Palo Alto Networks, Inc. — Q2 FY2015 Form 10-Q
Reporting period: Quarter and six months ended January 31, 2015. The company sells enterprise cybersecurity products and recurring subscription and support services. Financial amounts below are in U.S. dollars; statements are unaudited.
Financial performance and liquidity
| Metric | Q2 FY2015 | Year-over-year change |
|---|---|---|
| Revenue | $217.7 million | +54.3% |
| Product revenue | $115.6 million | +43.1% |
| Services revenue | $102.0 million | +69.4% |
| Gross margin | 72.7% | Down 0.7 percentage point |
| Operating loss | $38.5 million | Compared with $37.2 million loss |
| Net loss | $43.0 million; $0.53 per share | Compared with $39.9 million; $0.55 per share |
For the six months, revenue was $410.0 million (+52.3%), gross margin was 72.5% (down 1.0 percentage point), operating loss was $62.3 million, and net loss was $73.1 million ($0.91 per share). Operating expenses rose 39.9% in Q2, including substantial increases in research and development and sales and marketing. Share-based compensation was $95.4 million for the first six months.
Q2 services revenue included $50.1 million of subscriptions (+73.8%) and $52.0 million of support and maintenance (+65.3%). Management attributed growth to demand for its firewall products and services, new and existing customers, and expansion of sales capacity. The company reported more than 22,500 end-customers in over 130 countries.
At January 31, cash, cash equivalents, and investments totaled $1.139 billion, versus $974.4 million at July 31, 2014; working capital was $446.4 million. Cash and equivalents were $343.0 million, with $796.0 million in investments. For the six months, operating cash flow was $151.8 million and non-GAAP free cash flow was $139.7 million. Investing activities used $487.4 million, primarily reflecting investment purchases; cash decreased by $310.8 million.
Total deferred revenue was $535.8 million, up from $422.6 million at July 31, 2014. Non-GAAP billings were $282.8 million in Q2 (+51.5%) and $523.3 million for the six months (+51.8%). The company reported a $575.0 million principal amount of 0.0% convertible senior notes due 2019; their balance-sheet carrying amount, net of discount, was $476.9 million. Management said the notes were not convertible as of January 31, 2015.
Material changes and unusual items
- Q2 services revenue grew faster than product revenue, increasing services’ share of total revenue to 46.9% from 42.7% a year earlier. Gross margin nevertheless edged lower, primarily reflecting amortization of intellectual-property licenses and purchased intangibles.
- Operating loss widened in dollars despite higher revenue, as research and development, sales and marketing, and general and administrative expenses increased. The prior-year comparable quarter included a $20.0 million Fortinet legal settlement charge; there was no such charge in Q2 FY2015.
- Interest expense rose to $5.5 million in Q2 and $11.0 million for the six months, chiefly from non-cash amortization of the convertible notes’ debt discount and issuance costs.
- A December 2014 corporate reorganization resulted in a deferred tax charge; the filing says the charge will be amortized over approximately six years. Q2 also included a $12.8 million tax payment related to an intercompany transfer of intellectual property.
- The company had $38.9 million of open contract-manufacturer purchase orders. Operating lease commitments totaled $107.7 million gross, partly offset by $9.7 million of expected sublease proceeds.
Outlook, commentary, and risks
Management said existing cash, investments, and operating cash flow should meet anticipated needs for the foreseeable future. It expects operating expenses to rise in absolute dollars as it invests in products, personnel, sales, and international operations, while aiming for expenses to decline as a percentage of revenue over the longer term. No specific numeric revenue or earnings guidance is provided in this filing.
Management expected Traps billings to begin ramping in the second half of FY2015, with a more meaningful revenue contribution in FY2016. The company cautioned that this new offering may not gain market acceptance. It also expects services revenue to grow over the long term with subscriptions, renewals, and the installed customer base, while noting that actual results may vary and profitability is not assured.
Key disclosed risks include intense competition; dependence on channel partners and third-party manufacturers; customer renewal and demand uncertainty; rapid growth and the ability to scale systems and operations; product defects or security failures; and exposure to international, tax, and litigation matters. Three channel partners represented 70% of revenue for the six-month period, while two represented 66% of gross accounts receivable at January 31. The company reported no accrual for ordinary-course legal proceedings and did not determine an unfavorable outcome to be probable or reasonably possible. Disclosure controls were assessed as effective at a reasonable-assurance level.
Important facts for investors to verify
- Whether rapid revenue, services, and deferred-revenue growth continues, and whether renewal rates and billings support future recognized revenue.
- Whether spending growth and substantial share-based compensation can be managed while narrowing operating losses and sustaining margins.
- Customer, revenue, and receivables concentration among channel partners, and the resilience of the channel and manufacturing supply chain.
- The timing and market adoption of Traps, and the extent to which it contributes to billings and revenue as management anticipated.
- Cash generation and liquidity after investment activity, including the potential cash or dilution effects of the $575.0 million convertible notes and associated warrants.
- The tax and accounting effects of the corporate reorganization, deferred tax charge, and unrecognized tax benefits; and any material developments in legal contingencies.