Palo Alto Networks, Inc. — Form 10-Q Summary
Reporting period: First quarter of fiscal 2017, the three months ended October 31, 2016. Comparisons are with the three months ended October 31, 2015, unless stated otherwise. Amounts are in U.S. dollars; financial statement amounts are in millions except per-share data.
Business context and performance
Palo Alto Networks provides network, endpoint, and cloud security products and services. It reported more than 35,500 end-customers in over 150 countries. Its hybrid model combines appliance product sales with subscriptions and support, which are generally recognized over one-to-five-year contract terms.
Revenue rose 34.0% to $398.1 million. Subscription and support grew faster than product revenue and increased to 58.9% of total revenue, from 50.3% a year earlier. Management attributed growth to demand from new and existing customers, including demand for higher-end appliances and subscription offerings.
Financial results and liquidity
| Metric | Q1 FY2017 | Q1 FY2016 | Change or context |
|---|---|---|---|
| Total revenue | $398.1 | $297.2 | Up 34.0% |
| Product revenue | $163.8 | $147.7 | Up 10.9% |
| Subscription and support revenue | $234.3 | $149.5 | Up 56.7% |
| Gross profit / gross margin | $296.8 / 74.6% | $218.0 / 73.3% | Margin improved 1.3 percentage points |
| Operating expenses | $346.7 | $250.0 | Up 38.7% |
| Operating loss / margin | $(49.9) / (12.5)% | $(32.0) / (10.8)% | Loss and margin worsened |
| Net loss / diluted loss per share | $(61.8) / $(0.69) | $(39.9) / $(0.47) | Loss increased |
| Billings | $516.9 | $388.0 | Up 33.2% |
| Operating cash flow | $203.3 | $146.7 | Up $56.6 |
| Non-GAAP free cash flow | $182.4 | $127.2 | Operating cash flow less capital purchases |
Product gross margin was 74.2%, compared with 73.8%; subscription and support gross margin was 74.8%, compared with 72.9%. Management cited product cost reductions and a higher-margin subscription mix. Research and development, sales and marketing, and general and administrative expenses all increased, principally reflecting personnel and headcount growth. Sales and marketing expense was $220.3 million, or 55.3% of revenue.
Cash, cash equivalents, and investments totaled $2.098 billion at October 31, 2016, versus $1.938 billion at July 31, 2016. Cash and cash equivalents were $839.4 million; investments were $1.259 billion. Operating cash generation included an $118.8 million increase in deferred revenue. Cash used in investing was $71.2 million, mainly reflecting net investment purchases; financing used $27.1 million, including $50.0 million of share repurchases.
Total deferred revenue was $1.360 billion, up from $1.241 billion at July 31, 2016. Working capital was $465.0 million, down from $927.2 million, primarily in the context of the convertible notes being classified as current liabilities in October.
The company had $575.0 million principal amount of 0.0% convertible senior notes due 2019, with a net carrying amount of $506.2 million. Because the stock-price conversion condition was met for the quarter, holders could convert during the quarter ending January 31, 2017; the notes were consequently reclassified as current. The notes’ estimated fair value was $851.0 million. The company reported $2.1 billion of cash and investments and stated it believed operating cash flow and existing cash would meet anticipated needs for the foreseeable future.
Material changes and unusual items
- Accounting policy: Effective August 1, 2016, the company retrospectively changed its accounting for incremental, directly related sales commissions on non-cancelable contracts. It now defers and amortizes commissions over the related contract term in proportion to recognized revenue. The cumulative effect at August 1, 2015 was $71.8 million. The change increased Q1 FY2017 reported sales and marketing expense by $2.6 million and net loss by $3.4 million; comparable-period figures were also adjusted. It did not change cash flows.
- Share-based compensation: Expense was $114.2 million, up from $72.9 million. Unrecognized compensation cost was $1.0 billion, expected to be recognized over a weighted-average 2.7 years.
- Share repurchases: The board authorized a $500.0 million program in August 2016. The company repurchased 0.3 million shares for $50.0 million; $450.0 million remained authorized at quarter-end.
- Tax: The $8.4 million income tax provision resulted in a negative effective tax rate of 15.7%, as the company recorded tax expense despite a consolidated loss. Management cited foreign and other taxes, non-deductible share-based compensation, and valuation allowance changes.
- Legal matters: The company reported ordinary-course litigation, including intellectual property matters, but no significant loss accrual and no unfavorable outcome it considered probable or reasonably possible and estimable at quarter-end.
Outlook, commentary, and risks
The filing provides no specific numerical forward guidance. Management expected operating expenses to rise in absolute dollars as it invests in research and development, sales and marketing, and infrastructure, while expecting expenses to decline as a percentage of revenue over the long term as the business scales. It also expects subscription and support revenue to vary quarterly and increase over the long term with new offerings, renewals, and customer-base growth. Management cautioned that revenue and margins may fluctuate with seasonality and other factors.
Key risks highlighted include the need to manage rapid growth; intense competition and pricing pressure; dependence on subscription renewals and channel partners; concentration among distributors (two accounted for 57.0% of quarterly revenue, while three accounted for 64.8% of gross receivables); reliance on third-party and sole-source manufacturing and components; product defects or security incidents; quarter-end sales timing; foreign-exchange exposure; and uncertainty in global economic and political conditions. The company had $63.9 million of non-cancelable contract-manufacturer purchase commitments and $511.7 million of net future operating lease obligations. It had entered into $63.8 million notional foreign-currency forward contracts to hedge euro-denominated expenditures.
Management reported effective disclosure controls as of October 31, 2016, with no material change in internal control over financial reporting identified during the quarter. It stated that market-risk exposures had not changed materially since July 31, 2016.
Important facts for investors to verify
- Whether subscription and support growth, renewals, and deferred revenue continue to support billings and cash generation.
- Whether operating expense growth and substantial share-based compensation allow progress toward improved operating margins and GAAP profitability.
- The status and potential cash or dilution effects of the notes’ conversion eligibility, related note hedges, and warrants.
- Whether distributor concentration, customer receivables, manufacturing commitments, and supply-chain dependencies change materially.
- How the retrospective commission accounting change affects comparisons with earlier reported periods, and whether future accounting standards alter reported results.
- Execution of the $500.0 million repurchase authorization and its effect on liquidity and share count.
- Developments in litigation, tax matters, cybersecurity, and other disclosed contingencies; the filing does not provide a clear estimated loss value for litigation.