Palo Alto Networks, Inc. — Q3 FY2014 Form 10-Q
Reporting period: Quarter and nine months ended April 30, 2014. Financial amounts are in U.S. dollars; statements are unaudited. Palo Alto Networks sells cybersecurity products and subscriptions, primarily through channel partners.
Financial performance
| Metric | Three months ended Apr. 30, 2014 | Year-over-year change | Nine months ended Apr. 30, 2014 | Year-over-year change |
|---|---|---|---|---|
| Revenue | $150.7 million | +48.8% | $419.9 million | +48.0% |
| Product revenue | $84.1 million | +38.4% | $240.4 million | +34.9% |
| Services revenue | $66.6 million | +64.4% | $179.5 million | +70.2% |
| Gross profit / margin | $111.0 million / 73.6% | Margin +0.9 percentage points | $308.9 million / 73.6% | Margin +1.6 percentage points |
| Operating loss | $145.7 million | Prior-year loss: $6.5 million | $189.9 million | Prior-year loss: $11.7 million |
| Net loss | $146.6 million; $1.96 per share | Prior-year loss: $7.3 million; $0.10 per share | $194.4 million; $2.66 per share | Prior-year loss: $13.4 million; $0.20 per share |
Subscription revenue grew 71.4% to $32.0 million and support and maintenance grew 58.4% to $34.6 million in the quarter. Management attributed product growth to demand for higher-end appliances and services growth to sales to new and existing customers. Gross-margin improvement reflected higher-end product mix, cost reductions, and subscription contribution.
Cash flow, liquidity, and balance sheet
- Cash, cash equivalents, and investments totaled $471.9 million at April 30, 2014, versus $436.9 million at July 31, 2013. Cash and cash equivalents were $234.8 million; investments were $237.1 million.
- Working capital was $81.1 million, down from $323.6 million, primarily amid higher accrued liabilities including the Juniper settlement accrual. Deferred revenue was $367.9 million, up from $249.2 million.
- For the nine-month period, operating cash flow was $114.6 million, free cash flow (non-GAAP) was $83.2 million, investing cash flow was negative $229.3 million, and financing cash flow was $38.9 million. Cash and cash equivalents declined by $75.8 million.
- The balance sheet reports no borrowings or debt line item. Total assets were $880.4 million and total liabilities were approximately $608.7 million.
- Share-based compensation was $66.8 million for the nine months. The company expected to recognize $282.9 million of remaining compensation cost over a weighted-average three years.
Material changes and unusual items
- Juniper settlement: After quarter-end, on May 27, 2014, the company agreed to resolve all pending litigation with Juniper. The agreement provides for approximately $75 million cash, 1.081 million common shares valued at approximately $70 million, and a warrant for 463,000 shares valued at approximately $30 million. The accounting fair value of consideration was $182.5 million. The company accrued $121.2 million of settlement expense in the reported quarter for dismissal of claims and the covenant not to sue; $61.3 million allocated to intellectual-property licensing is to be recorded in Q4 and amortized over five years. The $75 million cash payment was due in the quarter ending July 31, 2014. Warrant remeasurement will affect earnings until exercise.
- Fortinet settlement: A $20.0 million payment for a six-year extension of a mutual covenant not to sue was expensed in the nine-month period.
- Acquisitions included Cyvera, completed April 9 for approximately $177.6 million in cash and stock consideration, and Morta, completed in December 2013 for $10.3 million cash. Acquisition accounting added $155.1 million of goodwill and $49.6 million of net intangible assets by April 30. Cyvera’s results were described as immaterial for disclosure purposes.
- The unusually large quarterly loss principally reflects the $121.2 million Juniper accrual. Operating expenses also rose with hiring, sales expansion, research and development, share-based compensation, litigation, and acquisition costs.
Outlook, management commentary, and risks
- Management planned approximately $3.5 million of endpoint-protection investment in Q4 FY2014 and $25 million in FY2015 for research and development, customer support, and sales-force growth. It expected endpoint billings and revenue to begin ramping in the second half of FY2015, with a more meaningful revenue contribution in FY2016.
- The filing provides no formal quantified revenue or earnings guidance. Management said it expected operating expenses to increase in absolute dollars and believed existing cash and investments, with operating cash flow, would meet anticipated needs for the foreseeable future.
- Management cited rapid growth, competitive pressure, macroeconomic and customer-spending uncertainty, execution and integration risks, and the need to scale systems and headcount. Three channel partners accounted for 69% of nine-month revenue and 66% of gross accounts receivable at April 30.
- Supply-chain risk includes reliance on third-party manufacturers and limited-source components; open contract-manufacturer orders were $29.4 million. Other disclosed risks include subscription renewals, product defects or security failures, intellectual-property claims, international operations, and potential taxes if Cyvera intellectual property is transferred out of Israel.
- Approximately $103.1 million of cash, cash equivalents, and investments was held outside the United States; management did not plan to repatriate these funds. The company reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Reconcile the Juniper settlement’s approximate $175 million stated value with its $182.5 million accounting fair value, and track the Q4 cash payment, licensing asset amortization, share issuance, and warrant remeasurement.
- Assess underlying operating performance separately from the Juniper and Fortinet settlement charges, while accounting for substantial share-based compensation and rising operating expenses.
- Monitor recurring services growth, deferred revenue, billings (a non-GAAP measure), and subscription/support renewal trends.
- Evaluate channel-partner and supplier concentration, as well as integration and commercial execution for Cyvera and Morta.
- Track dilution from equity compensation, acquisition-related shares, and Juniper settlement securities, alongside liquidity and working-capital changes.