Palo Alto Networks, Inc. (PANW) Q4 2013 Earnings Report, Transcript and Summary

Very good day, ladies and gentlemen. Thank you all for joining. Welcome to the Fourth Quarter 2013 Palo Alto Networks, Inc. Earnings Conference Call. Today's conference is being recorded. [Operator Instructions] And now, I'd like to turn the conference over to Maria Riley for opening remarks. Please proceed.

Good afternoon and thank you for joining us on today's conference call to discuss Palo Alto Networks' fiscal fourth quarter 2013 financial results. This call is also being broadcast live over the web and can be accessed on the Investor section of the Palo Alto Networks website at investors.paloaltonetworks.com. With me on today's call are Mark McLaughlin, Palo Alto Networks' Chairman, President and Chief Executive Officer; and Steffan Tomlinson, Chief Financial Officer. After the market closed today, Palo Alto Networks issued a press release announcing the results for its fiscal fourth quarter and year ended July 31, 2013. If you would like a copy of the release, you can access it online at the company's website, or you can call The Blueshirt Group at (415) 217-7722, and we will e-mail you a copy. We would like to remind you that during the course of this conference call, Palo Alto Networks' management will make forward-looking statements, including statements regarding continued revenue growth, increases in market share and overall momentum in Palo Alto Networks' business, especially as a result of its land, expand and extend strategy; ability to achieve its target operating model, turns in its business and operating results, including customer growth, its services, revenue, gross margin, operating margin, services margin, non-GAAP effective rate, DSOs and seasonality, Palo Alto Networks' revenue, and non-GAAP estimated earnings per share for first fiscal quarter of 2014 ending October 31, 2013 and Palo Alto Networks' non-GAAP expected tax rate for fiscal year 2014 and expected rate at which its outstanding share count will increase in each quarter at fiscal 2014 and Palo Alto Networks' expected capital expenses for 2014. These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future. And we undertake no obligation to update these statements after this call. For a more detailed description of these risks and uncertainties, please refer to our quarterly report on Form 10-Q filed with the SEC on June 4, 2013 and our earnings release posted a few minutes ago on our website. Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in Investors section of our website located at investors.paloaltonetworks.com. Now I'd like to introduce Mark McLaughlin, Chairman, President and Chief Executive Officer of Palo Alto Networks. Mark?

Thank you, Maria, and thank you, everyone, for joining us today. I'm happy to be here to discuss Palo Alto Networks' 2013 and fiscal fourth quarter results. 2013 was a very good year for the company with record growth in new customers, revenue, subscription service revenue, penetration of G2000 accounts and the launch of multiple new offerings. During the year, we continued our rapid displacement of legacy network security vendors and enterprise customers across all business verticals around the world. Our lifetime value on our customer base continues to grow quickly, and our focus on customer satisfaction is best in class. In 2013, we continued our aggressive global go-to-market expansion, and we rapidly took share on our large $12 billion addressable market. We continued our investment in R&D, maintaining our clear technology leadership over the competition as we have every year since Palo Alto Networks came to market. We were able to accomplish all these achievements while growing operating income over 50% during the year. I'm proud of the results and even more proud of our team and world-class partners who deliver them. And we're very aware and appreciative of the confidence that our customers place in us each and every day. We have grown such significant rates relative to the market and relative to all of our competitors and we expect to continue to do so because we've established ourselves as the clear leader in next-generation security at the time when enterprises, governments and service providers face increasingly more frequent and sophisticated cyber attacks. These organizations had realized that legacy network security technology cannot protect them and as a result are switching to Palo Alto Networks as a strategic partner in the site. Our growth strategy as we continue to establish our position as the global leader in next-generation…

Thank you, Mark, and thank you all for joining us. As we conclude FY '13 and look towards FY '14 and beyond, I'll provide a brief refresher on our hybrid revenue model and highlight the positive impact it's having on the business. Then I'll discuss our results and conclude with guidance. First, our revenue model is comprised of 3 components. The first and largest component is our PA series of appliances and other products. When these products ship, we bill and recognize all the revenue at the time of shipment. The second component is maintenance and support services, which is priced at approximately 16% of the appliance list price per year. The third component is subscription services, which is the recurring SaaS-based revenue element of our business. Currently, we have 4 subscriptions, each priced at 20% of the appliance list price per year. For both maintenance and support and subscription services, we have annual and multiyear options. For either option, we bill the entire amount upfront, and it goes on to the balance sheet and deferred revenues and revenue is recognized ratably over the term of the contract. All 3 components of our model grew well in fiscal 2013. Product growth was strong in Q4 and the fiscal year, and we expect that to continue in FY '14. Services growth was also strong, and this has had a positive impacts on billings, deferred revenue, the visibility of future revenues and free cash flow. With that context outlined, I'll now turn to our results. In Q4 '13, total revenue grew to a record $112.4 million, an increase of 49% year-over-year and 11% sequentially. For the fiscal year, we reported record revenue of $396.1 million, a 55% increase over the prior year. Our results were driven by our land and expand strategy.…

[Operator Instructions] Your first question comes from the line of Keith Weiss.

I was wondering if we could start off on just your guys' view of the macro environment. You talked last quarter about seeing something about a stalling in the purchasing behavior. Maybe you can give us an update on what you guys saw through the end of your fiscal year in that regards.

It's Mark. We think things are looking better across the board in this quarter. You can see that from other companies' reported and ourselves. And I think particularly last quarter, folks were a little worried about what the growth rate of the security market was. And I think it shows this quarter sort of remains very healthy. And I think that's going to continue to grow over time, as far as I can tell. The attention that you've seen in the cybersecurity has been with us a long time. It's with us now, whatever happened in the last quarter, it applies -- it appears to have -- we've moved beyond it, at least in this quarter.

Got it. And if I could throw in one follow-up. There's been a lot of rumors, speculations about changes going on in your sales force, changes with sales management. Maybe you can give us an update on what exactly is going on in terms of changes in sales management. And heading into this next fiscal year, are there any big changes in the sales structure, sales comp plan or sales management that we should be expecting heading into FY '14?

Yes. So last quarter, people had asked about the changes in the sales leadership. And as I mentioned last quarter, when Mark Anderson joined us, he's been here more than a year now, he has gone through in the sales leadership ranks. He's made a number of changes to get folks who have the experience to scale very rapidly to $1 billion and beyond. He's got a pretty big appetite for that. We want people to know how to do that. So over the course of the last 6 or 9 months, he's made a number of changes in the leadership team there, which we think have gone very well. All those folks who are on board seem to be gelling very nicely. The team is executing really well. And I think you could see some of that in the -- is coming through in the fourth quarter results.

Your next question comes from the line of Jayson Noland with Robert Baird. Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division: I wanted to ask about the major accounting ramp. I think we were at about 40 in F '13. Maybe Mark, if you can talk about how successful that's been and how many account teams you would expect to add in this new fiscal year?

Jason, yes, that's going very well for us. We put a big, big focus on major and global accounts about 18 months ago. I did, and when bringing Mark on board, he adopted that immediately. He knows how to do that from his previous life. And he has done a great job in recruiting for those teams. So we're seeing bigger and bigger deals. We're getting in front of more deals on a global basis. So that's working really well. And particularly, with a really targeted approach into G2000 where the penetration is going up really nicely for us, winning new logos plus, importantly, selling into the accounts we already have. We'll continue to push on that in fiscal '14 and beyond, as -- there's a lot of money in those accounts and around the world. We want to make sure that we're getting more than our fair share.

Your next question comes from the line of Brent Thill with UBS.

Mark, if you could just give us a sense of how the WildFire 500 appliance are sold in the quarter. I know it was a relatively new joiner to your family. What you're seeing in that trajectory? And I had a quick follow-up.

Sure. Just as a reminder on WildFire -- when we come to market with WildFire, there's really 3 ways to buy that service. And it's the only detection and prevention service out there. The first and foremost is the cloud offering, which has the most impact because it's got the network effect of all customers seeing from our network perspective what other customers have seen. There was a number of customers who came to us, depending on the verticals and said, "We really liked the WildFire technology, but because of our industry, we have some concerns about sharing those samples into the cloud. So we don't think we can do that." So because of that, we developed the WildFire 500 appliance, which allows for the creation of a private network for those folks -- they could also buy and use it as a standalone appliance, although that's not what we're attempting to get folks to do because those appliances tend to be very expensive -- so that you can get more benefit from going into the private or the public cloud approaches, bang for your buck. So with that kind of background in mind, the WildFire 500 is designed for that private cloud number. But the private cloud folks who are in the verticals have really wanted that capability. And in the quarter we met our expectations and naturally we expect that to be nice for us in the future to serve that part of the market.

Okay. And then maybe for Steffan, on the government you're obviously coming into a critical period here. And I know it's probably too early to call, but what's embedded in your expectations for the current quarter in terms of the government follow-through?

With the government year end coinciding with our fiscal Q1, we're anticipating to see decent growth in the federal business. And we should participate in the year-end budget flush if there is one.

Your next question comes from the line of Greg Dunham with Goldman Sachs.

Billings again was another very strong quarter and I appreciate the further detail you provided from the mix of billings from product support and subscription. Can you remind us how salespeople are comped and if you think this trend is going to continue, I guess, what are your plans -- the margin target or [indiscernible]?

Greg, it's Mark. So yes, subscription is doing very nicely for us. And that's the reason we wanted to put a little more highlight on that about -- at the end of the year and give kind of a year-over-year view on that. As you can see that it is really powering the business. And we really love that recurring revenue because it goes into the deferred, it gets more visibility into the business. So there's lots of things to like, and it's growing at a very outsized rates. So very happy with the performance of that. We'd expect that to continue over time as well. From a compensation perspective, our sales folks are comped on selling products. You've got to remember that you can't fill a subscription until you get a product in the account, right? So they are primarily comped on putting products into the account, expanding the footprint of products. And in addition to that, they get compensated for services. And the amount of that depends on the term of the contract for which it's sold.

[Operator Instructions] Your next question comes from the line of Walter Pritchard with Citigroup.

Mark, I'm wondering if you could talk about -- it sounds like you're having some more success in the data center. You gave a couple of examples in the script. And then you have a high-speed product coming in towards the fee beginning next calendar year. Could you talk about maybe what percentage of your sales today are into the data center? How many of those are a primary firewall in the data center and how you expect what you're releasing here in the next 12 months to impact your success rate in that market?

Walter, we're doing really, really well in the data center space, which is great. When we came out with the 5000 series, the adoption rate on that for data center usage was very strong. And you see now -- if you don't know that the 50, 60 runs at 20 gigs right now with full-on, next-gen capabilities. So folks have adopted it very rapidly there. So if we kind of go look back historically, the data center space for us is around the 30-ish percents right now and growing nicely, and we expect that to tick up even more seeing when we came out with the 100-gig chassis, which customers have been saying, "We love everything about this technology and if you can make it faster, we'll love it even more." So we're going to do that. Also, that's an entry point for us into the service provider space. As you know, those guys demand very high throughput devices as well. And we've been working with a lot of those service providers to secure their networks. And now they'd like to work with us with this new appliance to help them secure other people's networks as well because of the throughput capabilities.

And are you generally a primary firewall in the data center or are you -- I know you started out obviously in the perimeter as not a primary firewall, became a primary firewall. What would you say the role is at this point in the data center?

We're winning the vast majority of deals when we go into the data center right now as the primary.

Your next question comes from the line of Michael Turits with Raymond. Michael Turits - Raymond James & Associates, Inc., Research Division: I'm wondering if you could just give us your headcount and also maybe just reiterate what the margin guidance is.

For headcount, we ended the year at 1,147. And that was an increase from the prior quarter, over 113 heads. And as far as operating margin guidance is concerned, we remain steady towards -- steady progress towards our target model on a non-GAAP basis of 22% to 25%, exiting Q4 FY '16. We had also provided some prepared comments around operating margin expansion within fiscal year '14. And we anticipate exiting Q4 in the double-digit -- low double-digit operating margin. I'll also just take a moment to note that free cash flow is becoming a more meaningful metric to our business as the profile of our billings has been morphing more positively into a hybrid SaaS model. And you can note that free cash flow margin this last quarter was very robust, exceeding 30%. Michael Turits - Raymond James & Associates, Inc., Research Division: And this one is a follow-up on the headcount issue. You mentioned the sales adds. What -- the sales management seemed to be stabilizing. But where are you in terms of attrition? Has attrition turns been stable, increasing, decreasing?

We're good on that, Michael. We're better than industry average on attrition. And we manage some folks out over time as folks do, but really, we're doing really well on the market. The winners want to be with the winners, so it's not a hard place to stay.

Your next question comes from the line of Phil Winslow with Credit Suisse. Philip Winslow - Crédit Suisse AG, Research Division: I just got a question on the pricing side. Obviously, there's been a lot made across the market about just how the pricing dynamics are across this quarter firewall next-gen, these add-on services. Just comment, if you could, what you saw this quarter, maybe if you compare that to recent quarters.

Phil, it's Mark. We've maintained for quite some time that we have something really different and unique in the market relative to the legacy competitors. And as a result of that, we've been able to charge a premium price for a long time and that was the same in the last quarter. You can see some of that reflected in our product gross margins, which were up. Discounting is stable. So we were able to power through the competition's reduction of prices in order to make up for shortfalls in technology and expect that's going to continue.

[Operator Instructions] Your next question comes from the line of Rob Owens with Pacific Crest Securities.

I guess along the lines of Phil's question around competition, are you seeing more aggressive behavior around customer acquisition, given the massive share gains that you guys are currently seeing? And then also given the discussion right now around APT protection that's out there, where do you think points of differentiation are in this market?

So on the competition front, it's been very competitive for a really long time for us. I can't remember where it hasn't been. So none of that's changed. As we've said in the past, we think that their customers buy primarily for security. They wanted it to [ph] make sense from an enterprise perspective. And then they want to create value. So we nailed all 3 of those value propositions for the customer. And as a result of that, we continue to sell very nice even in the face of the competition, pricing their stuff aggressively, which -- but they've been doing that for a long time now. So it doesn't seem to make much difference. On the APT front, lots of attention, as you know on that. When we think about that, we think about detection and prevention. So the APT angle is in the detection space. Our offering is detection and prevention, which is unique. And the amount of attention that goes into the detection space helps us in -- we are the only folks out there who can do detection and prevention. I think from a differentiation standpoint, the things to watch for are cloud offerings. Can you analyze all files, can you analyze everything application wide instead of just e-mail and web? Can you do that at a very fast speed to make enterprise class performance? And are you going to be able to share, for lack of a better term, what you're seeing in your environment with other folks, that they're seeing in their environments, so you can get the benefit of network effect out there. That's how we base our WildFire offering. We think that's why we're doing so well.

Your next question comes from the line of Jonathan Ho with William Blair. Jonathan Ho - William Blair & Company L.L.C., Research Division: I just wanted to understand a little bit about some of your plans to scale the business next year now that you've added about 4,800 customers this year. Can you talk about where you intend to make the investments in the P&L and just trying to support scaling of the enterprise over that timeframe?

Jonathan, well, it's kind of a both category thing, which is we've added over 4,800 customers last year. We would anticipate the ability to continue to add customers at a very rapid clip. So in customer acquisition, obviously, we'd be investing from a sales and marketing perspective. And then also in servicing those customers as well, we're making continued investments into the services organization to do that. Running -- we're running a world-class services organization here today, and we intend to keep in front of that because we know that you don't have -- customers don't purchase things. As you can see from our expansion in LTV [ph] and wallet share, customers appear to be very happy and buying a lot. And we want to keep them that way, so we keep making investments there. It probably goes unsaid, but I'll say it anywhere. You have the rest of the company out there, right, supporting the point of the spear. We have to continue to invest in this company to maintain this very rapid growth performance services for our customers, internal customers, external customers in a world-class manner, so we'll be doing that as well.

One additional follow-on point, Jonathan, is relative to scaling the business, we are looking to get operating leverage out of sales and marketing over time. When you look at FY '14, this will be the first year where a percentage of ramped versus ramping heads eclipses one another. So the percentage of ramped heads are higher than the ramping heads in FY '14. And so we should be starting to get more leverage in the business in sales and marketing.

Your next question comes from the line of Gray Powell with Wells Fargo.

On the WildFire products, specifically the appliance side, how do you see that impacting your addressable market? And then do you think that WildFire and similar products could potentially cannibalize traditional IPS offerings over time?

Yes. That's a fair question, Gray. So I think it's unclear right now still where the addressable market is coming from, from a wallet perspective for the things that are going on in the detection space around APT. I've heard a lot of folks think that, that might be IPS budget, maybe it's a new budget. For us, we've been winning in the IPS market with our threat prevention for a very long time, so we know how to do that. If that budget is shifting into the APT market, it's good for us. We continue to take the IPS budget, and we'll take that budget as well. If it's new budget, then it's additive. So -- but the win rates are very high and we like the fact that the addressable market is big, even though it may not be exactly clear yet where that might come from.

Your next question comes from the line of Aaron Schwartz with Jefferies.

I had a follow-up question on WildFire. You gave -- I know you're giving the metrics on the total sort of customer count there as well as the paid customer count. On the paid side, is that primarily new customers coming into Palo Alto? Are you actually seeing conversion of sort of existing customers on the paid WildFire version?

Aaron, it's actually both. So we're doing nicely in both. A lots of new customers are buying the service when they're buying the products for the first time. And then with that large of an installed base, the folks who are using the free services are fantastic place to go mine and upsell them to the paid for service. So we like the results in both categories.

Okay. And then a quick follow-up question maybe for Steffan. On the deferred revenue, I know it's very minor, but the mix shift, it ticked a little bit to the shorter term, and you had been seeing a trend of multi-year service engagements. I would have thought that would have been a little bit concentrated towards your Q4. Was there anything to read into there? I know the mix shift between short and long term and I know that that was just a very modest shift there, but it can shift back towards short term.

Every quarter, there's going to be fluctuations between the short-term deferred and long term deferred revenue growth. If you look at long-term deferred revenue growth on an annual basis, it grew north of 90% year-over-year. So we're very happy with that. The length of the services contracts has been increasing over time, but there will be some fluctuation.

Ladies and gentlemen, we only have time for 2 more questions. Your next question comes from the line of Gregg Moskowitz.

Mark, just wondering if you can comment on the linearity in the quarter. And then Steffan, there was a fairly large increase in CapEx that was guided for fiscal '14. I know some of that is due to the relocation of your headquarters. I was just wondering if you could put a finer point on the nature of the increase versus '13.

Gregg, on the linearity basis, we saw a back end-loaded quarter as we would expect, particularly at the end of the year. As we're getting bigger, we see more and more of that going to the back end of the quarter, but not in line with what you'd expect across the industry.

And from a CapEx standpoint, we did guide $45 million to $50 million in annual CapEx. We're assuming roughly, call it $5 million to $7 million per quarter in typical CapEx. And then we have a couple of discrete projects that we're working on. The biggest one is the move to our new facility. And from a timing standpoint in putting a finer point on it, in the first half of the fiscal year, we'll be spending the majority of the $45 million to $50 million as we conclude the move to the new facility. So hopefully that gives you a little bit more insight.

Your next question comes from the line of Tal Liani with Bank of America Merrill Lynch.

My question is actually a follow-up on the previous question about quarter linearity and understanding. I'd like to understand if you have information on how much of this quarter growth -- sequential growth is attributed to the weakness last quarter. When I look at April the previous years, I see pretty robust growth. And last quarter was much weaker, which I believe is the macro. But how much of the growth this quarter, in the July quarter, is reversion to the mean, and that means that the growth going forward may be slower than what we are seeing now? So maybe you can speak about what you've seen this quarter that is spillover from previous quarter or whether it's the macro that is driving it.

Tal, it's Mark. A couple of things, I guess. The first is, last quarter we did mention a number of deals that had slipped to the right of -- we closed the majority of those already, which is great. On the macro side, we discussed that in EMEA last quarter, both of those did really well for us in the fourth quarter, so that's great as well. I think the rest of the industry has done pretty decently, so that maybe the concern about macro and security growth slowing down seems to be an aberration. So I put a lot of perspective and say, we grew very, very nicely, 8% sequentially, 55% for the year. We think we're going to maintain some very respectable growth as we look forward, and doing a hell lot better than all the rest of the competition. So we're pretty confident that we've got a really good baseline here for growth.

Your next question comes from Scott Zeller with Needham & Company. Scott Zeller - Needham & Company, LLC, Research Division: Just a question about sales cycle, if you could. As you're increasingly being considered as the primary firewall on accounts, what does that do to the length of sales cycles since it's probably more often that you're considered a replacement for a competitor? Any commentary about changes in sales cycles?

Sales cycles have been being fairly steady for us for quite some time because we're always proposing our technology as a firewall. And more and more and more -- much more than majority of the time, it's being adopted as the firewall. So there can be some very long sales cycles and some really big deals. And then there can be really short ones, where we are literally selling a lot over the phone here. When we look at that on the aggregate, we said in the past sales cycles is up 90 days or so, and that seems to be the case as we go forward.

I would now like to turn the call over to Mr. Mark McLaughlin, CEO, for closing remarks.

Thanks, operator. Thanks, everybody, for being on the call today. I want to reiterate my appreciation for all of the hard work of the Palo Alto Networks team, support of our customers and partners as we continue to revolutionize the cybersecurity market. Thanks for all our shareholders as well. Thank you.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.