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EX-32.1 - CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 906 - Palo Alto Networks Incpanwex321q215.htm
EX-31.2 - CERTIFICATION OF THE CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 - Palo Alto Networks Incpanwex312q215.htm
EX-31.1 - CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 - Palo Alto Networks Incpanwex311q215.htm
EX-32.2 - CERTIFICATION OF THE CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 906 - Palo Alto Networks Incpanwex322q215.htm
EXCEL - IDEA: XBRL DOCUMENT - Palo Alto Networks IncFinancial_Report.xls



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 January 31, 2015
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 February 18, 2015 was 82,272,834.
 




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)
 
January 31, 2015
 
July 31, 2014
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
342,983

 
$
653,812

Short-term investments
332,074

 
118,690

Accounts receivable, net of allowance for doubtful accounts of $855 and $471 at January 31, 2015 and July 31, 2014, respectively
135,251

 
135,518

Prepaid expenses and other current assets
51,196

 
50,306

Total current assets
861,504

 
958,326

Property and equipment, net
52,639

 
48,744

Long-term investments
463,908

 
201,880

Goodwill
155,402

 
155,033

Intangible assets, net
45,856

 
47,955

Other assets
93,475

 
66,528

Total assets
$
1,672,784

 
$
1,478,466

Liabilities and stockholders’ equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
14,001

 
$
14,526

Accrued compensation
53,158

 
48,727

Accrued and other liabilities
23,436

 
25,000

Deferred revenue
324,479

 
259,918

Total current liabilities
415,074

 
348,171

Convertible senior notes, net
476,872

 
466,875

Long-term deferred revenue
211,364

 
162,660

Other long-term liabilities
53,413

 
32,177

Commitments and contingencies (Note 7)


 


Stockholders’ equity:
 
 
 
Preferred stock; $0.0001 par value; 100,000 shares authorized; none issued and outstanding at January 31, 2015 and July 31, 2014

 

Common stock; $0.0001 par value; 1,000,000 shares authorized; 82,265 and 79,519 shares issued and outstanding at January 31, 2015 and July 31, 2014, respectively
8

 
8

Additional paid-in capital
924,634

 
804,406

Accumulated other comprehensive income (loss)
221

 
(105
)
Accumulated deficit
(408,802
)
 
(335,726
)
Total stockholders’ equity
516,061

 
468,583

Total liabilities and stockholders’ equity
$
1,672,784

 
$
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
 
Six Months Ended
 
January 31,
 
January 31,
 
2015
 
2014
 
2015
 
2014
Revenue:
 
 
 
 
 
 
 
Product
$
115,621

 
$
80,823

 
$
217,097

 
$
156,308

Services
102,034

 
60,245

 
192,904

 
112,940

Total revenue
217,655

 
141,068

 
410,001

 
269,248

Cost of revenue:
 
 
 
 
 
 
 
Product
30,640

 
20,221

 
59,781

 
38,175

Services
28,685

 
17,283

 
53,005

 
33,136

Total cost of revenue
59,325

 
37,504

 
112,786

 
71,311

Total gross profit
158,330

 
103,564

 
297,215

 
197,937

Operating expenses:
 
 
 
 
 
 
 
Research and development
46,948

 
24,253

 
84,253

 
44,146

Sales and marketing
122,875

 
76,734

 
229,241

 
144,100

General and administrative
27,023

 
19,733

 
46,000

 
33,858

Legal settlement

 
20,000

 

 
20,000

Total operating expenses
196,846

 
140,720

 
359,494

 
242,104

Operating loss
(38,516
)
 
(37,156
)
 
(62,279
)
 
(44,167
)
Interest expense
(5,539
)
 
(14
)
 
(11,028
)
 
(22
)
Other income (expense), net
344

 
(170
)
 
685

 
235

Loss before income taxes
(43,711
)
 
(37,340
)
 
(72,622
)
 
(43,954
)
Provision for (benefit from) income taxes
(703
)
 
2,606

 
454

 
3,853

Net loss
$
(43,008
)
 
$
(39,946
)
 
$
(73,076
)
 
$
(47,807
)
Net loss per share, basic and diluted
$
(0.53
)
 
$
(0.55
)
 
$
(0.91
)
 
$
(0.66
)
Weighted-average shares used to compute net loss per share, basic and diluted
80,824

 
72,854

 
80,105

 
72,260


See notes to condensed consolidated financial statements.


- 4 -


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

 
Three Months Ended
 
Six Months Ended
 
January 31,
 
January 31,
 
2015
 
2014
 
2015
 
2014
Net loss
$
(43,008
)
 
$
(39,946
)
 
$
(73,076
)
 
$
(47,807
)
Other comprehensive gain, net of tax:
 
 
 
 
 
 
 
Change in unrealized gains (losses) on investments
234

 
48

 
326

 
69

Reclassification adjustment for realized net gains on investments included in net loss

 
(10
)
 

 
(10
)
Net change
234

 
38

 
326

 
59

Comprehensive loss
$
(42,774
)
 
$
(39,908
)
 
$
(72,750
)
 
$
(47,748
)

See notes to condensed consolidated financial statements.

- 5 -


PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
 
Six Months Ended
 
January 31,
 
2015
 
2014
Cash flows from operating activities
 
 
 
Net loss
$
(73,076
)
 
$
(47,807
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Share-based compensation for equity based awards
95,291

 
38,729

Depreciation and amortization
12,917

 
7,082

Amortization of investment premiums, net of accretion of purchase discounts
1,510

 
747

Amortization of debt discount and debt issuance costs
10,999

 

Excess tax benefit from share-based compensation arrangements
(1,271
)
 
(674
)
Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
267

 
1,371

Prepaid expenses and other assets
(32,435
)
 
(6,207
)
Accounts payable
(1,897
)
 
(4,387
)
Accrued compensation
4,431

 
7,709

Accrued and other liabilities
21,753

 
8,353

Deferred revenue
113,265

 
75,361

Net cash provided by operating activities
151,754

 
80,277

Cash flows from investing activities
 
 
 
Purchases of investments
(587,273
)
 
(249,803
)
Proceeds from sales of investments
1,999

 
6,630

Proceeds from maturities of investments
109,921

 
129,096

Acquisition of business, net of cash acquired

 
(10,102
)
Purchases of property, equipment, and other assets
(12,035
)
 
(25,483
)
Net cash used in investing activities
(487,388
)
 
(149,662
)
Cash flows from financing activities
 
 
 
Proceeds from exercise of stock options
15,743

 
14,085

Proceeds from employee stock purchase plan
7,791

 
5,988

Excess tax benefit from share-based compensation arrangements
1,271

 
674

Repurchases of restricted common stock from terminated employees

 
(109
)
Net cash provided by financing activities
24,805

 
20,638

Net decrease in cash and cash equivalents
(310,829
)
 
(48,747
)
Cash and cash equivalents—beginning of period
653,812

 
310,614

Cash and cash equivalents—end of period
$
342,983

 
$
261,867


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.
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 six months ended January 31, 2015, 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 standard also requires significantly expanded disclosures about revenue recognition. 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 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 an impact on our condensed consolidated financial statements.

- 7 -


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 January 31, 2015 and July 31, 2014 (in thousands):
 
 
January 31, 2015
 
July 31, 2014
 
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Short-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 
$

 
$
1,001

 
$

 
$
1,001

 
$

 
$

 
$

 
$

Corporate debt securities
 

 
51,352

 

 
51,352

 

 
22,239

 

 
22,239

U.S. government and agency securities
 

 
279,721

 

 
279,721

 

 
96,451

 

 
96,451

Total short-term investments
 

 
332,074

 

 
332,074

 

 
118,690

 

 
118,690

Long-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 

 

 

 

 

 
1,000

 

 
1,000

Corporate debt securities
 

 
107,579

 

 
107,579

 

 
39,018

 

 
39,018

U.S. government and agency securities
 

 
356,329

 

 
356,329

 

 
161,862

 

 
161,862

Total long-term investments
 

 
463,908

 

 
463,908

 

 
201,880

 

 
201,880

Other assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 
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

 
$
795,982

 
$

 
$
797,202

 
$
1,220

 
$
320,570

 
$

 
$
321,790

Refer to Note 6. Convertible Senior Notes for the carrying amount and estimated fair value of our convertible senior notes as of January 31, 2015.
3. Investments
The following tables summarize the unrealized gains and losses and fair value of our investments as of January 31, 2015 and July 31, 2014 (in thousands):
 
January 31, 2015
 
Amortized Cost 
 
Unrealized Gains
 
Unrealized Losses
 
Estimated Fair Value
Certificates of deposit
$
1,000

 
$
1

 
$

 
$
1,001

Corporate debt securities
158,933

 
60

 
(62
)
 
158,931

U.S. government and agency securities
635,702

 
423

 
(75
)
 
636,050

Total
$
795,635

 
$
484

 
$
(137
)
 
$
795,982


- 8 -


 
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 January 31, 2015 and July 31, 2014 (in thousands):
 
January 31, 2015
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
Corporate debt securities
$
84,073

 
$
(62
)
 
$

 
$

 
$
84,073

 
$
(62
)
U.S. government and agency securities
206,056

 
(75
)
 

 

 
206,056

 
(75
)
Total
$
290,129

 
$
(137
)
 
$

 
$

 
$
290,129

 
$
(137
)
 
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 likely 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 January 31, 2015.
The following table summarizes the amortized cost and fair value of our investments as of January 31, 2015, by contractual years-to-maturity (in thousands):
 
Amortized Cost
 
Fair Value
Due within one year
$
332,047

 
$
332,074

Due within one to two years
462,498

 
462,819

Due within two to three years
1,090

 
1,089

Total
$
795,635

 
$
795,982


- 9 -


4. Intangible Assets
The following table presents details of our purchased intangible assets as of January 31, 2015 and July 31, 2014 (in thousands):
 
 
January 31, 2015
 
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

 
$
(4,469
)
 
$
37,631

 
$
34,500

 
$
(1,643
)
 
$
32,857

Acquired intellectual property
 
8,156

 
(1,399
)
 
6,757

 
6,546

 
(958
)
 
5,588

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

 
(686
)
 
1,214

 
1,900

 
(370
)
 
1,530

Other
 
500

 
(246
)
 
254

 
500

 
(120
)
 
380

Total intangible assets with finite lives
 
52,656

 
(6,800
)
 
45,856

 
43,446

 
(3,091
)
 
40,355

In-process research and development with indefinite lives
 

 

 

 
7,600

 

 
7,600

Total purchased intangible assets
 
$
52,656

 
$
(6,800
)
 
$
45,856

 
$
51,046

 
$
(3,091
)
 
$
47,955

We recognized amortization expense of $1,955,000 and $3,709,000 for the three and six months ended January 31, 2015, respectively, and $270,000 and $425,000 for the three and six months ended January 31, 2014, respectively. Our in-process research and development acquired from Cyvera Ltd. (“Cyvera”) 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 January 31, 2015 (in thousands):
 
Fiscal Years Ending July 31,
 
Remaining 2015
 
2016
 
2017
 
2018
 
2019
 
2020 and Thereafter
Developed technology
$
3,007

 
$
6,014

 
$
6,014

 
$
6,014

 
$
6,014

 
$
10,568

Acquired intellectual property
491

 
947

 
853

 
617

 
511

 
3,338

In-process research and development held for defensive purposes
317

 
633

 
264

 

 

 

Other
124

 
130

 

 

 

 

Total future amortization expense
$
3,939

 
$
7,724

 
$
7,131

 
$
6,631

 
$
6,525

 
$
13,906

5. Other Financial Information
The following table presents details of our other assets as of January 31, 2015 and July 31, 2014 (in thousands):
 
January 31, 2015
 
July 31, 2014
Intellectual property licenses
$
44,624

 
$
46,997

Deferred tax charge
30,423

 

Debt issuance costs
11,330

 
12,332

Other assets
7,098

 
7,199

Total other assets
$
93,475

 
$
66,528

In December 2014, we reorganized our corporate structure to more closely align with the global nature of our business. As a result, we recorded a deferred tax charge in other assets in our condensed consolidated balance sheets. This amount will be amortized on a straight-line basis over approximately six years as a component of provision for income taxes in our condensed consolidated statements of operations.
6. Convertible Senior Notes

- 10 -


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 “Indenture”). 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;
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 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, 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 our 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 our condensed consolidated balance sheets and are being amortized to interest expense in our 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 our 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 January 31, 2015 and July 31, 2014 (in thousands):
 
January 31, 2015
 
July 31, 2014
Liability:
 
 
 
Principal
$
575,000

 
$
575,000

Less: debt discount, net of amortization
98,128

 
108,125

Net carrying amount
$
476,872

 
$
466,875

 
 
 
 
Equity
$
(109,785
)
 
$
(109,785
)

- 11 -


The total estimated fair value of the Notes was $751,813,000 and $587,087,000 at January 31, 2015 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 January 31, 2015 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. As of January 31, 2015, the if-converted value of the Notes exceeded its principal amount by $74,929,000.
The following table sets forth interest expense recognized related to the Notes for the three and six months ended January 31, 2015 (dollars in thousands):
 
Three Months Ended
 
Six Months Ended
 
January 31, 2015
Amortization of debt issuance costs
$
505

 
$
1,002

Amortization of debt discount
5,016

 
9,997

Total interest expense recognized
$
5,521

 
$
10,999

 
 
 
 
Effective interest rate of the liability component
4.8
%
 
4.8
%
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 our 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 our condensed consolidated balance sheets.
7. 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 under our operating leases as of January 31, 2015 (in thousands):

- 12 -


 
Amount
Fiscal years ending July 31:
 
Remaining 2015
$
8,479

2016
16,901

2017
15,919

2018
12,926

2019
10,620

2020 and thereafter
42,833

Committed gross lease payments
107,678

Less: proceeds from sublease rental
9,703

Net operating lease obligation
$
97,975

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 January 31, 2015, we had $38,893,000 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 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. Refer to Note 8. Legal Settlement for more information on the settlement agreement.
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 January 31, 2015, 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.
8. Legal Settlement
Mutual Covenant Not to Sue and Release Agreement
On January 27, 2014, we executed a Mutual Covenant Not to Sue and Release Agreement with Fortinet, Inc., thereby extending an existing covenant for six more years. We evaluated the transaction as a multiple-element arrangement and allocated the one-time payment that we made in the amount of $20,000,000 to each identifiable element using its relative fair value. Based on our estimates of fair value, we determined that the primary benefit of the arrangement is avoided litigation cost and the release of any potential past claims, with no material value attributable to future use or benefit. Accordingly, we recorded a $20,000,000 settlement charge within legal settlement expense in our condensed consolidated statement of operations during the three months ended January 31, 2014.
Settlement, Release and Cross-License Agreement with Juniper
On May 27, 2014, we entered into the settlement agreement with Juniper, whereby we resolved all pending litigation matters. Under the terms of the settlement agreement, we agreed to pay Juniper a one-time settlement amount of approximately $175,000,000,

- 13 -


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 our consolidated statement of operations during the three months 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 legal settlement expense in our condensed consolidated statement of operations during the three months ended April 30, 2014. The licensing of intellectual property is being amortized over the estimated period of benefit of five years.
9. 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):
 
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
(38
)
 
17.31

 
 
 
 
Options exercised
(1,304
)
 
12.09

 
 
 
 
Balance—January 31, 2015
4,488

 
$
13.26

 
6.6
 
$
507,727

Options vested and expected to vest—January 31, 2015
4,431

 
$
13.18

 
6.5
 
$
501,634

Options exercisable—January 31, 2015
2,993

 
$
11.07

 
6.3
 
$
345,153

Restricted Stock Unit (RSU) Activities

- 14 -


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
3,150

 
107.24

 
 
 
 
RSUs vested
(1,326
)
 
54.68

 
 
 
 
RSUs forfeited
(199
)
 
62.32

 
 
 
 
Balance—January 31, 2015
7,671

 
$
80.13

 
1.4
 
$
969,538

RSUs vested and expected to vest—January 31, 2015
6,943

 
$
79.68

 
1.4
 
$
877,526

Share-Based Compensation
The following table summarizes share-based compensation included in costs and expenses (in thousands):
 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2015
 
2014
 
2015
 
2014
Cost of product revenue
$
955

 
$
320

 
$
1,704

 
$
584

Cost of services revenue
5,140

 
2,085

 
8,635

 
3,571

Research and development
18,990

 
5,807

 
32,989

 
9,159

Sales and marketing
21,727

 
9,745

 
37,526

 
16,678

General and administrative
10,069

 
6,427

 
14,502

 
8,803

Total
$
56,881

 
$
24,384

 
$
95,356

 
$
38,795

At January 31, 2015, total compensation cost related to unvested share-based awards not yet recognized was $528,930,000, 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.
10. Income Taxes
Our provision for (benefit from) income taxes for the three and six months ended January 31, 2015 reflects an effective tax rate of 1.6% and negative 0.6%, respectively. Our effective tax rate for the six months ended January 31, 2015 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 U.S. federal and state income taxes. 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 same periods last year, our 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 and six months ended January 31, 2014 reflects an effective tax rate of negative 7.0% and negative 8.8%, respectively. Our effective tax rates for these periods were negative due to the fact that we recorded a provision for income taxes on year to date losses. The key components of our income tax provision, and the related effective tax rate, consist of foreign tax losses which derive no benefit, non-deductible share-based compensation, and foreign income and withholding taxes.
In December 2014, the Tax Increase Prevention Act of 2014 was signed into law, which retroactively extends the federal research and development credit, bonus depreciation, and other corporate tax incentives through December 31, 2014. The benefit from income tax derived from this for the fiscal year ending July 31, 2015 is dependent on actual results for the year.
As of January 31, 2015, we had $44,583,000 of unrecognized tax benefits, $4,856,000 of which would affect income tax expense if recognized, after consideration of our valuation allowance in the U.S. and other assets. The increase in unrecognized tax benefits since July 31, 2014 relates to positions taken in the current year. As of January 31, 2015, our federal, state, and foreign returns for the tax years 2008 through the current period remain open to examination. Fiscal years outside the normal statute of limitation

- 15 -


remain open to audit by tax authorities due to tax attributes generated in earlier years, which have been carried forward and may be audited in subsequent years when utilized. We do not expect the unrecognized tax benefits to change significantly over the next 12 months. We recognize both interest and penalties associated with uncertain tax positions as a component of income tax expense. The ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty.
11. Net Income (Loss) Per Share
Basic net income (loss) per 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
 
Six Months Ended
 
January 31,
 
January 31,
 
2015
 
2014
 
2015
 
2014
Net loss
$
(43,008
)
 
$
(39,946
)
 
$
(73,076
)
 
$
(47,807
)
Weighted-average shares used to compute net loss per share, basic and diluted
80,824

 
72,854

 
80,105

 
72,260

Net loss per share, basic and diluted
$
(0.53
)
 
$
(0.55
)
 
$
(0.91
)
 
$
(0.66
)
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):
 
January 31,
 
2015
 
2014
Options to purchase common stock
4,488

 
7,807

RSUs
7,671

 
5,201

ESPP shares
98

 
132

Convertible senior notes
5,214

 

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

 

Total
22,685

 
13,140


- 16 -


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: expectations regarding drivers of and factors affecting growth in our business; 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 Traps, 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 and six months ended January 31, 2015 to the three and six months ended January 31, 2014.
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.
Contractual Obligations and Commitments. An overview of our contractual obligations, contingent liabilities, commitments, and off-balance sheet arrangements outstanding as of January 31, 2015, including expected payment schedule.
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.     

- 17 -


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-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 our hardware appliances is also available in our 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, which together provide us with a source of recurring services revenue. 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 January 31, 2015, we had sold to more than 22,500 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 six months ended January 31, 2015, our headcount increased by 361 to 2,083 employees.
For the second quarter of fiscal 2015 and 2014, revenues were $217.7 million and $141.1 million, respectively, representing year over year growth of 54.3%. All three components of our hybrid SaaS revenue model experienced year over year growth, led by revenue from subscription services, which grew 73.8% to $50.1 million, followed by support and maintenance services, which grew 65.3% to $52.0 million, and product, which grew 43.1% to $115.6 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.

- 18 -


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).
 
January 31, 2015
 
July 31, 2014
 
(in thousands)
Total deferred revenue
$
535,843

 
$
422,578

Cash, cash equivalents, and investments
$
1,138,965

 
$
974,382

 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2015
 
2014
 
2015
 
2014
 
(dollars in thousands)
Total revenue
$
217,655

 
$
141,068

 
$
410,001

 
$
269,248

Year over year percentage increase
54.3
 %
 
46.2
 %
 
52.3
 %
 
47.6
 %
Gross margin percentage
72.7
 %
 
73.4
 %
 
72.5
 %
 
73.5
 %
Operating loss
$
(38,516
)
 
$
(37,156
)
 
$
(62,279
)
 
$
(44,167
)
Operating margin percentage
(17.7
)%
 
(26.3
)%
 
(15.2
)%
 
(16.4
)%
Billings (non-GAAP)
$
282,778

 
$
186,703

 
$
523,266

 
$
344,609

Cash flow provided by operating activities
 
 
 
 
$
151,754

 
$
80,277

Free cash flow (non-GAAP)
 
 
 
 
$
139,719

 
$
54,794

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:

- 19 -


 
Six Months Ended January 31,
 
2015
 
2014
 
(in thousands)
Free cash flow (non-GAAP):
 
 
 
Cash flow provided by operating activities
$
151,754

 
$
80,277

Less: purchases of property, equipment, and other assets
12,035

 
25,483

Free cash flow (non-GAAP)
$
139,719

 
$
54,794

Net cash used in investing activities
$
(487,388
)
 
$
(149,662
)
Net cash provided by financing activities
$
24,805

 
$
20,638

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 January 31,
 
Six Months Ended January 31,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Billings (non-GAAP):
 
 
 
 
 
 
 
Total revenue
$
217,655

 
$
141,068

 
$
410,001

 
$
269,248

Add: change in total deferred revenue
65,123

 
45,635

 
113,265

 
75,361

Billings (non-GAAP)
$
282,778

 
$
186,703

 
$
523,266

 
$
344,609

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, WildFire, and GlobalProtect 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.

- 20 -


Cost of Revenue
Our 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 acquired intangible assets, 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, general and administrative, and legal settlement 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 January 31, 2015, we expect to recognize approximately $528.9 million of share-based compensation expense over a weighted-average period of approximately 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.
Legal Settlement. Legal settlement expense consists of the charge related to the Mutual Covenant Not to Sue and Release Agreement with Fortinet, Inc. (“Fortinet”) in the second quarter of fiscal 2014.

- 21 -


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 (Benefit from) Income Taxes
Provision for (benefit from) 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.
During the second quarter of fiscal 2015, we recorded a deferred tax charge of $36.7 million. The current portion of the deferred tax charge is included in prepaid expenses and other current assets and the remainder in other assets in our condensed consolidated balance sheets. The deferred tax charge will be amortized on a straight-line basis over approximately six years as a component of provision for income taxes.
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 January 31,
 
Six Months Ended January 31,
 
2015
 
2014
 
2015
 
2014
 
(dollars in thousands)
Condensed Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
Revenue:
 
 
 
 
 
 
 
Product
$
115,621

 
$
80,823

 
$
217,097

 
$
156,308

Services
102,034

 
60,245

 
192,904

 
112,940

Total revenue
217,655

 
141,068

 
410,001

 
269,248

Cost of revenue:
 
 
 
 
 
 
 
Product
30,640

 
20,221

 
59,781

 
38,175

Services
28,685

 
17,283

 
53,005

 
33,136

Total cost of revenue
59,325

 
37,504

 
112,786

 
71,311

Total gross profit
158,330

 
103,564

 
297,215

 
197,937

Operating expenses:
 
 
 
 
 
 
 
Research and development
46,948

 
24,253

 
84,253

 
44,146

Sales and marketing
122,875

 
76,734

 
229,241

 
144,100

General and administrative
27,023

 
19,733

 
46,000

 
33,858

Legal settlement

 
20,000

 

 
20,000

Total operating expenses
196,846

 
140,720

 
359,494

 
242,104

Operating loss
(38,516
)
 
(37,156
)
 
(62,279
)
 
(44,167
)
Interest expense
(5,539
)
 
(14
)
 
(11,028
)
 
(22
)
Other income (expense), net
344

 
(170
)
 
685

 
235

Loss before income taxes
(43,711
)
 
(37,340
)
 
(72,622
)
 
(43,954
)
Provision for (benefit from) income taxes
(703
)
 
2,606

 
454

 
3,853

Net loss
$
(43,008
)
 
$
(39,946
)
 
$
(73,076
)
 
$
(47,807
)
 
 
 
 
 
 
 
 
Number of employees at period end
2,083

 
1,375

 
2,083

 
1,375


- 22 -



 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2015
 
2014
 
2015
 
2014
 
(as a percentage of revenue)
Condensed Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
Revenue:
 
 
 
 
 
 
 
Product
53.1
 %
 
57.3
 %
 
53.0
 %
 
58.1
 %
Services
46.9
 %
 
42.7
 %
 
47.0
 %
 
41.9
 %
Total revenue
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Cost of revenue:
 
 
 
 
 
 
 
Product
14.1
 %
 
14.3
 %
 
14.6
 %
 
14.2
 %
Services
13.2
 %
 
12.3
 %
 
12.9
 %
 
12.3
 %
Total cost of revenue
27.3
 %
 
26.6
 %
 
27.5
 %
 
26.5
 %
Total gross profit
72.7
 %
 
73.4
 %
 
72.5
 %
 
73.5
 %
Operating expenses:
 
 
 
 
 
 
 
Research and development
21.6
 %
 
17.2
 %
 
20.5
 %
 
16.4
 %
Sales and marketing
56.5
 %
 
54.4
 %
 
55.9
 %
 
53.5
 %
General and administrative
12.3
 %
 
13.9
 %
 
11.3
 %
 
12.6
 %
Legal settlement
 %
 
14.2
 %
 
 %
 
7.4
 %
Total operating expenses
90.4
 %
 
99.7
 %
 
87.7
 %
 
89.9
 %
Operating loss
(17.7
)%
 
(26.3
)%
 
(15.2
)%
 
(16.4
)%
Interest expense
(2.5
)%
 
 %
 
(2.7
)%
 
 %
Other income (expense), net
0.1
 %
 
(0.2
)%
 
0.2
 %
 
0.1
 %
Loss before income taxes
(20.1
)%
 
(26.5
)%
 
(17.7
)%
 
(16.3
)%
Provision for (benefit from) income taxes
(0.3
)%
 
1.8
 %
 
0.1
 %
 
1.4
 %
Net loss
(19.8
)%
 
(28.3
)%
 
(17.8
)%
 
(17.7
)%


- 23 -


Comparison of the Three and Six Month Periods Ended January 31, 2015 and 2014
Revenue
 
Three Months Ended January 31,
 
 
 
 
 
Six Months Ended January 31,
 
 
 
 
 
2015
 
2014
 
Change
 
2015
 
2014
 
Change
 
Amount
 
Amount
 
Amount
 
%
 
Amount
 
Amount
 
Amount
 
%
 
(dollars in thousands)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
115,621

 
$
80,823

 
$
34,798

 
43.1
%
 
$
217,097

 
$
156,308

 
$
60,789

 
38.9
%
Services
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subscription
50,076

 
28,818

 
21,258

 
73.8
%
 
93,774

 
53,614

 
40,160

 
74.9
%
Support and maintenance
51,958

 
31,427

 
20,531

 
65.3
%
 
99,130

 
59,326

 
39,804

 
67.1
%
Total services
102,034

 
60,245

 
41,789

 
69.4
%
 
192,904

 
112,940

 
79,964

 
70.8
%
Total revenue
$
217,655

 
$
141,068

 
$
76,587

 
54.3
%
 
$
410,001

 
$
269,248

 
$
140,753

 
52.3
%
Revenue by geographic theater:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Americas
$
147,080

 
$
90,869

 
$
56,211

 
61.9
%
 
$
278,935

 
$
177,035

 
$
101,900

 
57.6
%
EMEA
44,820

 
33,098

 
11,722

 
35.4
%
 
83,304

 
56,973

 
26,331

 
46.2
%
APAC
25,755

 
17,101

 
8,654

 
50.6
%
 
47,762

 
35,240

 
12,522

 
35.5
%
Total revenue
$
217,655

 
$
141,068

 
$
76,587

 
54.3
%
 
$
410,001

 
$
269,248

 
$
140,753

 
52.3
%
Product revenue increased $34.8 million, or 43.1%, for the three months ended January 31, 2015 compared to the three months ended January 31, 2014. Product revenue increased $60.8 million, or 38.9%, for the six months ended January 31, 2015 compared to the six months ended January 31, 2014. The increase in both periods 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 $41.8 million, or 69.4%, for the three months ended January 31, 2015 compared to the three months ended January 31, 2014. The increase was driven by a 73.8% increase in our subscription revenue and a 65.3% increase in our support and maintenance revenue due to increased sales to new and existing end-customers. Services revenue increased $80.0 million, or 70.8%, for the six months ended January 31, 2015 compared to the six months ended January 31, 2014. The increase was driven by a 74.9% increase in our subscription revenue and a 67.1% 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 and six months ended January 31, 2015 compared to the three and six months ended January 31, 2014 due to its larger and more established sales force compared to our other theaters. Revenue from both EMEA and APAC increased for the three and six months ended January 31, 2015 compared to the three and six months ended January 31, 2014 due to our investment in increasing the size of our sales force and number of channel partners in these theaters.

- 24 -


Cost of Revenue and Gross Margin
 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2015
 
2014
 
2015
 
2014
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
(dollars in thousands)
Cost of revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
30,640

 
 
 
$
20,221

 
 
 
$
59,781

 
 
 
$
38,175

 
 
Services
28,685

 
 
 
17,283

 
 
 
53,005

 
 
 
33,136

 
 
Total cost of revenue