Palo Alto Networks, Inc. — Q2 FY2013 Form 10-Q
Reporting period: Quarter and six months ended January 31, 2013. Palo Alto Networks sells next-generation network security products and subscriptions, primarily through distributors and resellers. It reported more than 11,000 end-customers in over 100 countries.
Financial performance
Amounts below are in millions of dollars except percentages and per-share data.
| Metric | Q2 FY2013 | Q2 FY2012 | Six months FY2013 | Six months FY2012 |
|---|---|---|---|---|
| Revenue | $96.5 | $56.7 | $182.4 | $113.8 |
| Gross profit / margin | $68.9 / 71.4% | $41.2 / 72.6% | $130.6 / 71.6% | $83.4 / 73.3% |
| Operating income (loss) | ($2.2) | $1.3 | ($5.3) | $8.2 |
| Net income (loss) | ($2.6) | $0.4 | ($6.1) | $4.5 |
| Diluted EPS | ($0.04) | $0.00 | ($0.09) | $0.00 |
Q2 revenue grew 70.2% year over year: product revenue rose 60.3% to $61.9 million and services revenue rose 91.5% to $34.6 million. For the six-month period, revenue grew 60.3%; product revenue increased 44.1% and services revenue 101.2%.
- Margins and expenses: Gross margin fell 1.2 percentage points in Q2 and 1.7 points for the six months. Management cited lower initial margins on newer PA-3000 products, lower average selling prices and product mix, and higher service-support costs. Operating expenses rose 78% in Q2 and 81% for the six months, led by sales and marketing and increased personnel and share-based compensation.
- Cash flow: Six-month operating cash flow was $57.6 million, versus $47.7 million. Non-GAAP free cash flow was $47.3 million, versus $40.6 million, calculated as operating cash flow less $10.2 million of property and equipment purchases. Operating cash flow benefited substantially from a $52.4 million increase in deferred revenue.
- Liquidity and balance sheet: At January 31, cash and cash equivalents were $187.9 million and investments were $180.4 million, totaling $368.3 million, compared with $322.6 million in cash and no investments at July 31, 2012. Current assets were $426.7 million and current liabilities $169.0 million. Deferred revenue totaled $188.2 million. The balance sheet reports no debt; liabilities primarily include deferred revenue and operating obligations.
- Cash movement: Cash declined $134.7 million over the six months, primarily as the company shifted cash-equivalent holdings into investments; investing activities used $192.2 million, including $252.6 million of investment purchases, partly offset by sales and maturities.
Material changes and management commentary
- Growth reflected higher product unit volumes, including PA-5000 and newly introduced PA-3000 firewalls, and subscription/support sales to new customers. The customer base expanded from over 6,000 a year earlier to over 11,000.
- Services rose to 35.8% of Q2 revenue from 31.8%; product revenue represented 64.2%, down from 68.2%. Geographic Q2 revenue was 63% Americas, 25% EMEA, and 12% APAC.
- Management expects operating expenses to increase in absolute dollars as it invests in product development, sales, customer support, and international expansion. The filing provides no specific revenue or earnings guidance; management cautions that recent growth rates may not continue and says operating results may vary significantly.
- Management stated that cash, cash equivalents, and operating cash flow should cover anticipated needs for at least the next 12 months. Approximately $7.9 million held outside the U.S. was not presently available for domestic operations without potential U.S. tax consequences.
- Two Santa Clara lease agreements have approximately $94.4 million of payments over their terms; total disclosed operating lease obligations were $107.2 million. The agreements support planned headquarters expansion and relocation.
Risks, contingencies, and unusual items
- Juniper litigation: Juniper alleges infringement of seven patents and seeks injunctions, damages, and fees. The company denies infringement and is defending the case; the filing says a possible loss or range cannot be estimated. Trial was scheduled for February 24, 2014. Patent-office reexaminations rejected some claims in three patents, while requests concerning two others were denied.
- Share-based compensation: Six-month share-based compensation was approximately $17.1 million. Unrecognized compensation cost was $126.0 million, expected to be recognized over a weighted-average three years. The company also recorded $1.9 million of six-month expense from modifying certain awards.
- Tax: The six-month income tax provision was $0.8 million despite a pretax loss, primarily reflecting foreign income and withholding taxes. The company is reorganizing its corporate structure in an effort to reduce its long-term effective tax rate, but benefits are uncertain.
- Other exposures: Risks include reliance on channel partners and third-party/sole-source manufacturing and component suppliers, competition and pricing pressure, rapid growth and execution demands, service renewals, product defects or security vulnerabilities, international operations, and foreign-exchange exposure. The filing identifies $21.3 million of purchase obligations and approximately $0.7 million of uncertain tax-position liabilities.
- The company implemented a new enterprise resource planning system in Q2 FY2013. Management said disclosure controls were effective at a reasonable-assurance level and reported no other material changes to internal control over financial reporting.
Important facts for investors to verify
- Whether revenue and deferred-revenue growth translate into sustainable operating profitability, given rising operating expenses and declining margins.
- How much operating cash flow depends on deferred-revenue growth, and how receivables and collections develop; reported days sales outstanding was 58 days versus 47 a year earlier.
- Developments and potential financial or commercial impact of Juniper’s patent litigation, including possible damages, royalties, or sales restrictions.
- Execution and cost of the headquarters leases and relocation, and the company’s ability to scale systems, staffing, customer support, and supply capacity.
- Actual results versus management’s non-specific outlook, including service renewals, product mix, international growth, and any tax benefits from the planned corporate reorganization.