue, non-GAAP R&D expense was 13.5%, a decrease of 20 basis points sequentially.

Q4 '12 non-GAAP sales and marketing expense was $35.5 million, an increase of $6.2 million from the prior quarter.

And as a percentage of revenue, it was 46.9%, an increase of 230 basis points sequentially, primarily due to headcount and related expenses as we expand our footprint, as well as end-of-year accelerators.

Q4 '12 non-GAAP G&A expense was $6.4 million, an increase of $1.2 million from the prior quarter, primarily due to the increased cost of being public.

As a percentage of revenue, it was 8.4%, an increase of 60 basis points sequentially.

In total, Q4 '12 non-GAAP operating expenses were $52.1 million, or 68.9% of revenue.

Q4 '12 non-GAAP operating margin was 3.1%, up 1,420 basis points year-over-year, and as planned, down 270 basis points sequentially.

Given the market opportunity and our traction, we intend to continue to invest in our sales and marketing, support, and R&D organizations, while also demonstrating progress toward our target model.

For fiscal 2012, we reported total non-GAAP operating expenses of $167.5 million, or 65.7% of revenue, and non-GAAP operating margin of 7%.

Our tax provision for the quarter was approximately $0.3 million, consisting of federal and state income taxes in the United States and income taxes in foreign jurisdictions in which we conduct business.

For fiscal 2012, our tax provision was approximately $2.1 million, and our non-GAAP effective tax rate was 12.4%.

In fiscal 2013, we expect a non-GAAP effective tax rate of 34% to 39%, depending on our global pretax profit mix, and excluding any potential discrete items, such as the removal of our domestic valuation allowance.

In Q4 '12, we began the first steps of implementing our corporate international structure to more closely align with the international nature of our business activities, which we expect will improve our annual effective tax rate over the long term.

Non-GAAP net income for Q4 '12 was approximately $1.9 million, or $0.03 per diluted share, using 35.5 million shares.

This compares to non-GAAP net income of $4.7 million, or $0.07 per diluted share in fiscal Q3 '12, and non-GAAP net loss of $5.1 million, or $0.34 per basic and diluted share in fiscal Q4 '11.

For fiscal 2012, we reported non-GAAP net income of $14.7 million, or $0.14 per diluted share, compared with a net loss of $7.8 million, or $0.55 per basic and diluted share in fiscal 2011.

On a GAAP basis for Q4 '12, net loss was $4.6 million, or $0.18 per basic and diluted share.

For fiscal 2012, we reported GAAP net income of $0.7 million, or $0.00 per basic and diluted share.

Now before I discuss our balance sheet, I'd like to review our target operating model that we expect to achieve in approximately three to four years.

On a non-GAAP basis, we anticipate gross margin to be in the 70% to 73% range.

As a percentage of revenue, we anticipate non-GAAP R&D to be 13% to 15%, sales and marketing 30% to 33%, and G&A 5% to 6%.

We anticipate this will lead to a non-GAAP operating income margin in the range of 22% to 25%.

Turning to the balance sheet, we finished July with cash and cash equivalents of $323 million, which includes $215 million in net proceeds from our initial public offering.

In fiscal year 2012, cash flow from operations was $77 million.

Free cash flow was $63 million, and free cash flow margin was approximately 25%.

Cash flows benefit from our hybrid revenue model, in which we bill for our services at the beginning of the engagement, and we collect the cash shortly thereafter.

We ended Q4 with $45.6 million of accounts receivable, up from the Q3 '12 balance of $38.8 million.

Average days sales outstanding were 50 days, at the lower end of our target range of 50 to 55 days.

Moving down the balance sheet, our hybrid revenue model helped increase total deferred revenue to $135.8 million or an increase of 102% year-over-year and 16% sequentially.

Short-term deferred revenue of $86.3 million increased 15% sequentially.

The majority of our service engagements are on an annual basis, but we are seeing an uptick in multi-year deals.

Let me now turn to our Q1 '13 guidance.

We expect for revenue to be in the range of $80 million to $84 million and non-GAAP EPS to be approximately $0.03 per share using 80 million to 82 million shares on a diluted basis.

Year-over-year, this represents revenue growth of 40% to 47% when compared to a very strong comp in Q1 2012, which was up 42% sequentially due to the timing of certain large orders.

On a bottom-line basis, the change in share count and in taxes will impact EPS in the first quarter by about $0.01 a share when compared to the immediately preceding quarter.

With that, I'll turn the call back over to Mark.

Thanks, Steffan.

In summary, we had a very strong quarter to close a very exciting year for Palo Alto Networks.

Revenue grew significantly, both on a quarter-over-quarter and year-over-year basis as we continue to outpace the market.

With that, Steffan and I would be happy to take any questions you may have.

So operator, I'll turn it over to you.

Thank you.

(Operator Instructions)

Keith Weiss, Morgan Stanley.

Excellent.

Very nice quarter, guys.

And thank you for taking the question.

When looking at the revenue by geo, it looks like Europe slowed down more so than the other geographies.

Any rising macro impact that you're seeing from that region, or any color you could give us on the apparent slowdown in Europe?

Hi, Keith, it's Mark.

Big-picture-wise, when we look across the globe, the first thing we think about is the fact of what segment we serve, which is security, which is something that's becoming less and less of a discretionary spend and more important for folks to buy.

So we think there's general headwind or a general uplift just because of the segment we serve.

When you start to look on a geographic basis, in EMEA, which is how we think about it.

Europe's a subcomponent of that.

We had good year-over-year sequential growth, and we had quarter-over-quarter sequential growth.

It's modest, but we are growing there.

Also, it's off a relatively small base.

The business, when we think about Europe itself, between Northern and Southern Europe, a lot of the problems we hear are in Southern Europe.

If we take all that into the mix, we think that Europe is still a growth sector for the business.

We like the fact that it grew quarter-over-quarter.

We like the fact that it grew year-over-year, and we think we can significantly outpace the market over there.

Got it.

And then a follow-up would be understanding that the October quarter is a really difficult comp and abnormal growth -- not abnormal, much higher growth rate you saw in October '11 than you saw in the rest of the year.

Can you give us some kind of idea either what we should be thinking about in terms of revenue growth for the full year?

Or maybe give us an idea about seasonality and what would be a more normal seasonality to expect off of that $80 million to $84 million guide that you gave us for Q1?

Yes, sure.

I'll take the first part and hand it off to Steffan for the second part.

Big picture, we're not providing a full-year guide.

We're giving out a quarter in advance on the guidance side.

And if you think about the point that you raised, which is if you look at the comp to last year, we like the fact we think we've got healthy guidance here in the range of 6% to 11%.

But you've got to look back a year ago on a quarter where we had a 42% quarter-over-quarter increase.

It's probably the most difficult comp we're ever going to have on this, so we have to take that into account.

Do you want to take the second part of that?

As far as you look at overall trajectory for the year, while we're not providing guidance for the full year, we expect to continue to grow market share, and as evidenced by the number of new customers that we've added, and we anticipate to continue to add new customers to the funnel.

We're not providing quarterly guidance, but if by definition it's market share gain, that's what we're looking at doing for the balance of the year.

Greg Dunham, Goldman Sachs.

Yes, thanks for taking my question.

The first question I have, switching gears, Mark Anderson obviously just joined and is leading the field operations today.

How should that impact the business, and what have you kind of learned thus far in him joining the team?

Hi, Greg.

Thanks for joining us.

A couple things.

First is that we can create a new organization with Mark coming on board, which was field operations.

So we combined for the first time sales and customer support.

The reason we did that was we're really trying to get a holistic view of the customer, plus just a great experience for the customer from the time we're selling something to them all the way through to their continued support.

And that feeds back into the sales cycle as well, because of the expand and extend.

If they're having a great experience with us, then they tend to buy more.

They tend to buy more faster.

So the first thing is Mark, with his experience of being able to run the combined organization like that, and having that viewpoint.

The second thing, with Mark's background from F5, he took that company as the head of sales from about $250 million to well over $1 billion in sales and revenue.

We have a very analogous sort of trajectory here at the Company.

So we want to make sure we have somebody who's been to that play before.

And all the indications in his first 90 days here of working with the team are that he's bringing a lot of that experience and discipline to the table.

I guess a follow-up would be -- or two quick follow-ups.

You again headed north of -- excuse me, 1,000 customers, and my expectation would be that the momentum in the business within the install base is continuing to pick up.

How has the mix of business from new customers versus existing evolved?

And how should we think about new customer adds as we go forward?

It's a great question.

So we haven't broken out the business that's coming from the new customers versus the expand customers, but basically there's a good balance between the two.

The way we think about things, it's a lifetime value of the customer.

We think that's most important, and we're trying to grow that through the land, expand, and extend.

So the land is our funnel.

We expand and extend.

That grows the lifetime value of the customer.

Both of those are doing very well for us.

It's our third quarter in a row where we've added over 1,000 customers in a quarter, so that's the land aspect of it.

And when you look at the LTV aspect, which is the expand and extend, when we were out on the road, we said on average the customer purchases three times their initial purchase.

The top 25 purchases eight times their initial purchase.

Those numbers continue to grow for us, so the model's working on -- it's firing on both those cylinders.

Joel [Fishbein], Lazard.

Good quarter, guys.

Thanks for taking my question.

First, on the support side of the organization, you guys have scaled massively, bringing on new customers.

Can you talk about what you guys are doing to scale the support operation to handle the service levels for your customers?

That's a great question, Joel.

When we think about our customer support organization, we have a first customer principle, which makes very clear to us that we are giving the best level of customer service we can.

We've added over 3,000 customers in the last nine months.

The types of investments we're making are in the area of personnel, of systems, and for also global depots, which are being deployed in order to provide real-time exchanges in product when necessary and making sure that we are as close to the customer as we can be.

We pride ourselves on differentiating our customer support versus the competition.

Great.

And just as a follow-up, in terms of lead times, how have the lead times changed over the past, call it, couple of quarters to the customers?

That would be great.

Lead times have been stable.

We have a standard, call it, two week lead time once we receive an order, and that's been stable.

Okay.

Walter Pritchard, Citi.

Couple questions.

Steffan, on revenue and the billings calculation, it looks like your deferred all year has grown faster than it did a year ago on an absolute basis.

Ending the fourth quarter, it looks like it was even to actually a little less growth than you saw a (technical difficulty).

And that results in billings.

It looked like it slowed from over 100% or around 100% each -- for in the first three to around 56 or 57.

And I'm just wondering how should we think about what's driving that trend and how should we think about that trend going forward?

I think it's most important to note that we are primarily a book-and-ship business.

We have a component of our revenues that are SaaS-based, which is our subscription revenue, which provides enhanced visibility and which is why you saw services as a percentage of total revenue increase to 34.6%.

When you think about trending, deferred revenue, given the subscription element, should be increasing, because that's -- it's booked up front, but it's recognized ratably.

We have customer support and maintenance that gets booked up front and recognized ratably.

The billings metric is not a metric that we actually track internally.

It's something that you use the industry standard convention around current-quarter revenue plus change in deferred, you get to about $95 million in booking -- in billings, I should say.

That's something that is an output of math.

It's not something that we track internally.

We do see that deferred revenue should be increasing, and billings will be whatever the billings are.

And then on the product line, any update?

I know the PA-200's been out now for two or three quarters.

Any update on how that product's doing, and any thoughts of actually introducing a product that's below that in terms of price point?

It's selling very well, Walter.

We came out with a very high-end, very low-end.

Both of those are doing nicely.

You can see in our product gross margins the impact of the higher-end product sales.

Product margins doing very nicely.

And when we think about serving the enterprise, you always think about all the way from the big data centers all the way down to the branch office.

The 200's filled a very nice market need for us there.

And we think about whether to bring out something lower than that, and we'll take that into consideration based on the customer input.

Okay.

Thank you.

Phil Winslow, Credit Suisse.

Hi, thanks, guys.

Wanted to get a sense for what you're seeing in terms of average deal size right now?

And then also, in terms of the maintenance and then also the subscription, attach and renewal rates, curious what trends you're seeing there as well?

Thanks.

On an average deal size basis, like we said earlier, we tend to look at lifetime value as more important than that.

So we just use rough-and-ready math.

From a deal-size perspective, if you took all the total revenue in the Company since its inception, it's about $440 million, and 9,000 customers, you can get to the average deal size.

We don't think that tells us a heck of a lot, because some of our very largest customers started off with very small purchases and have grown into multi-million dollar customers.

But that's a way to look at it, and that increases over time, or has been increasing over time.

And then on the attach ratio, we break that into two categories.

Services for us are the subscription services, and also the maintenance services.

The maintenance services are close to 100%, as you can imagine on that.

And the attach rates for the subscription services really depend on the use case and then how long the service has been out.

So the two services with the highest attach rate are threat prevention and URL filtering.

They've been out the longest and very defined use cases, and usually, when we sell a product, we're getting one to two attaches of services to it.

Great.

Thanks, guys.

Congrats.

Jeff Kvaal, Barclays.

Thanks, Mark, Steffan.

I was wondering would you mind telling us a little bit more about what happened in the quarter last year at this time that drove the sequential increase?

That might help us if we could think about what maybe a more normalized quarter last year would be.

That way, we could think more about what seasonality might be through the balance of the year.

Certainly.

In Q1 of last year, on a sequential basis, revenues grew $17 million, or 42% quarter-on-quarter.

And that was due in large part to timing of some certain large orders and contribution from the federal government business.

The growth rate was very steep, obviously, 42% sequentially, and that set a new baseline for the Company from which to grow.

This quarter, we factored in a number of things in terms of calculating what we think is an appropriate level from a revenue range, from a guidance standpoint.

We factored a number of things into that calculation, and we feel comfortable that a 6% to 11% sequential increase, or 40% to 47% year-over-year increase, will continue to establish us as the clear market-share gainer as we look at taking more market share away from the competition.

Would it be too much, Steffan, to read into your statements that after we get through this quarter that the year-over-year growth rates would go up again in, say, the January quarter?

That's a good question.

We're not providing guidance more than one quarter out.

But as I said in an earlier statement, our goal is to continue to take market share.

And if you look at both the product and services growth rates, when you compare Palo Alto Networks to the competitive landscape, we're growing much faster than the competition on both a quarter-quarter and year-over-year basis.

Okay.

Would you consider breaking out the services and software revenue from your services all-in bucket line item?

Not at this point.

As a subscription, I meant.

Not at this point.

As a reminder, our services line is comprised of subscriptions and maintenance.

And they're both ratable in nature, and we're not breaking them out.

Okay.

Then finally, could you talk about what you've seen in the competitive landscape?

I think Cisco has perhaps just recently launched the next generation of firewall.

Have you seen that in the market yet?

No, we haven't, Jeff.

So I think the thing I'm most familiar with that Cisco announced was probably what you're talking about, the last RSA Conference last year, which was sort of a blade concept to enable some application blocking.

We don't consider that next-generation firewall technology, because it can't safely enable applications.

But that's all we've seen.

Okay.

So as far as you're concerned, everything is steady.

I think Cisco has a new ASA CX box out there, but we'll take it offline.

Okay.

Thank you.

Brent Thill, UBS.

Thanks.

Mark, you've had strong momentum in the government businesses.

Was just curious if you could give us all an update from what you're seeing, especially as we go into obviously an important time in the US, and what you're seeing globally?

And had one quick follow-up for Steffan.

Sure.

So the government -- public sector, and particularly the federal government on the DoD side of things, has been a strong vertical for us.

No vertical at all represents more than about 13% of our overall business, so we're spread out pretty nicely, but that's been a good one and a growing one for us.

If you think about what we do for a living and what they do for a living, it seems like a great combination, and we see that in our results.

Okay.

And Steffan, you mentioned an uptick in multi-year deals.

Can you give us a sense of what you're seeing and what percent of those deals are now going into the multi-year bucket?

It's a great question.

The vast majority is still annual, but the guidance or the color commentary that we gave in the prepared remarks, was we are seeing multi-year deals being typically three-year deals, and at times, while it's on the margin, five-year deals, that may come into the mix.

But you can look at the short-term deferred revenue, and that's still -- it's a good proxy for the split between short- and long-term.

So we're seeing an uptick.

The majority is still annual.

Michael Turits, Raymond James.

Hi, guys.

A little bit more on the competitive side.

You mentioned about Cisco, but other major competitors, whether they include Juniper or Check Point, any change in the competitive dynamic?

Any catching up that either of those competitors could possibly be doing that would make it any tougher for you to close displacements?

Hi, Michael.

It's Mark.

No, we just haven't seen that in the market.

I know there's a lot of stepped-up marketing going on.

But as from a technology perspective, we haven't seen any new releases or introductions by anybody that indicates they're closing the gap.

And I think you can see from the number of new customer we're adding, I think the market would agree with that.

Okay.

And then housekeeping, can you tell us where your ending headcount was and a little bit about where you might think you'll be growing headcount in the next year?

And also, what to expect in terms of CapEx for next year?

Certainly.

On the headcount front, we ended at 755 headcount, and that came off of the prior quarter at 690.

Where we're going to be making investments is really tracking to innovation, which is product development.

Our go-to-market organization, and our field operations, we're going to be adding sales and marketing professionals, and then also in product management.

There will be other growth across other parts of the organization as well, but those are the primary ones.

And as far as CapEx is concerned, for the quarter, we spent approximately -- let me just capture it here -- about $3.2 million to $3.3 million in CapEx for Q4 '12.

That's a -- I'll call that normal baseline that you could look at from a modeling standpoint going forward.

And if I could just have a follow-up on that, that headcount is a slower sequential add than you've had previously.

Should that be the new expectation for baseline for sequential headcount add, or was it slower this quarter for some reason?

No, Michael, we were adding about 75 to 100 per quarter.

I think the distinction here is is that's actual FTE.

You have to take the [Putson Shares Plus] folks who accepted offers haven't yet started.

We're using the actual number of chairs, Steffan's, number.

If we take the offers accepted there, it would've been higher.

But if you use like 75 to 100 a quarter, you're going to be in the right ballpark.

Great.

Thanks a lot.

Jayson Noland, Robert Baird.

Great.

Thank you.

Steffan, just to clarify, you're expecting a normal federal flush for F Q1?

Yes, we take into consideration a number of things.

So as you would expect, federal government should be strong for us in fiscal Q1.

And any surprises by vertical on the quarter just completed?

Really no surprises.

Again, we remain very horizontally distributed.

There's no concentration from a vertical standpoint.

So we felt very good about the balanced nature of the revenues.

And anything you guys can say about the managed security service provider market, MSSP, now or in the future as an opportunity?

Yes, it's a good opportunity for us, Jayson.

We're actually been working quite well for quite some time with all the leading providers there.

The way we view that is those folks are going to manage network infrastructures for companies.

We want to make sure that they can manage Palo Alto and the customers we have.

And I think if you go through the list of all the major MSS providers out there, we're working with all of them right now.

Okay.

Thank you.

Jonathan Ho, William Blair.

Good afternoon.

Starting off, can you characterize for us maybe how you think about the pipeline of opportunities this quarter, and maybe what levers could potentially drive upside or some risk to the quarter as you look at the pipeline?

Yes, Jonathan, it's Mark.

From a pipeline perspective, maybe not surprisingly, when we look at that as we've got our targets in mind about what we think we're going to sell for the quarter.

We've got a pipeline coverage ratio that's something X times bigger than that.

That has been working very consistently for the Company for a number of years, about what those numbers actually equate to from a sales perspective.

It is possible for us, if we put more marketing dollars at work, we found that we can drive a bigger pipeline.

The problem with that is just the ability to actually on a high-quality manner go close the deals then.

So we don't want to be -- we certainly don't want to be under on the pipeline coverage, and we don't want to be over on the pipeline coverage, because that tends to be wasted money in the quarter.

We think we've got a pretty good, fine-tuned model here to get the [right] coverage.

Got it.

Relative to prior quarters, some of our discussions have suggested that more and more folks are viewing you as not just an application-control blade or application-control box, but also looking at this as an edge-of-network firewall displacement.

Can you maybe characterize for us whether there's been a shift towards more people buying this as a firewall or what that general trend looks like?

That's a great question.

We know that over half of our installations right now, we're the primary firewall.

And we also know, and we track this fairly closely in salesforce.com [staff] in the field that more than half of our sales right now are sold as a primary firewall.

We know that's happening out in the market and has been happening for quite some time.

On the flip side, when we're not that, if you think of the times when we're not that, that's not bad either, because we're the only provider in the market who can go in as whatever the need is for enterprise network security, whether it's IPS or web gate, but it doesn't really matter.

And historically, we've shown that no matter how you get in the door, we ultimately get the chance and then the high degree of the time become the firewall.

We're very patient on that, and our experience shows it's working.

Great.

Thank you.

Shebly Seyrafi, FBN Securities.

So your sales and marketing percentage of revenue, it has been increasing the last several quarters.

Can you give us an idea where you expect that to go longer term, actually over the next year or so?

You have a long-term target around 30% to 33%, but right now, it's at 47%.

You're investing for growth.

You want to gain share against the competition.

Give us a handle on where you see sales and marketing percent, for example, over the next few quarters?

I'll take that one.

This is Steffan.

It's a good question.

We've given you two effectively, book ends, where we are today and our target model of 30% to 33%.

What you're asking for is the equivalent of us guiding for the next couple of quarters, and we're not going to be providing guidance on that.

But if you were to look at I would say a normal trend where we get to the 30% to 33% over a multi-year period, there's going to be some fluctuations in the next call it 12 to 18 months.

But directionally, that is the key line in our operating expenses that will be providing the most leverage in our business.

We're going to be getting there through increased sales productivity.

The fact that we have close to 800 channel partners who will be becoming more productive.

We have new product introductions coming out.

Our market share goals, et cetera.

The fact that we're growing faster than the market right now, we feel comfortable with sales and marketing being at these levels.

But we will be disciplined in the sense of how we are dividing territories, how we're growing the sales organization, et cetera.

So the directional trend will be down, but there will be some fluctuations in the near term.

Okay.

Also, your product gross margin conversely has been increasing the last several quarters, and now it's almost 75%.

You mentioned before that part of this is due to the mix shift to higher-end boxes.

Do you expect that trend to continue going forward?

Should we think perhaps around 75% as the baseline for your product gross margin?

Product gross margins were strong this quarter.

We were very excited about it.

It's a little too soon to make a judgment call around if this is establishing a new level for the near term.

There will always be product mix depending on our customers' needs.

What we talked about during our IPO road show was a couple quarters ago, we introduced our PA-200 series of appliance, which is for the branch office.

We're going to be coming out with new products as well over the year, so there will be product-mix shifts.

I will also tell you though, that in the face of pretty strong competition, we have not had to go down the discounting route either.

So the product gross margins are a good indication that we are competing on technological value and differentiation.

Okay.

Thank you.

Tal Liani, Bank of America.

Hi, two questions.

You mentioned you have 800 channel partners.

From your numbers, it looks like you've been growing this number substantially.

Can you discuss how much was -- how many channel partners you had a year ago?

And how do you manage the channel conflict and things come with increasing channel partners?

(multiple speakers) So let's start with that.

Then I have one more question.

Yes, so we have a bit over 800 channel partners right now.

We've added close to 200 in the last 18 to 24 months, call it.

And you could expect us to continue to grow at that rate.

That's actually not a lot relative to the world, and then if you look at some of the competitors.

We have a real quality versus quantity view around this.

So we want our channel partners to not only install our products, but provide some value-added services on their own as well, so we're fairly selective who those folks are.

And then we hold them to a very high standard as far as the programs that we're running with them.

And they're performing on them.

I think they're making a good money with us.

From a channel conflict perspective, the best way we do that is we have really rigorous deal registration program.

So we're very careful about somebody who comes in, which deal is whose, and then we protect the partner downstream as well, meaning that it's not just the initial sale, but it's for follow-on sales as well.

If you're working with, you get a chance to make good money for a long-term basis with the customer.

That's why when I say the quantity/quality thing is important, we want to make sure we're working with people who are going to be around for a while, have a good base of training and understanding of our technology and [can get] really high customer satisfaction scores.

You mentioned that you have a target expense ratio for sales and marketing of 30% to 33% long term.

What kind of revenues do you need to have in order to get to this ratio?

Tal, this is Steffan.

How we were looking at that is more time based as opposed to revenue based.

And what we've told folks is three to four years from today we should be able to achieve those targets.

So when you do your modeling, you should take that into consideration.

But are you going to get there through cutting the costs, or you're going to get there through revenue?

So the question is what should we assume that the run rate needs to be in order to get there?

Because I assume you're only going to increase the number of channel partners.

You're not going to reduce them.

Tal, it's a combination, but obviously we're going to be growing revenues over the years, and we are about a 3% market share player right now.

The market is $10 billion plus and growing, and our desire is to continue to gain market share.

So by definition, our top-line revenue will grow.

Our expenses in terms of absolute dollars will grow.

But in terms of percentage of revenue, we'll get leverage from revenue growth and disciplined investing.

Thank you.

Rob Owens, Pacific Crest Securities.

Great.

Thanks, and good afternoon, guys.

Could you talk about linearity in the quarter?

I think DSO is at 60 days if I remember correctly.

Do you typically see better linearity given that the fiscal year shifted one month?

And how did the July quarter shape up?

This is Steffan.

DSOs were 50 days, at the lower end of our target range of 50 to 55.

They did increase sequentially, but they were also down year-over-year.

Linearity in the quarter, we didn't see anything abnormal.

Q4 tends to have -- from a order standpoint, about half the business comes in the last month of the quarter.

That's very typical with companies in our space.

So we didn't see anything really different in terms of linearity.

Great.

And then second, relative to your deferred revenue, is there any deferred product revenue in there?

And can you quantify it?

There is very little product deferred revenue.

We're not by bifurcating it between product and services, but the vast majority is services.

Under 10%, would you say?

Product deferred revenue is under 10%.

Great.

Thank you.

And we have no further questions at this time.

I would now like to turn the call back over to Mr. Mark McLaughlin for any closing remarks.

Great.

Thanks a lot.

We thank you for being on the call with us today.

Want to reiterate my appreciate for all the hard work of the Palo Alto team in support of our customers and partners as we continue to revolutionize the IT security market.

And we look forward to updating you next quarter.

Thanks, everybody.

Ladies and gentlemen, that concludes today's conference.

Thank you so much for your participation.

You may now disconnect.

Have a great day.