Palo Alto Networks, Inc. — Q3 FY2016 Form 10-Q
Reporting period: Quarter and nine months ended April 30, 2016. Amounts are in millions of dollars, except per-share data and percentages. The company provides next-generation network security products and recurring subscription and support services.
Financial performance and liquidity
| Metric | Q3 FY2016 | Q3 FY2015 | Nine months FY2016 | Nine months FY2015 |
|---|---|---|---|---|
| Revenue | $345.8 | $234.2 | $977.7 | $644.2 |
| Revenue growth, year over year | 47.7% | 55.4% | 51.8% | 53.4% |
| Gross profit / margin | $250.9 / 72.6% | $169.8 / 72.5% | $709.4 / 72.6% | $467.0 / 72.5% |
| Operating loss / margin | $(58.6) / (16.9)% | $(36.7) / (15.7)% | $(144.7) / (14.8)% | $(99.0) / (15.4)% |
| Net loss | $(70.2) | $(45.9) | $(171.4) | $(119.0) |
| Net loss per share, diluted | $(0.80) | $(0.56) | $(1.98) | $(1.47) |
- Revenue mix: Q3 product revenue was $162.1, up 33.4%; services revenue was $183.7, up 63.0%. Subscription revenue rose 68.9% to $92.6 and support and maintenance rose 57.4% to $91.1. Services represented 53.1% of quarterly revenue, versus 48.1% a year earlier.
- Cash generation: Nine-month operating cash flow was $470.6, versus $239.0; non-GAAP free cash flow was $414.4, versus $217.1. The company ended April 30 with $550.0 cash and equivalents and $1,220.4 investments, totaling $1,770.4. Operating cash flow benefited from a $355.5 increase in deferred revenue and included $283.2 of share-based compensation.
- Deferred revenue and billings: Total deferred revenue rose to $1,069.2 from $713.7 at July 31, 2015. Q3 billings, a non-GAAP measure, were $486.2 versus $302.2; nine-month billings were $1,333.2 versus $825.5.
- Balance sheet and debt: Working capital was $207.2. The $575.0 principal amount of 0.0% convertible notes due 2019 had a net carrying amount of $502.8 and was classified as current. Holders could convert during the quarter ending July 31, 2016; conversion requires cash equal to principal, with any excess payable in cash and/or shares at the company’s election.
- Share-based compensation: Nine-month expense was approximately $283.3, compared with $155.6 a year earlier. The company reported $879.0 of unrecognized compensation cost expected to be recognized over about three years.
Material changes and management commentary
- Revenue growth remained strong but decelerated from the prior-year comparable rates. Management attributed product growth mainly to demand for higher-end appliances and service growth to subscription adoption and high renewal rates.
- Gross margin was essentially stable. Product gross margin improved, attributed to material cost reductions; services gross margin declined slightly, which management linked to customer-support headcount growth.
- Operating expenses grew substantially, especially sales and marketing and research and development, primarily due to personnel and headcount growth. The quarterly operating loss widened in dollars and as a share of revenue; the nine-month operating margin improved modestly.
- Management expects operating expenses to increase in absolute dollars, while potentially decreasing over time as a percentage of revenue. It expects services revenue to increase over the long term, though its share of revenue may fluctuate. The filing gives no specific numerical earnings or revenue guidance.
- Management stated that operating cash flow and existing cash and equivalents should meet anticipated cash needs for the foreseeable future. Cash, equivalents and investments were $1,770.4, including approximately $126.0 held outside the United States.
Risks, contingencies, and commitments
- Customer and channel concentration: Two channel partners accounted for 58.5% of nine-month revenue; three accounted for 62.4% of gross accounts receivable at April 30, 2016. Substantially all revenue is generated through channel partners.
- Convertible notes and dilution: The notes’ if-converted value exceeded principal by $210.9 at April 30. Note hedges are intended to reduce potential dilution, while related warrants may dilute shareholders if the stock price exceeds their strike price. The notes may require substantial cash payments upon conversion or certain fundamental changes.
- Commitments: Contractual obligations included $498.8 of gross operating lease payments, $54.5 of non-cancelable purchase commitments, and $575.0 principal on the notes. A new office lease calls for approximately $101.2 of rent over its initial term. The company reported no off-balance-sheet arrangements.
- Tax matters: The company reported $109.8 of unrecognized tax benefits, of which $19.2 would affect income tax expense if recognized. The filing notes open tax years and uncertainty in the timing and amount of any future settlements.
- Litigation: The company reported no significant accruals for legal loss contingencies and had not determined that an unfavorable outcome was probable or reasonably possible or that a loss range was reasonably estimable.
- Principal business risks: Rapid growth and scaling systems, competition and pricing pressure, customer renewals, reliance on channel partners and third-party manufacturers, component supply, product defects or security incidents, international operations, and volatile quarterly results. Management also cited seasonal and cyclical variability and dependence on timely quarter-end shipments.
Important facts for investors to verify
- Whether recurring-services growth, renewals, deferred revenue, and billings continue to support reported revenue growth.
- Whether operating expenses and share-based compensation grow more slowly than revenue, and whether the company can narrow GAAP operating losses.
- The timing and cash-versus-share settlement consequences of potential convertible-note conversions, and the resulting dilution after considering the hedge and warrants.
- Whether channel-partner concentration, receivables exposure, and supply-chain commitments change materially.
- Whether lease, tax, litigation, and other commitments or contingencies develop beyond the amounts and assessments disclosed in this filing.