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EXCEL - IDEA: XBRL DOCUMENT - Palo Alto Networks IncFinancial_Report.xls
EX-32.2 - CERTIFICATION OF THE CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 906 - Palo Alto Networks Incpanwex322q115.htm
EX-32.1 - CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 906 - Palo Alto Networks Incpanwex321q115.htm
EX-10.3 - 2012 EMPLOYEE STOCK PURCHASE PLAN, AS AMENDED AND RESTATED - Palo Alto Networks Incpanwex103q115.htm
EX-31.1 - CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 - Palo Alto Networks Incpanwex311q115.htm
EX-10.2 - EMPLOYEE INCENTIVE COMPENSATION PLAN, AS AMENDED AND RESTATED - Palo Alto Networks Incpanwex102q115.htm
EX-31.2 - CERTIFICATION OF THE CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 - Palo Alto Networks Incpanwex312q115.htm



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_____________________ 
Form 10-Q
 _____________________
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended October 31, 2014
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from             to             
Commission File Number 001-35594
Palo Alto Networks, Inc.
(Exact name of registrant as specified in its charter)
 
 
Delaware
20-2530195
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
4401 Great America Parkway
Santa Clara, California 95054
(Address of principal executive office, including zip code)
(408) 753-4000
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
x
Accelerated filer
¨
Non-accelerated filer
¨ (Do not check if a smaller reporting company)
Smaller reporting company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  ¨   No   x
The number of shares outstanding of the registrant's common stock as of November 17, 2014 was 80,545,942.
 




TABLE OF CONTENTS


- 2 -


PART I

ITEM 1.
FINANCIAL STATEMENTS
 
PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except per share data)
 
October 31, 2014
 
July 31, 2014
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
543,747

 
$
653,812

Short-term investments
227,752

 
118,690

Accounts receivable, net of allowance for doubtful accounts of $983 and $471 at October 31, 2014 and July 31, 2014, respectively
116,224

 
135,518

Prepaid expenses and other current assets
45,844

 
50,306

Total current assets
933,567

 
958,326

Property and equipment, net
49,823

 
48,744

Long-term investments
289,011

 
201,880

Goodwill
155,033

 
155,033

Intangible assets, net
47,451

 
47,955

Other assets
65,471

 
66,528

Total assets
$
1,540,356

 
$
1,478,466

Liabilities and stockholders’ equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
10,497

 
$
14,526

Accrued compensation
35,935

 
48,727

Accrued and other liabilities
27,852

 
25,000

Deferred revenue
286,682

 
259,918

Total current liabilities
360,966

 
348,171

Convertible senior notes, net
471,856

 
466,875

Long-term deferred revenue
184,038

 
162,660

Other long-term liabilities
30,285

 
32,177

Commitments and contingencies (Note 6)


 


Stockholders’ equity:
 
 
 
Preferred stock; $0.0001 par value; 100,000 shares authorized; none issued and outstanding at October 31, 2014 and July 31, 2014

 

Common stock; $0.0001 par value; 1,000,000 shares authorized; 80,518 and 79,519 shares issued and outstanding at October 31, 2014 and July 31, 2014, respectively
8

 
8

Additional paid-in capital
859,010

 
804,406

Accumulated other comprehensive loss
(13
)
 
(105
)
Accumulated deficit
(365,794
)
 
(335,726
)
Total stockholders’ equity
493,211

 
468,583

Total liabilities and stockholders’ equity
$
1,540,356

 
$
1,478,466

 
See notes to condensed consolidated financial statements.

- 3 -


PALO ALTO NETWORKS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share data)
 
 
Three Months Ended
 
October 31,
 
2014
 
2013
Revenue:
 
 
 
Product
$
101,476

 
$
75,485

Services
90,870

 
52,695

Total revenue
192,346

 
128,180

Cost of revenue:
 
 
 
Product
29,141

 
17,954

Services
24,320

 
15,853

Total cost of revenue
53,461

 
33,807

Total gross profit
138,885

 
94,373

Operating expenses:
 
 
 
Research and development
37,305

 
19,893

Sales and marketing
106,366

 
67,366

General and administrative
18,977

 
14,125

Total operating expenses
162,648

 
101,384

Operating loss
(23,763
)
 
(7,011
)
Interest expense
(5,489
)
 
(8
)
Other income, net
341

 
405

Loss before income taxes
(28,911
)
 
(6,614
)
Provision for income taxes
1,157

 
1,247

Net loss
$
(30,068
)
 
$
(7,861
)
Net loss per share, basic and diluted
$
(0.38
)
 
$
(0.11
)
Weighted-average shares used to compute net loss per share, basic and diluted
79,388

 
71,681


See notes to condensed consolidated financial statements.


- 4 -


PALO ALTO NETWORKS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(Unaudited, in thousands)

 
Three Months Ended
 
October 31,
 
2014
 
2013
Net loss
$
(30,068
)
 
$
(7,861
)
Other comprehensive gain, net of tax:
 
 
 
Change in unrealized gains (losses) on investments
92

 
21

Comprehensive loss
$
(29,976
)
 
$
(7,840
)

See notes to condensed consolidated financial statements.

- 5 -


PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
 
Three Months Ended
 
October 31,
 
2014
 
2013
Cash flows from operating activities
 
 
 
Net loss
$
(30,068
)
 
$
(7,861
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Share-based compensation for equity based awards
38,443

 
14,383

Depreciation and amortization
6,115

 
3,146

Amortization of investment premiums, net of accretion of purchase discounts
667

 
386

Amortization of debt discount and debt issuance costs
5,478

 

Excess tax benefit from share-based compensation
(346
)
 
(56
)
Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
19,294

 
(3,978
)
Prepaid expenses and other assets
3,409

 
(1,707
)
Accounts payable
(4,460
)
 
(205
)
Accrued compensation
(12,792
)
 
1,614

Accrued and other liabilities
1,046

 
3,433

Deferred revenue
48,142

 
29,726

Net cash provided by operating activities
74,928

 
38,881

Cash flows from investing activities
 
 
 
Purchase of investments
(247,849
)
 
(122,238
)
Proceeds from sales of investments
1,999

 

Proceeds from maturities of investments
50,692

 
43,959

Purchase of property, equipment, and other assets
(5,935
)
 
(15,680
)
Net cash used in investing activities
(201,093
)
 
(93,959
)
Cash flows from financing activities
 
 
 
Proceeds from exercise of stock options
7,963

 
4,610

Proceeds from employee stock purchase plan
7,791

 
5,988

Excess tax benefit from share-based compensation
346

 
56

Repurchase of restricted common stock from terminated employees

 
(8
)
Net cash provided by financing activities
16,100

 
10,646

Net decrease in cash and cash equivalents
(110,065
)
 
(44,432
)
Cash and cash equivalents—beginning of period
653,812

 
310,614

Cash and cash equivalents—end of period
$
543,747

 
$
266,182


See notes to condensed consolidated financial statements.

- 6 -


 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(all dollar and share amounts rounded to the nearest thousand, except per share data)
1. Description of Business and Summary of Significant Accounting Policies
Description of Business
Palo Alto Networks, Inc. (the “Company,” “we,” “us,” or “our”), located in Santa Clara, California, was incorporated in March 2005 under the laws of the State of Delaware and commenced operations in April 2005. We offer a next-generation enterprise security platform that allows enterprises, service providers, and government entities to simultaneously empower and secure their organizations by safely enabling the increasingly complex and rapidly growing number of applications running on their networks and by preventing breaches stemming from targeted cyber attacks.
Our enterprise security platform consists of three major elements: our Next-Generation Firewall, our Advanced Endpoint Protection, and our Threat Intelligence Cloud. Our Next-Generation Firewall delivers application, user, and content visibility and control as well as protection against network-based cyber threats integrated within the firewall through our proprietary hardware and software architecture. Our Advanced Endpoint Protection prevents cyber attacks that aim to exploit software vulnerabilities on a broad variety of fixed and virtual endpoints. Our Threat Intelligence Cloud provides central intelligence capabilities as well as automated delivery of preventative measures against cyber attacks. The cloud-based element of our platform is delivered in the form of a service that can be used either in the public cloud or in a private cloud using a dedicated appliance.
We primarily sell our products and services to end-customers through our channel partners and infrequently directly to end-customers. Our partners are supported by our sales and marketing organization in the Americas, in Europe, the Middle East, and Africa (EMEA), and in Asia Pacific and Japan (APAC).
Basis of Presentation
The accompanying condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles, consistent in all material respects with those applied in our Annual Report on Form 10-K for the fiscal year ended July 31, 2014. The condensed consolidated financial statements include all adjustments necessary for a fair presentation of our quarterly results. All adjustments are of a normal recurring nature. We have made estimates and judgments affecting the amounts reported in our condensed consolidated financial statements and the accompanying notes. The actual results that we experience may differ materially from our estimates. Certain prior period amounts have been reclassified to conform with current period presentation.
Principles of Consolidation
The condensed consolidated financial statements include our accounts and our wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Summary of Significant Accounting Policies
There have been no material changes to our significant accounting policies as of and for the three months ended October 31, 2014, as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended July 31, 2014.
Recent Accounting Pronouncements
In August 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40)-Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. The standard provides guidance about management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures. The standard is effective for fiscal years ending after December 15, 2016, and for interim periods thereafter. Early adoption is permitted. We will adopt the new standard in our fiscal year ending 2017. The adoption of this standard is not expected to have a material impact on our condensed consolidated financial statements.
In May 2014, the FASB issued ASU No. 2014-09 regarding Accounting Standards Codification (ASC) Topic 606-Revenue from Contracts with Customers. The standard provides principles for recognizing revenue for the transfer of promised goods or services to customers with the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance is effective for us in the first quarter of fiscal 2018 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within the guidance; or (ii) retrospective with the cumulative effect of initially applying the guidance recognized at the date of initial application and providing certain additional disclosures as defined per

- 7 -


the guidance. Early adoption is not permitted. We are currently evaluating adoption methods and whether this standard will have a material impact on our condensed consolidated financial statements.
In July 2013, the FASB issued ASU No. 2013-11, Income Taxes (Topic 740)-Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The standard requires us to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss (NOL) carryforward or other tax credit carryforward when settlement in this manner is available under applicable tax law. The guidance was effective for us in the first quarter of fiscal 2015. Our adoption of this guidance did not have any impact on our condensed consolidated financial statements.
2. Fair Value Measurements
We categorize assets and liabilities recorded at fair value on our condensed consolidated balance sheets based upon the level of judgment associated with inputs used to measure their fair value. The categories are as follows:
Level 1—Inputs are unadjusted quoted prices in active markets for identical assets or liabilities.
Level 2—Inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the assets or liabilities, either directly or indirectly through market corroboration, for substantially the full term of the financial instruments.
Level 3—Inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. The inputs require significant management judgment or estimation.
The following table presents the fair value of our financial assets and liabilities using the above input categories as of October 31, 2014 and July 31, 2014 (in thousands):
 
 
October 31, 2014
 
July 31, 2014
 
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Short-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$

 
$
39,297

 
$

 
$
39,297

 
$

 
$
22,239

 
$

 
$
22,239

U.S. government and agency securities
 

 
188,455

 

 
188,455

 

 
96,451

 

 
96,451

Total short-term investments
 

 
227,752

 

 
227,752

 

 
118,690

 

 
118,690

Long-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 

 
1,000

 

 
1,000

 

 
1,000

 

 
1,000

Corporate debt securities
 

 
63,433

 

 
63,433

 

 
39,018

 

 
39,018

U.S. government and agency securities
 

 
224,578

 

 
224,578

 

 
161,862

 

 
161,862

Total long-term investments
 

 
289,011

 

 
289,011

 

 
201,880

 

 
201,880

Other assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Restricted cash
 
1,220

 

 

 
1,220

 
1,220

 

 

 
1,220

Total other assets
 
1,220

 

 

 
1,220

 
1,220

 

 

 
1,220

Total assets measured at fair value
 
$
1,220

 
$
516,763

 
$

 
$
517,983

 
$
1,220

 
$
320,570

 
$

 
$
321,790

Refer to Note 5. Convertible Senior Notes for the carrying amount and estimated fair value of our convertible senior notes, which were not recorded at fair value as of October 31, 2014.
3. Investments
The following tables summarize the unrealized gains and losses and fair value of our investments as of October 31, 2014 and July 31, 2014 (in thousands):

- 8 -


 
October 31, 2014
 
Amortized Cost 
 
Unrealized Gains
 
Unrealized Losses
 
Estimated Fair Value
Certificates of deposit
$
1,000

 
$

 
$

 
$
1,000

Corporate debt securities
102,797

 
18

 
(85
)
 
102,730

U.S. government and agency securities
412,980

 
172

 
(119
)
 
413,033

Total
$
516,777

 
$
190

 
$
(204
)
 
$
516,763

 
July 31, 2014
 
Amortized Cost 
 
Unrealized Gains
 
Unrealized Losses
 
Estimated Fair Value
Certificates of deposit
$
1,000

 
$

 
$

 
$
1,000

Corporate debt securities
61,299

 
16

 
(58
)
 
61,257

U.S. government and agency securities
258,376

 
45

 
(108
)
 
258,313

Total
$
320,675

 
$
61

 
$
(166
)
 
$
320,570

The following tables present our investments that were in an unrealized loss position as of October 31, 2014 and July 31, 2014 (in thousands):
 
October 31, 2014
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
Corporate debt securities
$
72,352

 
$
(85
)
 
$

 
$

 
$
72,352

 
$
(85
)
U.S. government and agency securities
185,151

 
(119
)
 

 

 
185,151

 
(119
)
Total
$
257,503

 
$
(204
)
 
$

 
$

 
$
257,503

 
$
(204
)
 
July 31, 2014
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
Corporate debt securities
$
43,868

 
$
(58
)
 
$

 
$

 
$
43,868

 
$
(58
)
U.S. government and agency securities
142,490

 
(108
)
 

 

 
142,490

 
(108
)
Total
$
186,358

 
$
(166
)
 
$

 
$

 
$
186,358

 
$
(166
)
Unrealized losses related to these investments are due to interest rate fluctuations as opposed to credit quality. In addition, we do not intend to sell and it is not more likely than not that we would be required to sell these investments before recovery of their amortized cost basis, which may be at maturity. As a result, there is no other-than-temporary impairment for these investments at October 31, 2014.
The following table summarizes the amortized cost and fair value of our investments as of October 31, 2014, by contractual years-to-maturity (in thousands):
 
Amortized Cost
 
Fair Value
Due within one year
$
227,738

 
$
227,752

Due within one to two years
287,530

 
287,506

Due within two to three years
1,509

 
1,505

Total
$
516,777

 
$
516,763


- 9 -


4. Intangible Assets
The following table presents details of our purchased intangible assets as of October 31, 2014 and July 31, 2014 (in thousands):
 
 
October 31, 2014
 
July 31, 2014
 
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
Intangible assets with finite lives:
 
 
 
 
 
 
 
 
 
 
 
 
Developed technology
 
$
42,100

 
$
(2,965
)
 
$
39,135

 
$
34,500

 
$
(1,643
)
 
$
32,857

Acquired intellectual property
 
7,796

 
(1,169
)
 
6,627

 
6,546

 
(958
)
 
5,588

In-process research and development held for defensive purposes
 
1,900

 
(528
)
 
1,372

 
1,900

 
(370
)
 
1,530

Other
 
500

 
(183
)
 
317

 
500

 
(120
)
 
380

Total intangible assets with finite lives
 
52,296

 
(4,845
)
 
47,451

 
43,446

 
(3,091
)
 
40,355

In-process research and development with indefinite lives
 

 

 

 
7,600

 

 
7,600

Total purchased intangible assets
 
$
52,296

 
$
(4,845
)
 
$
47,451

 
$
51,046

 
$
(3,091
)
 
$
47,955

We recognized amortization expense of $1,754,000 and $155,000 for the three months ended October 31, 2014 and 2013, respectively. Our in-process research and development acquired from Cyvera Ltd. in April 2014 was transferred to developed technology during the three months ended October 31, 2014 and is being amortized over its estimated useful life of seven years.
The following table summarizes our estimated future amortization expense of intangible assets with finite lives by type as of October 31, 2014 (in thousands):
 
Fiscal Years Ending July 31,
 
Remaining 2015
 
2016
 
2017
 
2018
 
2019
 
2020 and Thereafter
Developed technology
$
4,511

 
$
6,014

 
$
6,014

 
$
6,014

 
$
6,014

 
$
10,568

Acquired intellectual property
644

 
816

 
722

 
596

 
511

 
3,338

In-process research and development held for defensive purposes
475

 
633

 
264

 

 

 

Other
187

 
130

 

 

 

 

Total future amortization expense
$
5,817

 
$
7,593

 
$
7,000

 
$
6,610

 
$
6,525

 
$
13,906

5. Convertible Senior Notes
Convertible Senior Notes
On June 30, 2014, we issued $575,000,000 aggregate principal amount of 0.0% convertible senior notes due 2019 (the “Notes”). The Notes are governed by an indenture between us, as the issuer, and U.S. Bank National Association, as Trustee. The Notes are unsecured, unsubordinated obligations that do not contain any financial covenants or restrictions on the payments of dividends, the incurrence of indebtedness, or the issuance or repurchase of securities by us or any of our subsidiaries. The Notes mature on July 1, 2019 unless converted or repurchased in accordance with their terms prior to such date. We cannot redeem the Notes prior to maturity.
The Notes are convertible for up to 5,214,000 shares of our common stock at an initial conversion rate of approximately 9.068 shares of common stock per $1,000 principal amount, which is equal to an initial conversion price of approximately $110.28 per share of common stock, subject to adjustment. Holders of the Notes may surrender their Notes for conversion at their option at any time prior to the close of business on the business day immediately preceding January 1, 2019, only under the following circumstances, none of which have occurred to date:
during any fiscal quarter commencing after the fiscal quarter ending on October 31, 2014 (and only during such fiscal quarter), if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is greater than or equal to 130% of the conversion price for the Notes on each applicable trading day;

- 10 -


during the five business day period after any five consecutive trading day period (the “measurement period”), in which the trading price per $1,000 principal amount of Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate for the Notes on each such trading day; or
upon the occurrence of specified corporate events.
On or after January 1, 2019, holders may convert all or any portion of their Notes at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date regardless of the foregoing conditions. Upon conversion, holders will receive cash equal to the aggregate principal amount of the Notes to be converted, and, at our election, cash and/or shares of our common stock for any amounts in excess of the aggregate principal amount of the Notes being converted.
The conversion price will be subject to adjustment in some events. Holders of the Notes who convert their Notes in connection with certain corporate events that constitute a “make-whole fundamental change” per the Indenture governing the Notes are, under certain circumstances, entitled to an increase in the conversion rate. Additionally, upon the occurrence of a corporate event that constitutes a “fundamental change” per the Indenture governing the Notes, holders of the Notes may require us to repurchase for cash all or a portion of the Notes at a purchase price equal to 100% of the principal amount of the Notes plus accrued and unpaid contingent interest.
In accounting for the issuance of the Notes, we separated the Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the par value of the Notes as a whole. The difference between the principal amount of the Notes and the liability component (the “debt discount”), is amortized to interest expense using the effective interest method over the term of the Notes. The equity component of the Notes is included in additional paid-in capital in the condensed consolidated balance sheets and is not remeasured as long as it continues to meet the conditions for equity classification.
In accounting for the transaction costs related to the issuance of the Notes, we allocated the total amount incurred to the liability and equity components using the same proportions as the proceeds from the Notes. Transaction costs attributable to the liability component were recorded in other assets in the condensed consolidated balance sheets and are being amortized to interest expense in the condensed consolidated statements of operations using the effective interest method over the term of the Notes. Transaction costs attributable to the equity component were netted with the equity component of the Notes in additional paid-in capital in the condensed consolidated balance sheets. We recorded liability issuance costs, or debt issuance costs, of $12,497,000 and equity issuance costs of $2,949,000.
The following table sets forth the components of the Notes as of October 31, 2014 and July 31, 2014 (in thousands):
 
October 31, 2014
 
July 31, 2014
Liability:
 
 
 
Principal
$
575,000

 
$
575,000

Less: debt discount, net of amortization
103,144

 
108,125

Net carrying amount
$
471,856

 
$
466,875

 
 
 
 
Equity
$
(109,785
)
 
$
(109,785
)
The total estimated fair value of the Notes was $677,856,000 and $587,087,000 at October 31, 2014 and July 31, 2014, respectively. The fair value was determined based on the closing trading price per $100 of the Notes as of the last day of trading for the period. We consider the fair value of the Notes at October 31, 2014 and July 31, 2014 to be a Level 2 measurement. The fair value of the Notes is primarily affected by the trading price of our common stock and market interest rates. Based on the closing price of our common stock of $105.70 on October 31, 2014, the if-converted value of the Notes was less than its principal amount.
The following table sets forth interest expense recognized related to the Notes for the three months ended October 31, 2014 (dollars in thousands):
 
Amount
Amortization of debt issuance costs
$
497

Amortization of debt discount
4,981

Total interest expense recognized
$
5,478

 
 
Effective interest rate of the liability component
4.8
%

- 11 -


Note Hedges
To minimize the impact of potential economic dilution upon conversion of the Notes, we entered into convertible note hedge transactions (the “Note Hedges”) with respect to our common stock concurrent with the issuance of the Notes. The Note Hedges cover up to 5,214,000 shares of our common stock at a strike price per share that corresponds to the initial conversion price of the Notes, which are also subject to adjustment, and are exercisable upon conversion of the Notes. The Note Hedges will expire upon maturity of the Notes. The Note Hedges are separate transactions and are not part of the terms of the Notes. Holders of the Notes will not have any rights with respect to the Note Hedges. The shares receivable related to the Note Hedges are excluded from the calculation of diluted earnings per share as they are antidilutive.
We paid an aggregate amount of $110,975,000 for the Note Hedges, which is included in additional paid-in capital in the condensed consolidated balance sheets.
Warrants
Separately, but concurrently with our issuance of the Notes, we entered into warrant transactions (the “Warrants”) whereby we sold warrants to acquire up to 5,214,000 shares of our common stock at a strike price of approximately $137.85 per share, subject to adjustments. The shares issuable under the Warrants will be included in the calculation of diluted earnings per share when the average market value per share of our common stock for the reporting period exceeds the strike price of the Warrants. The Warrants are separate transactions and are not part of the Notes or Notes Hedges, and are not remeasured through earnings each reporting period. Holders of the Notes and Note Hedges will not have any rights with respect to the Warrants.
We received aggregate proceeds of $78,258,000 from the sale of the Warrants, which is included in additional paid-in capital in the condensed consolidated balance sheets.
6. Commitments and Contingencies
Leases
We lease our facilities under various non-cancelable operating leases, which expire through the year ending July 31, 2023.
The following table presents details of the aggregate future non-cancelable minimum rental payments on our operating leases as of October 31, 2014 (in thousands):
 
Amount
Fiscal years ending July 31:
 
Remaining 2015
$
11,686

2016
15,629

2017
14,549

2018
12,016

2019
9,697

2020 and thereafter
42,603

Committed gross lease payments
106,180

Less: proceeds from sublease rental
10,282

Net operating lease obligation
$
95,898

Contract Manufacturer Commitments
Our independent contract manufacturer procures components and assembles our products based on our forecasts. These forecasts are based on estimates of demand for our products primarily for the next twelve months, which are in turn based on historical trends and an analysis from our sales and product marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate supply, we may issue forecasts and orders for components and products that are non-cancelable. Obligations under contracts that we can cancel without a significant penalty are not included. As of October 31, 2014, we had $39,018,000 of open orders.
Litigation
In December 2011, Juniper Networks, Inc. (“Juniper”) filed a complaint against us in the United States District Court for the District of Delaware alleging patent infringement, which sought preliminary and permanent injunctions against infringement, treble damages, and attorneys' fees. On September 30, 2013, we filed a lawsuit against Juniper in the United States District Court

- 12 -


for the Northern District of California alleging that Juniper’s products infringe three of our U.S. patents, and sought monetary damages and a permanent injunction.
On May 27, 2014, we entered into a Settlement, Release and Cross-License Agreement (the “settlement agreement”) with Juniper to resolve all pending litigation between the parties, including those discussed above. Under the terms of the settlement agreement, we agreed to pay Juniper a one-time settlement amount of approximately $175,000,000, which was comprised of $75,000,000 in cash, 1,081,000 shares of our common stock with an approximate value of $70,000,000, and a warrant to purchase 463,000 shares of our common stock with an approximate value of $30,000,000, in exchange for the following:
Mutual dismissal with prejudice of all pending litigation between the parties and general release of all liability for Palo Alto Networks and Juniper,
Cross-license between both parties for the patents-in-suit and associated family members and counterparts worldwide for the life of the patents, and
Mutual covenant not to sue for infringement of any other patents for a period of eight years.
For accounting purposes, the fair value of the total consideration as of the settlement date was $182,473,000, which was comprised of $75,000,000 in cash, $75,231,000 in common stock, and $32,242,000 in warrant. The fair values of the common stock and warrant were measured using the closing price of our common stock on the settlement date.
The warrant was issued on June 3, 2014 and entitled Juniper to purchase up to 463,000 shares of common stock at an exercise price of $0.0001 per share and was classified as a liability during the period it was outstanding. On July 1, 2014, Juniper exercised the warrant in full. Accordingly, we recorded the change in the fair value of the warrant liability through the exercise date of $5,859,000 within other income (expense), net in the consolidated statement of operations for the year ended July 31, 2014.
We accounted for the settlement agreement as a multiple-element arrangement and allocated the fair value of the consideration as of the settlement date to the identifiable elements based on their estimated fair values. Of the total settlement amount, $61,300,000 was allocated to the licensing of intellectual property, $54,300,000 was allocated to the mutual dismissal of claims, and the remaining amount was allocated to the mutual covenant not to sue. The mutual dismissal of claims and the mutual covenant not to sue have no identifiable future benefit, and as a result we recorded a settlement charge within operating expenses in the consolidated statements of operations for the year ended July 31, 2014. The licensing of intellectual property is being amortized over the estimated period of benefit of five years.
In addition to the above matter, we are subject to legal proceedings, claims, and litigation arising in the ordinary course of business, including intellectual property litigation. Such matters are subject to many uncertainties and outcomes are not predictable with assurance. We accrue for contingencies when we believe that a loss is probable and that we can reasonably estimate the amount of any such loss. We have made an assessment of the probability of incurring any such losses and whether or not those losses are estimable.
To the extent there is a reasonable possibility that a loss exceeding amounts already recognized may be incurred and the amount of such additional loss would be material, we will either disclose the estimated additional loss or state that such an estimate cannot be made. As of October 31, 2014, we have not recorded any accrual for loss contingencies associated with such legal proceedings, determined that an unfavorable outcome is probable or reasonably possible, or determined that the amount or range of any possible loss is reasonably estimable.
7. Equity Award Plans
Stock Option Activities
A summary of the activity under our stock plans during the reporting period and a summary of information related to options exercisable, vested, and expected to vest are presented below (in thousands, except per share amounts):

- 13 -


 
Options Outstanding 
 
Number
of
Shares
 
Weighted-
Average
Exercise
Price 
 
Weighted-
Average
Remaining
Contractual
Term
(Years)
 
Aggregate
Intrinsic
Value
Balance—July 31, 2014
5,830

 
$
13.02

 
7.0
 
$
395,507

Options granted

 

 
 
 
 
Options forfeited
(17
)
 
13.17

 
 
 
 
Options exercised
(618
)
 
12.86

 
 
 
 
Balance—October 31, 2014
5,195

 
$
13.04

 
6.8
 
$
481,369

Options vested and expected to vest—October 31, 2014
5,105

 
$
12.95

 
6.8
 
$
473,489

Options exercisable—October 31, 2014
3,247

 
$
10.63

 
6.6
 
$
308,692

Restricted Stock Unit (RSU) Activities
A summary of the activity under our stock plans during the reporting period and a summary of information related to RSUs vested and expected to vest are presented below (in thousands, except per share amounts):
 
RSUs Outstanding
 
Number
of
Shares
 
Weighted-
Average
Grant-Date Fair Value Per Share
 
Weighted-
Average
Remaining
Contractual
Term
(Years)
 
Aggregate
Intrinsic
Value
Balance—July 31, 2014
6,046

 
$
59.84

 
1.4
 
$
488,880

RSUs granted
511

 
92.61

 
 
 
 
RSUs vested
(265
)
 
50.88

 
 
 
 
RSUs forfeited
(99
)
 
59.39

 
 
 
 
Balance—October 31, 2014
6,193

 
$
62.93

 
1.3
 
$
654,600

RSUs vested and expected to vest—October 31, 2014
5,658

 
$
62.64

 
1.2
 
$
598,051

Share-Based Compensation
The following table summarizes share-based compensation included in costs and expenses (in thousands):
 
Three Months Ended October 31,
 
2014
 
2013
Cost of product revenue
$
749

 
$
250

Cost of services revenue
3,495

 
1,413

Research and development
13,999

 
3,262

Sales and marketing
15,799

 
6,628

General and administrative
4,433

 
2,858

Total
$
38,475

 
$
14,411

At October 31, 2014, total compensation cost related to unvested share-based awards not yet recognized was $327,189,000, net of estimated forfeitures. This cost is expected to be amortized on a straight-line basis over a weighted-average period of approximately three years. Future grants will increase the amount of compensation expense to be recorded in these periods.
8. Income Taxes
Our provision for income taxes for the three months ended October 31, 2014 reflects an effective tax rate of negative 4.0%. Our effective tax rate for this period was negative as we recorded a provision for income taxes on year to date losses. The key components of our income tax provision consist of foreign income, foreign withholding taxes, and limited US federal and state income tax due

- 14 -


primarily to our net operating loss carryforward. Key components of our effective tax rate consist of foreign tax losses which derive no benefit, non-deductible share-based compensation, and changes in our valuation allowance. As compared to the three months ended October 31, 2013, our negative effective tax rate changed due to fluctuations in our overall loss before income taxes and the geographic mix of income due to global expansion.
Our provision for income taxes for the three months ended October 31, 2013 reflects an effective tax rate of negative 18.9%, and consists of foreign income, withholding taxes, and limited state income tax due to our net operating loss carryforwards and other tax attributes.
9. Net Income (Loss) Per Share
Basic net income (loss) per common share is computed by dividing net income (loss) by basic weighted-average shares outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by diluted weighted-average shares outstanding, including potentially dilutive securities.
The following table presents the computation of basic and diluted net loss per share of common stock (in thousands, except per share data):
 
Three Months Ended
 
October 31,
 
2014
 
2013
Net loss
$
(30,068
)
 
$
(7,861
)
Weighted-average shares used to compute net loss per share, basic and diluted
79,388

 
71,681

Net loss per share, basic and diluted
$
(0.38
)
 
$
(0.11
)
The following securities were excluded from the computation of diluted net income (loss) per share of common stock for the periods presented as their effect would have been antidilutive (in thousands):
 
October 31,
 
2014
 
2013
Options to purchase common stock
5,195

 
9,203

RSUs
6,193

 
2,565

ESPP shares
35

 
53

Convertible senior notes
5,214

 

Warrants related to the issuance of the convertible senior notes
5,214

 


- 15 -


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. The following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things: statements regarding trends in billings, revenue, cost of revenue, gross margin, cash flows, operating expenses, including future share-based compensation expense, interest expense, income taxes, investments and liquidity; expectations regarding billings and revenue from our Advanced Endpoint Protection offering; expected recurring revenues resulting from expected growth in our installed base; the sufficiency of our existing cash and investments to meet our cash needs for the foreseeable future; and other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements generally can be identified by words such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “predicts,” “projects,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q, and in particular, the risks discussed under the caption “Risk Factors” in Part II, Item 1A of this report and those discussed in other documents we file with the Securities and Exchange Commission. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.
Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is organized as follows:
Overview. A discussion of our business and overall analysis of financial and other highlights in order to provide context for the remainder of MD&A.
Key Financial Metrics. An analysis of our generally accepted accounting principles (GAAP) and non-GAAP key financial metrics, which management monitors to evaluate our performance.
Financial Overview. A discussion of the nature and trends of components of our financial results.
Results of Operations. An analysis of our financial results comparing the three months ended October 31, 2014 to the three months ended October 31, 2013.
Liquidity and Capital Resources. An analysis of changes in our balance sheets and cash flows, and discussion of our financial condition and our ability to meet cash needs.
Critical Accounting Policies and Estimates. A discussion of accounting policies that require critical estimates, assumptions, and judgments.
Recent Accounting Pronouncements. A discussion of expected impacts of impending accounting changes on financial information to be reported in the future.
Available Information. A discussion of sources of additional information available to investors.
Overview
We have pioneered the next-generation of enterprise security with our innovative platform that allows enterprises, service providers, and government entities to simultaneously empower and secure their organizations by safely enabling the increasingly complex and rapidly growing number of applications running on their networks and by preventing breaches stemming from targeted cyber attacks. Our enterprise security platform consists of three major elements: our Next-Generation Firewall, our Advanced Endpoint Protection, and our Threat Intelligence Cloud. Our Next-Generation Firewall delivers application, user, and content visibility and control as well as protection against network-based cyber threats integrated within the firewall through our proprietary hardware and software architecture. Our Advanced Endpoint Protection prevents cyber attacks that aim to exploit software vulnerabilities on a broad variety of fixed and virtual endpoints. Our Threat Intelligence Cloud provides central intelligence capabilities as well as automated delivery of preventative measures against cyber attacks. The cloud-based element of our platform is delivered in the form of a service that can be used either in the public cloud or in a private cloud using a dedicated appliance.     
We derive revenue from sales of our products and services, which together comprise our platform. Product revenue is generated from sales of our Next-Generation Firewall, which is available in hardware and virtualized form factors. Our Next-Generation Firewall incorporates our proprietary PAN-OS operating system, which provides a consistent set of capabilities across our entire product line. These capabilities include: application visibility and control (App-ID), user identification (User-ID), site-

- 16 -


to-site virtual private network (VPN), remote access Secure Sockets Layer (SSL) VPN, and Quality-of-Service (QoS). Our products are designed for different performance requirements throughout an organization, ranging from the PA-200, which is designed for enterprise remote offices, to the PA-7050, which is designed for data centers and high-speed networks. The same firewall functionality that is delivered in the hardware appliances is also available in the VM-Series virtual firewalls, which secure virtualized and cloud-based computing environments. Multiple firewalls can jointly use our WildFire appliance, WF-500, which identifies, analyzes, and blocks known and unknown malware in a private cloud-based environment. Our platform can be centrally managed in both virtualized and hardware appliances across an organization with our Panorama product. In addition, our GlobalProtect appliance, GP-100, provides mobile device management, malware detection, and shares device state information to safely enable mobile devices for business use.
Services revenue is generated from sales of subscriptions and support and maintenance. Our Threat Prevention, URL Filtering, GlobalProtect, and WildFire subscriptions provide our end-customers with real-time access to the latest antivirus, intrusion prevention, web filtering, and modern malware prevention capabilities across fixed and mobile devices. Our Advanced Endpoint Protection subscription protects against cyber attacks that exploit software vulnerabilities in Windows-based fixed and virtual endpoints through the use of its unique capability of stopping the underlying exploit techniques, and can prevent cyber attacks without relying on prior knowledge of the attack.
When end-customers purchase an appliance, they typically purchase one or more of our subscriptions for additional functionality, as well as support and maintenance in order to receive ongoing security updates, upgrades, bug fixes, and repairs. We leverage our appliances to sell software as a service (SaaS) subscription services to meet our customers’ evolving enterprise security requirements. Our hybrid SaaS revenue model consists of product, subscriptions, and support and maintenance, which we believe will enable us to benefit from recurring revenues as we continue to grow our installed end-customer base.
We maintain a field sales force that works closely with our channel partners in developing sales opportunities. We use a two-tier, indirect fulfillment model whereby we sell our products and services to our global distributor channel partners, which, in turn, sell our products and services to our reseller network, which then sell to our end-customers. Our channel partners purchase our products and services at a discount to our list prices before reselling them to our end-customers. Our channel partners generally receive an order from an end-customer prior to placing an order with us and generally do not stock appliances.
We continue to invest in innovation and strengthening our product portfolio. For example, in September 2014, we announced the availability of Traps, our Advanced Endpoint Protection offering, designed to prevent sophisticated cyber attacks on endpoints. In addition, in October 2014, we expanded our partnership with VMware, Inc. (“VMware”) by extending our advanced security to VMware’s public cloud platform, vCloud Air.
As of October 31, 2014, we had sold to approximately 21,000 end-customers in over 130 countries. Our end-customers represent a broad range of industries including education, energy, financial services, government entities, healthcare, Internet and media, manufacturing, public sector, and telecommunications, and include some of the largest Fortune 100 and Global 2000 companies in the world. Also, during the first quarter of fiscal 2015, our headcount increased by 178 to 1,900 employees.
For the first quarter of fiscal 2015 and 2014, revenues were $192.3 million and $128.2 million, respectively, representing year-over-year growth of 50.1%. All three components of our hybrid SaaS revenue model experienced year-over-year growth, led by revenue from subscription services, which grew 76.2% to $43.7 million, followed by support and maintenance services, which grew 69.1% to $47.2 million, and product, which grew 34.4% to $101.5 million. Revenue growth reflected rapid adoption of our Next-Generation Firewall and related support and maintenance, as well as increasing momentum in our subscription services business. We believe the growth was also driven by increased security spending by customers, as security continues to be a critical business imperative for every business in the world.
We believe that the growth of our business and our short-term and long-term success are dependent upon many factors, including our ability to extend our technology leadership, grow our base of end-customers, expand deployment of our platform and services within existing end-customers, extend the length of service terms within existing end-customers, and focus on end-customer satisfaction. While these areas present significant opportunities for us, they also pose challenges and risks that we must successfully address in order to sustain the growth of our business and improve our operating results.
To manage any future growth effectively, we must continue to improve and expand our information technology and financial infrastructure, our operating and administrative systems and controls, and our ability to manage headcount, capital, and processes in an efficient manner. Additionally, we face intense competition in our market, and to succeed, we need to innovate and offer products that are differentiated from existing infrastructure products, as well as effectively hire, retain, train, and motivate qualified personnel and senior management. If we are unable to successfully address these challenges, our business, operating results, and prospects could be adversely affected.

- 17 -


Key Financial Metrics
We monitor the key financial metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts, and assess operational efficiencies. We discuss revenue, gross margin, and the components of operating loss and margin below under “—Financial Overview” and “—Results of Operations.” The following tables summarize deferred revenue, cash flow provided by operating activities, free cash flow (non-GAAP), and billings (non-GAAP).
 
October 31, 2014
 
July 31, 2014
 
(in thousands)
Total deferred revenue
$
470,720

 
$
422,578

Cash, cash equivalents, and investments
$
1,060,510

 
$
974,382

 
Three Months Ended October 31,
 
2014
 
2013
 
(dollars in thousands)
Total revenue
$
192,346

 
$
128,180

Year over year percentage increase
50.1
 %
 
49.2
 %
Gross margin percentage
72.2
 %
 
73.6
 %
Operating loss
$
(23,763
)
 
$
(7,011
)
Operating margin percentage
(12.4
)%
 
(5.5
)%
Billings (non-GAAP)
$
240,488

 
$
157,906

Cash flow provided by operating activities
$
74,928

 
$
38,881

Free cash flow (non-GAAP)
$
68,993

 
$
23,201

Deferred Revenue. Our deferred revenue consists of amounts that have been invoiced, but that have not yet been recognized as revenue as of the period end. The majority of our deferred revenue balance consists of subscription and support and maintenance revenue that is recognized ratably over the contractual service period. We monitor our deferred revenue balance because it represents a significant portion of revenue to be recognized in future periods.
Cash Flow Provided by Operating Activities. We monitor cash flow provided by operating activities as a measure of our overall business performance. Our cash flow provided by operating activities is driven in large part by sales of our products and from up-front payments for both subscriptions and support and maintenance services. Monitoring cash flow provided by operating activities enables us to analyze our financial performance without the non-cash effects of certain items such as depreciation, amortization, and share-based compensation costs, thereby allowing us to better understand and manage the cash needs of our business.
Free Cash Flow (non-GAAP). We define free cash flow, a non-GAAP financial measure, as cash provided by operating activities less purchases of property, equipment, and other assets. We consider free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after the purchases of property, equipment, and other assets, can be used for strategic opportunities, including investing in our business, making strategic acquisitions, and strengthening the balance sheet. A limitation of the utility of free cash flow as a measure of our financial performance and liquidity is that it does not represent the total increase or decrease in our cash balance for the period. In addition, it is important to note that other companies, including companies in our industry, may not use free cash flow, may calculate free cash flow in a different manner than we do, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a comparative measure. A reconciliation of free cash flow to cash flow provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

- 18 -


 
Three Months Ended October 31,
 
2014
 
2013
 
(in thousands)
Free cash flow (non-GAAP):
 
 
 
Cash flow provided by operating activities
$
74,928

 
$
38,881

Less: purchase of property, equipment, and other assets
5,935

 
15,680

Free cash flow (non-GAAP)
$
68,993

 
$
23,201

Net cash used in investing activities
$
(201,093
)
 
$
(93,959
)
Net cash provided by financing activities
$
16,100

 
$
10,646

Billings (non-GAAP). We define billings, a non-GAAP financial measure, as total revenue plus the change in deferred revenue during the period. Billings is a key measure used by our management to manage our business because billings drive deferred revenue, which is an important indicator of the health and visibility of our business. We consider billings to be a useful metric for management and investors, particularly as we experience increased sales of subscriptions and strong renewal rates for subscriptions and support and maintenance services, and monitor our near term cash flows. We believe that billings provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management. However, it is important to note that other companies, including companies in our industry, may not use billings, may calculate billings differently, may have different billing frequencies, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of billings as a comparative measure. A reconciliation of billings to revenue, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:
 
Three Months Ended October 31,
 
2014
 
2013
 
(in thousands)
Billings (non-GAAP):
 
 
 
Total revenue
$
192,346

 
$
128,180

Add: change in total deferred revenue
48,142

 
29,726

Billings (non-GAAP)
$
240,488

 
$
157,906

Financial Overview
Revenue
We derive revenue from sales of our products and services. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured.
Our total revenue is comprised of the following:
Product Revenue. The substantial majority of our product revenue is derived from sales of our appliances. Product revenue also includes revenue derived from software licenses of Panorama, GlobalProtect, and the VM-Series. We recognize product revenue at the time of shipment, provided that all other revenue recognition criteria have been met. As a percentage of total revenue, we expect our product revenue to vary from quarter to quarter based on seasonal and cyclical factors.
Services Revenue. Services revenue is derived primarily from Threat Prevention, URL Filtering, GlobalProtect, and WildFire subscriptions and support and maintenance. In addition, in September 2014, we released Traps, our Advanced Endpoint Protection subscription. We anticipate billings (non-GAAP) from Traps will begin ramping in the second half of fiscal 2015 with a more meaningful revenue contribution in fiscal 2016. Our contractual subscription and support and maintenance terms are typically one year, with three to five year terms available. We recognize revenue from subscriptions and support and maintenance over the contractual service period. As a percentage of total revenue, we expect our services revenue to vary from quarter to quarter and increase over the long term as we introduce new subscriptions, renew existing services contracts, and expand our installed end-customer base.

- 19 -


Cost of Revenue
Our total cost of revenue consists of cost of product revenue and cost of services revenue. Our cost of revenue includes costs paid to our third-party contract manufacturer and personnel costs, which consist of salaries, bonuses, and share-based compensation associated with our operations and global customer support organizations. Our cost of revenue also includes allocated costs, which consist of certain facilities, depreciation, benefits, recruiting, and information technology costs that we allocate based on headcount, and amortization of intangible assets.
Cost of Product Revenue. Cost of product revenue primarily includes costs paid to our third-party contract manufacturer. Our cost of product revenue also includes amortization of intellectual property licenses, product testing costs, allocated costs, warranty costs, shipping costs, and personnel costs associated with logistics and quality control. We expect our cost of product revenue to increase as our product revenue increases.
Cost of Services Revenue. Cost of services revenue includes personnel costs for our global customer support organization, amortization of intangible assets acquired, allocated costs, and URL filtering database service fees. We expect our cost of services revenue to increase as our installed end-customer base grows.
Gross Margin
Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including the average sales price of our products, manufacturing costs, the mix of products sold, and the mix of revenue between products and services. For sales of our products, our higher throughput firewall products generally have higher gross margins than our lower throughput firewall products within each product series. For sales of our services, our subscriptions typically have higher gross margins than our support and maintenance. We expect our gross margins to fluctuate over time depending on the factors described above.
Operating Expenses
Our operating expenses consist of research and development, sales and marketing, and general and administrative expense. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, share-based compensation, and with regard to sales and marketing expense, sales commissions. We expect operating expenses to increase in absolute dollars, and decrease over the long term as a percentage of revenue as we continue to scale our business. As of October 31, 2014, we expect to recognize approximately $327.2 million of share-based compensation expense over a weighted-average period of three years, excluding additional share-based compensation expense related to any future grants of share-based awards. Share-based compensation expense, net of forfeitures, is recognized on a straight-line basis over the requisite service periods of the awards.
Research and Development. Research and development expense consists primarily of personnel costs. Research and development expense also includes prototype related expenses and allocated costs. We expect research and development expense to increase in absolute dollars as we continue to invest in our future products and services, although our research and development expense may fluctuate as a percentage of total revenue.
Sales and Marketing. Sales and marketing expense consists primarily of personnel costs, including commission costs. We expense commission costs as incurred. Sales and marketing expense also includes costs for market development programs, promotional and other marketing costs, travel costs, professional services, and allocated costs. We continue to increase the size of our sales force and have also substantially grown our sales presence internationally. We expect sales and marketing expense to continue to increase in absolute dollars as we increase the size of our sales and marketing organizations to increase touch points with end-customers and to expand our international presence, although our sales and marketing expense may fluctuate as a percentage of total revenue.
General and Administrative. General and administrative expense consists of personnel costs, professional services, and certain non-recurring general expenses. General and administrative personnel include our executive, finance, human resources, legal, and IT organizations. Professional services consist primarily of legal, auditing, accounting, and other consulting costs. We expect general and administrative expense to increase in absolute dollars due to additional costs associated with accounting, compliance, insurance, and investor relations, although our general and administrative expense may fluctuate as a percentage of total revenue.

- 20 -


Interest Expense
Interest expense consists of the amortization of the debt discount and debt issuance costs related to our 0.0% convertible senior notes due 2019 (the “Notes”). This interest expense is non-cash and will range from $22.3 million to $25.7 million per year through fiscal 2019.
Other Income (Expense), Net
Other income (expense), net includes interest income earned on our cash, cash equivalents, and investments, foreign currency re-measurement gains and losses, and foreign currency transaction gains and losses.
Provision for Income Taxes
Provision for income taxes consists primarily of income taxes in foreign jurisdictions in which we conduct business, withholding taxes, and federal and state income taxes in the United States. We maintain a full valuation allowance for domestic deferred tax assets, including net operating loss carryforwards and tax credits. We implemented our corporate structure and intercompany relationships to more closely align with the international nature of our business in the fourth quarter of fiscal 2013. Income in certain countries may be taxed at statutory tax rates that are lower than the U.S. statutory tax rate. As a result, our overall effective tax rate over the long term may be lower than the U.S. federal statutory tax rate on positive income through changes in international procurement and sales operations.
Results of Operations
The following tables summarize our results of operations for the periods presented and as a percentage of our total revenue for those periods. The period to period comparison of results is not necessarily indicative of results for future periods.
 
Three Months Ended October 31,
 
2014
 
2013
 
(dollars in thousands)
Condensed Consolidated Statements of Operations Data:
 
 
 
Revenue:
 
 
 
Product
$
101,476

 
$
75,485

Services
90,870

 
52,695

Total revenue
192,346

 
128,180

Cost of revenue:
 
 
 
Product
29,141

 
17,954

Services
24,320

 
15,853

Total cost of revenue
53,461

 
33,807

Total gross profit
138,885

 
94,373

Operating expenses:
 
 
 
Research and development
37,305

 
19,893

Sales and marketing
106,366

 
67,366

General and administrative
18,977

 
14,125

Total operating expenses
162,648

 
101,384

Operating loss
(23,763
)
 
(7,011
)
Interest expense
(5,489
)
 
(8
)
Other income, net
341

 
405

Loss before income taxes
(28,911
)
 
(6,614
)
Provision for income taxes
1,157

 
1,247

Net loss
$
(30,068
)
 
$
(7,861
)
 
 
 
 
Number of employees at period end
1,900

 
1,264


- 21 -



 
Three Months Ended October 31,
 
2014
 
2013
 
(as a percentage of revenue)
Condensed Consolidated Statements of Operations Data:
 
 
 
Revenue:
 
 
 
Product
52.8
 %
 
58.9
 %
Services
47.2
 %
 
41.1
 %
Total revenue
100.0
 %
 
100.0
 %
Cost of revenue:
 
 
 
Product
15.2
 %
 
14.0
 %
Services
12.6
 %
 
12.4
 %
Total cost of revenue
27.8
 %
 
26.4
 %
Total gross profit
72.2
 %
 
73.6
 %
Operating expenses:
 
 
 
Research and development
19.4
 %
 
15.5
 %
Sales and marketing
55.3
 %
 
52.6
 %
General and administrative
9.9
 %
 
11.0
 %
Total operating expenses
84.6
 %
 
79.1
 %
Operating loss
(12.4
)%
 
(5.5
)%
Interest expense
(2.9
)%
 
 %
Other income, net
0.2
 %
 
0.3
 %
Loss before income taxes
(15.1
)%
 
(5.2
)%
Provision for income taxes
0.5
 %
 
1.0
 %
Net loss
(15.6
)%
 
(6.2
)%

Comparison of the Three Month Periods Ended October 31, 2014 and 2013
Revenue
 
Three Months Ended October 31,
 
 
 
 
 
2014
 
2013
 
Change
 
Amount
 
% of Revenue
 
Amount
 
% of Revenue
 
Amount
 
%
 
(dollars in thousands)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Product
$
101,476

 
52.8
%
 
$
75,485

 
58.9
%
 
$
25,991

 
34.4
%
Services
 
 
 
 
 
 
 
 
 
 
 
Subscription
43,698

 
22.7
%
 
24,796

 
19.3
%
 
18,902

 
76.2
%
Support and maintenance
47,172

 
24.5
%
 
27,899

 
21.8
%
 
19,273

 
69.1
%
Total services
90,870

 
47.2
%
 
52,695

 
41.1
%
 
38,175

 
72.4
%
Total revenue
$
192,346

 
100.0
%
 
$
128,180

 
100.0
%
 
$
64,166

 
50.1
%
Revenue by geographic theater:
 
 
 
 
 
 
 
 
 
 
 
Americas
$
131,855

 
68.6
%
 
$
86,166

 
67.2
%
 
$
45,689

 
53.0
%
EMEA
38,484

 
20.0
%
 
23,875

 
18.6
%
 
14,609

 
61.2
%
APAC
22,007

 
11.4
%
 
18,139

 
14.2
%
 
3,868

 
21.3
%
Total revenue
$
192,346

 
100.0
%
 
$
128,180

 
100.0
%
 
$
64,166

 
50.1
%

- 22 -


Product revenue increased $26.0 million, or 34.4%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013. The increase was driven by increased demand, including broader adoption of our newly introduced PA-7050 firewall. The impact of changes in pricing on our product revenue was insignificant.
Services revenue increased $38.2 million, or 72.4%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013. The increase was driven by a 76.2% increase in our subscription revenue and a 69.1% increase in our support and maintenance revenue due to increased sales to new and existing end-customers. The relative increases in subscription and support and maintenance revenue will fluctuate over time, depending on the mix of services revenue and the introduction of new subscription offerings. The impact of changes in pricing on our services revenue was insignificant.
With respect to geographic theaters, the Americas contributed the largest portion of the increase in revenue for the three months ended October 31, 2014 compared to the three months ended October 31, 2013 due to its larger and more established sales force compared to our other theaters. Revenue from both EMEA and APAC increased for the three months ended October 31, 2014 compared to the three months ended October 31, 2013 due to our investment in increasing the size of our sales force and number of channel partners in these theaters.
Cost of Revenue and Gross Margin
 
Three Months Ended October 31,
 
 
 
2014
 
2013
 
Change
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
Amount
 
Percentage
 
(dollars in thousands)
Cost of revenue:
 
 
 
 
 
 
 
 
 
 
 
Product
$
29,141

 
 
 
$
17,954

 
 
 
$
11,187

 
62.3
 %
Services
24,320

 
 
 
15,853

 
 
 
8,467

 
53.4
 %
Total cost of revenue
$
53,461

 
 
 
$
33,807

 
 
 
$
19,654

 
58.1
 %
Includes share-based compensation of:
 
 
 
 
 
 
 
 
 
 
 
Product
$
749

 
 
 
$
250

 
 
 
$
499

 
199.6
 %
Services
3,495

 
 
 
1,413

 
 
 
2,082

 
147.3
 %
Total
$
4,244

 
 
 
$
1,663

 
 
 
$
2,581

 
155.2
 %
Gross profit:
 
 
 
 
 
 
 
 
 
 
 
Product
$
72,335

 
71.3
%
 
$
57,531

 
76.2
%
 
$
14,804

 
(4.9
)%
Services
66,550

 
73.2
%
 
36,842

 
69.9
%
 
29,708

 
3.3
 %
Total gross profit
$
138,885

 
72.2
%
 
$
94,373

 
73.6
%
 
$
44,512

 
(1.4
)%
Product cost increased $11.2 million, or 62.3%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013 due to an increase in product unit volume.
Service cost increased $8.5 million, or 53.4%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013 due to an increase in personnel costs of $4.2 million related to increasing our headcount, amortization of acquired intangible assets of $1.3 million, allocated costs of $1.1 million, and other costs incurred to expand our customer service capabilities to support our growing installed end-customer base.
Gross margin decreased 140 basis points for the three months ended October 31, 2014 compared to the three months ended October 31, 2013. The decrease of 490 basis points in product margin was driven by a decrease of 300 basis points due to amortization of intellectual property licenses of $3.1 million. The remaining decrease was due to higher product cost as a result of new product introductions, including the PA-7050 firewalls, which will have lower product margins until increased volume drives better economies of scale. The increase of 330 basis points in services margin was driven by an increase of 480 basis points due to contributions from our higher margin subscription services, partially offset by a 150 basis points decrease due to amortization of purchased intangible assets.

- 23 -


Operating Expenses
 
Three Months Ended October 31,
 
 
 
 
 
2014
 
2013
 
Change
 
Amount
 
% of Revenue
 
Amount
 
% of Revenue
 
Amount
 
%
 
(dollars in thousands)
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Research and development
$
37,305

 
19.4
%
 
$
19,893

 
15.5
%
 
$
17,412

 
87.5
%
Sales and marketing
106,366

 
55.3
%
 
67,366

 
52.6
%
 
39,000

 
57.9
%
General and administrative
18,977

 
9.9
%
 
14,125

 
11.0
%
 
4,852

 
34.4
%
Total operating expenses
$
162,648

 
84.6
%
 
$
101,384

 
79.1
%
 
$
61,264

 
60.4
%
Includes share-based compensation of:
 
 
 
 
 
 
 
 
 
 
 
Research and development
$
13,999

 
 
 
$
3,262

 
 
 
$
10,737

 
329.2
%
Sales and marketing
15,799

 
 
 
6,628

 
 
 
9,171

 
138.4
%
General and administrative
4,433

 
 
 
2,858

 
 
 
1,575

 
55.1
%
Total
$
34,231

 
 
 
$
12,748

 
 
 
$
21,483

 
168.5
%
Research and development expense increased $17.4 million, or 87.5%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013, due to an increase in personnel costs of $15.6 million largely due to an increase in headcount and an increase in allocated costs of $1.2 million.
Sales and marketing expense increased $39.0 million, or 57.9%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013, due to an increase in personnel costs of $23.5 million largely due to an increase in headcount, an increase in demand generation activities, trade shows, and other marketing activities of $4.9 million, an increase in allocated costs of $3.4 million, and an increase in travel and entertainment costs of $3.3 million.
General and administrative expense increased $4.9 million, or 34.4%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013, due to an increase in personnel costs of $3.8 million, largely due to an increase in headcount.
Interest Expense
 
Three Months Ended October 31,
 
 
 
 
 
2014
 
2013
 
Change
 
Amount
 
Amount
 
Amount
 
%
 
(dollars in thousands)
Interest expense
$
5,489

 
$
8

 
$
5,481

 
NM
Interest expense increased $5.5 million for the three months ended October 31, 2014 compared to the three months ended October 31, 2013 due to the amortization of the debt discount and debt issuance costs related to the Notes. This interest expense is non-cash and will range from $22.3 million to $25.7 million per year through fiscal 2019.
Provision for Income Taxes
 
Three Months Ended October 31,
 
 
 
 
 
2014
 
2013
 
Change 
 
(dollars in thousands)
Provision for income taxes
$
1,157

 
$
1,247

 
$
(90
)
 
(7.2
)%
Effective tax rate
(4.0
)%
 
(18.9
)%
 
 
 
 
We recorded an income tax provision for the three months ended October 31, 2014 due to federal, state, and foreign income taxes and foreign withholding taxes. The provision for income taxes decreased for the three months ended October 31, 2014 compared

- 24 -


to the three months ended October 31, 2013 due to increased U.S. taxable income and a shift in geographical mix of income due to global expansion.
Liquidity and Capital Resources
 
October 31, 2014
 
July 31, 2014
 
(in thousands)
Working capital
$
572,601

 
$
610,155

Cash, cash equivalents, and investments:
 
 
 
Cash and cash equivalents
$
543,747

 
$
653,812

Investments
516,763

 
320,570

Total cash, cash equivalents, and investments
$
1,060,510

 
$
974,382

At October 31, 2014, our cash, cash equivalents, and investments of $1.1 billion were held for general corporate purposes, of which approximately $140.5 million was held outside the United States. Our current plans do not include repatriating these funds. However, if these funds were needed for our domestic operations, we would be required to accrue and pay U.S. taxes on undistributed earnings of foreign subsidiaries. There are no other restrictions on the use of these funds. We do not provide for federal income taxes on the undistributed earnings of our foreign subsidiaries, all of which we expect to reinvest outside of the United States indefinitely. If we were to repatriate these earnings to the United States, any associated income tax liability would be insignificant.
In June 2014, we issued the Notes with an aggregate principal amount of $575.0 million. The Notes will mature on July 1, 2019. Prior to January 1, 2019, holders may surrender their Notes for early conversion under certain circumstances. Upon conversion of the Notes, we will pay cash up to the aggregate principal amount of the Notes to be converted and we may choose to pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock with respect to the remainder of our conversion obligation in excess of the aggregate principal amount of the Notes being converted. As of October 31, 2014, the Notes were not convertible. Refer to Note 5. Convertible Senior Notes of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for information on the Notes.
The following table summarizes our cash flows for the three months ended October 31, 2014 and 2013.
 
Three Months Ended October 31,
2014
 
2013
 
(in thousands)
Cash provided by operating activities
$
74,928

 
$
38,881

Cash used in investing activities
(201,093
)
 
(93,959
)
Cash provided by financing activities
16,100

 
10,646

Net decrease in cash and cash equivalents
$
(110,065
)
 
$
(44,432
)
We believe that our cash flow from operations with existing cash and cash equivalents will be sufficient to meet our anticipated cash needs for the foreseeable future. Our future capital requirements will depend on many factors including our growth rate, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced products and services offerings, the costs to acquire or invest in complementary businesses and technologies, the costs to ensure access to adequate manufacturing capacity, and the continuing market acceptance of our products. In addition, from time to time we may incur additional tax liability in connection with certain tax structuring decisions, for example, we may be required to pay additional taxes related to the acquisition of Cyvera Ltd. if we transfer the acquired intellectual property out of Israel.
We may also choose to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results, and financial condition may be adversely affected.
Operating Activities
Our operating activities have consisted of net loss adjusted for certain non-cash items and changes in assets and liabilities.

- 25 -


Cash provided by operating activities during the three months ended October 31, 2014 was $74.9 million, an increase of $36.0 million compared to the three months ended October 31, 2013 due to changes in our assets and liabilities and growth of our business during the three months ended October 31, 2014. Changes in assets and liabilities during the three months ended October 31, 2014 compared to the three months ended October 31, 2013 include an increase in collections on accounts receivable and an increase in sales of subscriptions and support and maintenance contracts to new and existing customers as reflected by an increase in deferred revenue, partially offset by an increase in commissions paid during the three months ended October 31, 2014.
Investing Activities
Our investing activities have consisted of capital expenditures and net investment purchases, sales, and maturities. We expect to continue such activities as our business grows.
Cash used in investing activities during the three months ended October 31, 2014 was $201.1 million, an increase of $107.1 million as compared to the three months ended October 31, 2013. The increase was primarily due to higher net purchases of available-for-sale investments, partially offset by decreased purchases of property, equipment, and other assets during the three months ended October 31, 2014.
Financing Activities
Our financing activities have consisted of proceeds from sales of shares through employee equity incentive plans.
Cash provided by financing activities during the three months ended October 31, 2014 was $16.1 million, an increase of $5.5 million as compared to the three months ended October 31, 2013. The increase was due to higher proceeds from the sale of shares through employee equity incentive plans during the three months ended October 31, 2014.
Off-Balance Sheet Arrangements
Through October 31, 2014, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Critical Accounting Policies and Estimates
Our condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.
We believe the critical accounting policies and estimates discussed under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC) on September 18, 2014, reflect our more significant judgments and estimates used in the preparation of the condensed consolidated financial statements. See “Available Information” below for instructions on how to access our Annual Report on Form 10-K. There have been no significant changes to our critical accounting policies and estimates as filed in such report.
Recent Accounting Pronouncements
Refer to “Recent Accounting Pronouncements” in Note 1. Description of Business and Summary of Significant Accounting Policies of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
Available Information
Our website is located at www.paloaltonetworks.com, and our investor relations website is located at http://investors.paloaltonetworks.com. Copies of Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are available, free of charge, on our investor relations website as soon as reasonably practicable after we file such material electronically with or furnish it to the SEC. The SEC also maintains a website that contains our SEC filings. The address of the site is www.sec.gov. Further, a copy of this Quarterly Report on Form 10-Q is located at the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330.

- 26 -


Webcasts of our earnings calls and certain events we participate in or host with members of the investment community are on our investor relations website. Additionally, we announce investor information, including news and commentary about our business and financial performance, SEC filings, notices of investor events, and our press and earnings releases, on our investor relations website. Investors and others can receive notifications of new information posted on our investor relations website in real time by signing up for email alerts and RSS feeds. Further corporate governance information, including our certificate of incorporation, bylaws, corporate governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading “Corporate Governance.” The contents of our websites are not incorporated by reference into this Quarterly Report on Form 10-Q or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only.
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposures to market risk have not changed materially since July 31, 2014. For our quantitative and qualitative disclosures about market risk, see the disclosures in Part II, Item 7A in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on September 18, 2014.

ITEM 4.
CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.
Based on our evaluation, our chief executive officer and chief financial officer concluded that, as of October 31, 2014, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended October 31, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

- 27 -


PART II
ITEM 1.
LEGAL PROCEEDINGS
The information set forth under the “Litigation” subheading in Note 6. Commitments and Contingencies of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.
ITEM 1A.
RISK FACTORS
Our operations and financial results are subject to various risks and uncertainties including those described below. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, also may become important factors that affect us. If any of the following risks or others not specified below materialize, our business, financial condition, and results of operations could be materially adversely affected. In that case, the market price of our common stock could decline.
Risks Related to Our Business and Our Industry
Our business and operations have experienced rapid growth in recent periods, and if we do not effectively manage any future growth or are unable to improve our systems, processes, and controls, our operating results will be adversely affected.
We have experienced rapid growth and increased demand for our products over the last few years. Our employee headcount and number of end-customers have increased significantly, and we expect to continue to grow our headcount significantly over the next year. For example, from the end of fiscal 2014 to the end of the first quarter of fiscal 2015, our headcount increased from 1,722 to 1,900 employees, and our number of end-customers increased from more than 19,000 to approximately 21,000. The growth and expansion of our business and product and service offerings places a continuous significant strain on our management, operational, and financial resources. As we have grown, we have increasingly managed more complex deployments of our products and services with larger end-customers. To manage any future growth effectively, we must continue to improve and expand our information technology and financial infrastructure, our operating and administrative systems, and our ability to manage headcount, capital, and processes in an efficient manner.
We may not be able to successfully scale improvements to our enterprise resource planning system or implement or scale improvements to our other systems, processes, and controls in an efficient or timely manner or in a manner that does not negatively affect our operating results. In addition, our existing systems, processes, and controls may not prevent or detect all errors, omissions, or fraud. We have licensed technology from third parties to help us accomplish this objective. We may experience difficulties in managing improvements to our systems, processes, and controls or in connection with third-party software, which could disrupt existing customer relationships, cause us to lose customers, limit us to smaller deployments of our products, or increase our technical support costs. Our failure to improve our systems, processes, and controls, or their failure to operate in the intended manner, may result in our inability to manage the growth of our business and to accurately forecast our revenue, expenses, and earnings, or to prevent certain losses. For example, we are implementing certain new enterprise management systems and any failure to implement these systems may disrupt our operations and our operating expenses could increase. Additionally, our productivity and the quality of our products and services may be adversely affected if we do not integrate and train our new employees quickly and effectively, including employees we acquired in connection with our acquisition of Cyvera Ltd. (“Cyvera”). Any future growth would add complexity to our organization and require effective coordination throughout our organization. For example, as a result of growth in our employee headcount, we relocated our corporate headquarters to a larger office space in Santa Clara, California in November 2013. Failure to manage any future growth effectively could result in increased costs, negatively impact our end-customers’ satisfaction with our products and services, and harm our operating results.
Our operating results are likely to vary significantly from period to period and be unpredictable, which could cause the market price of our common stock to decline.
Our operating results, in particular, our revenues, gross margins, operating margins, and operating expenses, have historically varied from period to period, and we expect that this trend will continue as a result of a number of factors, many of which are outside of our control and may be difficult to predict, including:
our ability to attract and retain new end-customers;
the budgeting cycles and purchasing practices of end-customers;
changes in end-customer, distributor or reseller requirements, or market needs;
changes in the growth rate of the enterprise security market;

- 28 -


the timing and success of new product and service introductions by us or our competitors or any other change in the competitive landscape of our industry, including consolidation among our competitors or end-customers;
changes in mix of our products and services including increases in multi-year subscriptions and support and maintenance;
price competition;
deferral of orders from end-customers in anticipation of new products or product enhancements announced by us or our competitors;
our ability to successfully expand our business domestically and internationally;
the timing and costs related to the development or acquisition of technologies or businesses;
lack of synergy, or the inability to realize expected synergies, resulting from recent acquisitions;
our inability to complete or integrate efficiently any acquisitions that we have completed, or that we may undertake;
our ability to increase the size of our distribution channel;
decisions by potential end-customers to purchase enterprise security solutions from larger, more established security vendors or from their primary network equipment vendors;
changes in end-customer attach rates and renewal rates for our services;
timing of revenue recognition and revenue deferrals;
our ability to manage production and manufacturing related costs, global customer service organization costs, inventory excess and obsolescence costs, and warranty costs;
insolvency or credit difficulties confronting our customers, which could adversely affect their ability to purchase or pay for our products and services, or confronting our key suppliers, including our sole source suppliers, which could disrupt our supply chain;
any disruption in our channel or termination of our relationship with important channel partners, including as a result of consolidation among distributors and resellers of enterprise security solutions;
our inability to fulfill our end-customers’ orders due to supply chain delays or events that impact our manufacturers or their suppliers;
increased expenses, unforeseen liabilities, or write-downs and any impact on our results of operations from any acquisition consummated;
the cost and potential outcomes of litigation, which could have a material adverse effect on our business;
seasonality or cyclical fluctuations in our markets;
future accounting pronouncements or changes in our accounting policies, including the potential impact of the adoption and implementation of the May 2014 Financial Accounting Standards Board’s (FASB) Accounting Standards Update (ASU) No. 2014-09 regarding revenue recognition;
the impact on our overall effective tax rate caused by any reorganization in our corporate structure or any changes in our valuation allowance for domestic deferred assets;
increases or decreases in our expenses caused by fluctuations in foreign currency exchange rates, as an increasing portion of our expenses are incurred and paid in currencies other than the U.S. dollar;
political, economic and social instability, including continued hostilities in the Middle East and any disruption these events may cause to broader global industrial economy; and
general macroeconomic conditions, both domestically and in our foreign markets.
Any one of the factors above, or the cumulative effect of some of the factors referred to above, may result in significant fluctuations in our financial and other operating results. This variability and unpredictability could result in our failure to meet our revenue, margin, or other operating result expectations or those of securities analysts or investors for a particular period. If we fail to meet or exceed such expectations for these or any other reasons, the market price of our common stock could fall substantially, and we could face costly lawsuits, including securities class action suits.
Our revenue growth rate in recent periods may not be indicative of our future performance.
We have recently experienced revenue growth rates of 50% and 49% in the first quarter of fiscal 2015 and 2014, respectively. You should not rely on our revenue for any prior quarterly or annual periods as any indication of our future revenue or revenue

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growth. If we are unable to maintain consistent revenue or revenue growth, the market price of our common stock could be volatile, and it may be difficult to achieve and maintain profitability.
We have a history of losses, anticipate increasing our operating expenses in the future, and may not be able to achieve or maintain profitability or maintain or increase cash flow on a consistent basis. If we cannot achieve or maintain profitability or maintain or increase our cash flow, our business, financial condition, and operating results may suffer.
Other than fiscal 2012, we have incurred losses in all fiscal years since our inception. We incurred a net loss of $30.1 million in the first quarter of fiscal 2015, $226.5 million in fiscal 2014, and $29.2 million in fiscal 2013. As a result, we had an accumulated deficit of $365.8 million at October 31, 2014. We anticipate that our operating expenses will increase substantially in the foreseeable future as we continue to enhance our product and service offerings, broaden our installed end-customer base, expand our sales channels, expand our operations, hire additional employees, and continue to develop our technology. These efforts may prove more expensive than we currently anticipate, and we may not succeed in increasing our revenues sufficiently, or at all, to offset these higher expenses. Revenue growth may slow or revenue may decline for a number of possible reasons, including slowing demand for our products or services, increasing competition, a decrease in the growth of our overall market, or a failure to capitalize on growth opportunities. Any failure to increase our revenues as we grow our business could prevent us from achieving or maintaining profitability or maintaining or increasing cash flow on a consistent basis. If we are unable to meet these risks and challenges as we encounter them, our business, financial condition, and operating results may suffer.
Our limited operating history makes it difficult to evaluate our current business and future prospects, and may increase the risk of your investment.
We were founded in 2005 and shipped our first products in 2007. The majority of our revenue growth has occurred since 2009. Our limited operating history makes it difficult to evaluate our current business and our future prospects, including our ability to plan for and model future growth. We have encountered and will continue to encounter risks and difficulties frequently experienced by rapidly growing companies in constantly evolving industries, including the risks described in this Quarterly Report on Form 10-Q. If we do not address these risks successfully, our business and operating results will be adversely affected, and the market price of our common stock could decline. Further, we have limited historical financial data and we operate in a rapidly evolving market. As such, any predictions about our future revenue and expenses may not be as accurate as they would be if we had a longer operating history or operated in a more predictable market.
If we are unable to sell additional products and services to our end-customers or maintain or increase our installed end-customer base, our future revenue and operating results will be harmed.
Our future success depends, in part, on our ability to expand the deployment of our platform with existing end-customers by selling additional products, to secure other areas of our end-customers’ network and endpoints, and by upselling additional subscription services to provide increasing levels of enterprise security. This may require increasingly sophisticated and costly sales efforts and may not result in additional sales. In addition, the rate at which our end-customers purchase additional products and services depends on a number of factors, including the perceived need for additional enterprise security products and services as well as general economic conditions. If our efforts to sell additional products and services to our end-customers are not successful, our business may suffer.
Further, existing end-customers that purchase our subscriptions have no contractual obligation to renew their contracts after the completion of their initial contract period, which is typically one year, and we cannot accurately predict renewal rates. Our end-customers’ renewal rates may decline or fluctuate as a result of a number of factors, including their satisfaction with our services and our end-customer support, the frequency and severity of subscription outages, our product uptime or latency, and the pricing of our, or competing, services. If our end-customers renew their subscriptions, they may renew for shorter contract lengths or on other terms that are less economically beneficial to us. We have limited historical data with respect to rates of end-customer renewals, so we may not accurately predict future renewal trends. We cannot assure you that our end-customers will renew their subscriptions, and if our end-customers do not renew their agreements or renew on less favorable terms, our revenues may grow more slowly than expected or decline.
We also depend on our installed end-customer base for future support and maintenance revenues. Our support and maintenance agreements are typically one year. If end-customers choose not to continue renewing their support and maintenance or seek to renegotiate the terms of support and maintenance agreements prior to renewing such agreements, our revenue may decline.
We face intense competition in our market, especially from larger, well-established companies, and we may lack sufficient financial or other resources to maintain or improve our competitive position.
The market for enterprise security products is intensely competitive, and we expect competition to increase in the future from established competitors and new market entrants. Our main competitors fall into four categories:

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large networking vendors such as Cisco Systems, Inc. (“Cisco”) and Juniper Networks, Inc. (“Juniper”) that incorporate enterprise security features in their products;