Palo Alto Networks, Inc. — Q2 FY2016 Form 10-Q
Reporting period: Quarter and six months ended January 31, 2016. Unaudited results; comparisons are with the corresponding prior-year periods. Amounts are in millions of dollars except per-share data.
Business context
The company sells network-security appliances and related subscription, support, and maintenance services. Its hybrid model combines product sales with recurring services revenue. At period-end, Palo Alto Networks reported more than 30,000 end-customers in over 140 countries.
Key financial results
| Metric | Q2 FY2016 | Q2 FY2015 | Six months FY2016 | Six months FY2015 |
|---|---|---|---|---|
| Revenue | $334.7 | $217.7 | $631.9 | $410.0 |
| Gross profit / margin | $240.5 / 71.9% | $158.3 / 72.7% | $458.5 / 72.6% | $297.2 / 72.5% |
| Operating loss | $(55.3) | $(38.5) | $(86.1) | $(62.3) |
| Net loss | $(62.5) | $(43.0) | $(101.2) | $(73.1) |
| Basic and diluted loss per share | $(0.72) | $(0.53) | $(1.18) | $(0.91) |
| Operating cash flow | Not presented quarterly | Not presented quarterly | $300.5 | $151.8 |
| Free cash flow (non-GAAP) | Not presented quarterly | Not presented quarterly | $263.6 | $139.7 |
- Revenue growth: Q2 revenue rose 53.8%; six-month revenue rose 54.1%. Q2 product revenue increased 46.9% to $169.9, while services revenue rose 61.6% to $164.8. Subscription revenue grew 68.2% to $84.3 and support and maintenance grew 55.1% to $80.5.
- Margins and spending: Q2 gross margin declined 0.8 percentage points year over year, as services margin fell 1.7 points amid customer-support headcount growth; product margin was flat. Operating expenses rose 50.3% in Q2 to $295.8, led by sales and marketing and R&D investment. Operating margin improved to (16.5)% from (17.7)% as revenue grew faster than operating expenses.
- Billings and deferred revenue: Q2 billings, a non-GAAP measure, were $459.0 versus $282.8; six-month billings were $847.0 versus $523.3. Total deferred revenue was $928.8 at January 31, up from $713.7 at July 31, 2015.
- Cash generation: Six-month operating cash flow increased by $148.7 year over year, with growth in sales and deferred revenue contributing. Free cash flow is defined by the company as operating cash flow less purchases of property, equipment, and other assets.
- Liquidity: Cash, cash equivalents, and investments totaled $1,595.7, compared with $1,327.8 at July 31, 2015. Working capital was $120.7, versus $41.8. Management said existing cash and operating cash flow should cover anticipated needs for the foreseeable future.
- Debt: The company had $575.0 principal amount of 0.0% convertible notes due 2019, with a net carrying amount of $497.5. The notes were classified as current because holders could convert during the quarter ending April 30, 2016 under the stock-price conversion condition. The notes have no financial covenants. Cash settlement upon conversion may be required for principal; conversion terms also permit cash and/or shares for any excess value.
- Share-based compensation: Expense was $174.8 for the six months, versus $95.4 a year earlier, including $154.4 in operating expenses. A further $924.1 of unrecognized compensation cost was expected to be recognized over approximately three years.
Material changes and management commentary
- Growth was driven by demand for higher-end appliances and increased sales of services to new and existing customers. Management cited expansion of sales teams and channel partners, particularly internationally, and expects recurring services revenue to benefit from a larger installed base.
- Headcount increased to 3,343 from 2,083 a year earlier. Management expects operating expenses to rise in absolute dollars as it invests in product development, sales, support, and infrastructure, while stating that expenses should decline as a percentage of revenue over the long term.
- The company’s $39.0 of purchase commitments for components and products and $503.5 of gross operating lease payments are significant commitments. Net operating lease obligations, after expected sublease proceeds, were $496.9. A new Santa Clara office lease carries approximately $101.2 of rent over its initial term.
Outlook, risks, and contingencies
- The filing provides no specific numerical revenue or earnings guidance. Forward-looking statements are subject to risks, and management cautioned that actual results may vary materially.
- Key risks include sustaining rapid growth and scaling systems and controls; intense competition and pricing pressure; customer renewal and service demand; reliance on channel partners and third-party manufacturing; supply-chain constraints; product defects or security incidents; and dependence on hiring and retaining employees.
- Revenue and receivables were concentrated: two channel partners represented 59.5% of six-month revenue and 58.9% of gross accounts receivable at period-end.
- Convertible-note conversion or repurchase obligations could require substantial cash. The notes’ if-converted value exceeded principal by $278.7 at January 31, 2016; the company’s note hedges are intended to mitigate potential dilution, while warrants may dilute shares if the stock price exceeds their strike price.
- The company reported ordinary-course legal proceedings, including intellectual-property matters, but recorded no significant loss-contingency accrual and said it had not determined an unfavorable outcome was probable or reasonably possible, or that a loss range was estimable.
- Approximately $42.2 of uncertain tax-position liabilities were recorded. The company maintains a full valuation allowance for domestic deferred tax assets; foreign tax losses, non-deductible share-based compensation, and valuation-allowance changes affect its tax rate.
- Management reported effective disclosure controls as of January 31, 2016, with no identified material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether revenue, billings, deferred revenue, customer renewals, and services growth continue at comparable rates.
- Whether gross margins hold up as support costs and headcount expand, and whether operating losses narrow as the business scales.
- How much operating cash flow reflects sustainable business performance versus deferred-revenue timing and non-cash share-based compensation.
- The timing and cash or share impact of potential convertible-note conversions, including the note hedges and warrants.
- Exposure to the two largest channel partners, manufacturing and component suppliers, and the company’s substantial lease and purchase commitments.
- Whether the $924.1 of unrecognized share-based compensation and associated dilution materially affect future expenses and per-share results.