Palo Alto Networks, Inc. — Q3 FY2017 Form 10-Q
Reporting period: Fiscal third quarter and nine months ended April 30, 2017; comparisons are with the corresponding prior-year periods. Amounts are in U.S. dollars.
Business context
The company sells cybersecurity appliances and related subscription and support services. At quarter-end it reported more than 39,500 end-customers in over 150 countries. Subscription and support revenue represented 62% of Q3 revenue, reflecting the company’s growing recurring-revenue mix.
Financial performance and liquidity
| Metric | Q3 FY2017 | Q3 FY2016 | Nine months FY2017 | Nine months FY2016 |
|---|---|---|---|---|
| Total revenue | $431.8m | $345.8m | $1,252.5m | $977.7m |
| Gross profit / margin | $308.1m / 71.4% | $250.9m / 72.6% | $914.4m / 73.0% | $709.4m / 72.6% |
| Operating loss | $(49.1)m | $(52.5)m | $(152.5)m | $(134.6)m |
| Net loss | $(60.9)m | $(64.1)m | $(178.4)m | $(161.3)m |
| Net loss per share | $(0.67) | $(0.73) | $(1.97) | $(1.86) |
- Q3 revenue grew 24.9% year over year; nine-month revenue grew 28.1%. Product revenue rose 1.3% in Q3, while subscription and support revenue grew 45.7%.
- Q3 gross margin declined 1.2 percentage points, chiefly reflecting lower margins on newly introduced appliances. Operating loss narrowed in Q3, but increased for the nine-month period.
- Billings were $544.1m in Q3, up 11.9%, and $1,622.6m for nine months, up 21.7%. Deferred revenue was $1,611.8m at April 30, compared with $1,240.8m at July 31, 2016.
- Nine-month operating cash flow was $629.0m versus $471.3m; non-GAAP free cash flow was $514.8m versus $415.1m. The company attributed the cash flow increase primarily to business growth, higher billings, and collections.
- Cash, cash equivalents, and investments totaled $2,091.1m, including $692.0m cash and equivalents. Working capital was $840.5m. Management said existing cash and operating cash flow should meet anticipated needs for the foreseeable future.
- Convertible notes had $575.0m principal, a $518.4m net carrying value, and mature July 1, 2019. They bear 0% stated interest; reported interest expense primarily reflects amortization of debt discount and issuance costs.
Material changes and unusual items
- LightCyber was acquired in February 2017 for $103.1m in cash, adding behavioral analytics technology. The acquisition added $75.3m goodwill and $19.5m identified intangible assets; purchase accounting remained preliminary.
- The company retrospectively changed its sales commission accounting, deferring and amortizing qualifying commissions over the related contract term. Prior-period results were adjusted; the change reduced reported expense and net loss in the periods shown.
- Early adoption of share-based payment guidance affected tax and forfeiture accounting and adjusted certain prior-period figures. Share-based compensation remained substantial, with $913.0m of unrecognized compensation cost expected to be amortized over approximately 2.5 years.
- The board’s repurchase authorization increased to $1.0bn. The company repurchased $295.1m of shares during the nine months, with $704.9m remaining available at April 30.
Outlook, commentary, and risks
- No specific financial guidance for future periods is provided in the filing. Management expects operating expenses to rise in absolute dollars and, over the long term, decline as a percentage of revenue; it also expects research and development and sales and marketing investment to continue.
- Management cited recent execution challenges in elements of its go-to-market strategy and said changes were being implemented; these could cause further disruption or affect results in the second half of FY2017.
- Management expects revenue to vary with seasonality and customer purchasing patterns. Subscription and support revenue is recognized over contract terms, so changes in new or renewed sales may affect reported revenue with a delay.
- Key risks include intense competition, reliance on channel partners and third-party manufacturing, customer renewal and large-enterprise sales execution, product or security defects, and potential supply-chain disruption. Two distributors accounted for 56.5% of nine-month revenue, and four accounted for 78.2% of gross receivables at quarter-end.
- Unrecognized tax benefits were $289.1m, up from $127.7m at July 31, 2016; the increase related to current-year transfer-pricing positions. The filing says ultimate settlement amount and timing cannot be predicted with reasonable certainty.
- Operating lease obligations were $510.0m net of sublease proceeds; manufacturing purchase commitments were $104.3m. The company reported no significant litigation accruals and said no unfavorable outcome was determined probable or reasonably possible and estimable.
Important facts for investors to verify
- Whether billings growth and deferred revenue support sustained subscription and support growth, particularly given Q3 billings growth below revenue growth.
- Whether go-to-market changes address the cited execution challenges and support continued customer acquisition, renewals, and growth.
- How product mix and new appliance costs affect gross margins, and whether operating expense growth moderates relative to revenue.
- The final LightCyber purchase-price allocation and integration progress, plus the impact of the new revenue recognition standard expected to be adopted in FY2019.
- Potential cash requirements from the 2019 notes, share repurchases, leases, and purchase commitments; also monitor tax examinations and transfer-pricing exposures.