Kelsey Turcotte - Vice President of Investor Relations Mark D. McLaughlin - Chairman of the Board, President, & Chief Executive Officer Steffan C. Tomlinson - Chief Financial Officer.

Raimo Lenschow - Barclays Capital Matthew Niknam - Goldman Sachs Keith Weiss - Morgan Stanley Shaul Eyal - Oppenheimer Brent Thill - UBS Karl Keirstead - Deutsche Bank Rob Owens - Pacific Crest Securities Philip Winslow - Credit Suisse Walter Pritchard - Citigroup Gray Powell - Wells Fargo Scott Zeller - Needham & Company Andrew Nowinski - Piper Jaffray Aaron Schwartz - Macquarie Hendi Susanto - Gabelli & Company Erik Suppiger - JMP Securities Michael Turits - Raymond James Jeff Kvaal - Northland.

Welcome to the Palo Alto Networks’ first quarter 2015 earnings conference call. Today’s conference is being recorded. [Operator Instructions] At this time I would like to turn the conference over to Kelsey Turcotte..

the Credit Suisse 18th Annual Technology Conference on Wednesday December 3rd in Phoenix; the Raymond James 2014 Systems Semiconductor Software and Supply Chain Conference on Tuesday, December 9th in New York City; and the Barclay’s Global Technology Conference on Wednesday December 10th in San Francisco. With that, I’ll turn the call over to Mark..

first, at the most basic level, security continues to be a critical business imperative that must be addressed by every business in the world and this is driving increased security spend; second, in the security battle, prevention is the ultimate objective and Palo Alto Networks’ integrated and automated next generation security platform is unique and delivers unparalleled prevention capabilities in the $16 billion addressable market opportunity; and third, we believe we’ve successfully scaled a global sales coverage model with a powerful sales team and key distribution relationships in every geographic theater providing our customers with security subject matter experts that are best in class both before and after an order.

Our Q1 results reflect these long term factors at work and also reflect the power of our land and expand strategy. On the land side, we continue to acquire customers at a very fast pace and are now pleased to serve approximately 21,000 customers worldwide.

Examples of new customer wins in the quarter included replacing CISCO, Bluecoat, and Websense for perimeter security at a Fortune 10 company, replacing Checkpoint and CISCO at an enterprisewide global deployment in one of Asia’s largest financial institutions and replacing Checkpoint and CISCO as the primary datacenter firewall for one of the nation’s largest insurance companies.

The expand side of the business also continues to grow quickly.

To make our top 25 customer list in Q1, a customer had to have spent a minimum of $6.1 million in lifetime value, up from $5.6 million last quarter and almost all of those customers made a purchase in the quarter as to replace legacy technology and point product solutions in favor of our next generation enterprise platform.

Customers are switching to us and continue to make repeat purchases at a rapid pace because of our technology. We believe our platform provides customers with the most comprehensive protection and prevention in the market for all their security use cases, while each individual aspect offers best of breed capabilities.

For example, in the datacenter use case, we continue to see broad adoption of our high end PA-7050 chassis. In the quarter, we saw sizeable purchases such as a global service provider buying more than a dozen chassis and one of the world’s largest oil and gas companies significantly expanding the current deployment with eight additional chassis.

Also, to continue to provide the world’s best prevention capabilities at all points in the network, two weeks ago we launched our newest appliance the PA-3060 for our midsized enterprise customers’ datacenter use cases.

In the advanced persistent threat solutions space, we believe we are now the largest provider by customer count with approximately 4,000 customers paying for WildFire’s integrated and automated prevention capabilities, and in late September we made real time exploit and malware prevention at both the network and the endpoint reality with the integration of Traps and WildFire.

This is extremely compelling for all customers who understand how vulnerable endpoints are to attack.

While it will take time for Traps to ramp into a meaningful revenue contributor, we’re off to a good start and closed multiple Traps deals in the quarter including a mid-six figure win in a highly competitive bake off within a large US based energy company. We are seeing a lot of enthusiasm for this disruptive offering.

New product announcements like the PA-3060 and Traps place us at the forefront of solving some of our customers most complex security needs and we continue to innovate helping them to safely and securely embrace technology trends like Cloud and mobility.

We continue to be pleased with the high degree of interest in the Palo Alto Networks’ addition for NSX and are engaged in a large number of POCs. Also in October, we expanded our partnership with VMware to provide our advanced security to VMware’s public Cloud platform vCloud Air.

Enterprises can now apply the same rich set of security services available through VMware NSX and Palo Alto Networks across both public and private Cloud environments.

We also enhanced our global protect mobility offering helping organizations control access to enterprise applications and data based on key policy criteria such as application, user, and device, and we announced the latest release of our VM series with support for Amazon AWS and KBM.

Our customers can now take advantage of the productivity and cost benefits of the Cloud without compromising their security.

We were able to achieve all this in the quarter while at the same time delivering bottom line results and cash flow generation that continued to demonstrate the leverage we have in the business and the ability to expand it over time.

Given the strong start to the year, we remain confident in our continued growth and our ability to gain market share at a rapid rate. Security is the top IT spending priority across organizations of all sizes and our solutions to customers’ security problems is unique in the market.

We believe our highly integrated next generation firewall, subscription services, and advanced endpoint protection deliver best in class security at each point of the kill chain and when used together provide superior security at a superior total cost of ownership. With that, I’ll wrap it up and turn it over to Steffan..

product; subscription; and support all grew very well in Q1. Q1 product revenue of $101.5 million increased 34% over the prior year and 2% sequentially. We saw particular strength in the contribution from our highest end appliances, including the PA-7050 which continues to provide greater opportunity in the datacenter market.

Our recurring services revenue of $90.9 million increased 72% over the prior year and 16% sequentially and accounted for a 47% share of total revenue. Looking at the two components of recurring service revenue, the first component is our SAS based subscription revenue of $43.7 million which increased 76% over the prior year and 16% sequentially.

Support and maintenance revenue, the second component of recurring services, was $47.2 million, an increase of 69% over the prior year and 15% sequentially. Billings in Q1 were $240.5 million, an increase of 52% year-over-year and 3% sequentially. Growth in recurring services billings positively impacts deferred revenue.

Total deferred revenue in Q1 was $470.7 million, an increase of 69% year-over-year and 11% sequentially. Short term deferred revenue increased to $286.7 million, an increase of 67% year-over-year and 10% sequentially. Total gross margin for Q1 was 76.8%, an increase of 180 basis points compared to last year and 10 basis points sequentially.

Product gross margin was 75.1%, a decrease of 150 basis points year-over-year and 60 basis points sequentially. The sequential modest decline was due in part to investments we’re making in manufacturing operations, and we expect there will be fluctuations in product gross margin primarily due to product mix.

Services gross margin for Q1 was 78.6% an increase of 580 basis points year-over-year and 60 basis points sequentially due in part to ongoing growth in the contribution from subscription services. For the quarter, research and development expense was 11.9% of revenue, increasing approximately $2.1 million sequentially to $22.8 million.

This was primarily due to headcount growth. Sales and marketing expense for Q1 was 46.8% of revenue decreasing approximately $2.5 million sequentially to $90.1 million. This was primarily due to a decrease in sales commissions related to our strong fiscal year ’14 year end performance.

General and administrative expense for Q1 was 7.5% of revenue increasing approximately $5.4 million sequentially to $14.4 million. This was driven in part by consulting and outside services related to projects in the G&A organization. Total headcount at the end of the quarter was 1,900 up from 1,722 at the end of Q4 fiscal 2014.

In total Q1 operating expenses were $127.3 million or 66.2% of revenue. Operating margin grew 310 basis points year-over-year to 10.6% an increased sequentially 250 basis points.

Net income for the quarter was $12.8 million or $0.15 per diluted share using 84.7 million shares compared with net income of $6.2 million or $0.08 per diluted share in Q1 2014. On a GAAP basis for the first quarter net loss was $3.1 million or $0.38 per basic and diluted share.

This compares with a Q1 2014 GAAP net loss of $7.9 million or $0.11 per basic and diluted share. We finished October with cash, cash equivalents and investments of $1.1 billion. Cash flow from operations, free cash flow, and free cash flow margin for Q1 was $74.9 million, $69 million and 35.9% respectively.

Capital expenditures in the quarter totaled $5.9 million. Consistent with the strength we saw in the quarter linearity in Q1 tracked better than then the prior year period. Our accounts receivable balance was $116.2 million for this quarter, down from $135.5 million in Q4. DSOs decreased sequentially and year-over-year by four days to 59 days.

Turning to guidance, as we enter Q2 we feel good about the strength in our business and our ability to capitalize on expected year end buying patterns. In Q2 2015 we expect revenue to be in the range of $200 million to $204 million which represents 42% to 45% growth year-over-year.

We expect non-GAAP EPS to be in the range of $0.16 to $0.17 per share using 85 million to 87 million shares. Before I conclude, I’d like to highlight a few considerations for modeling purposes.

Due to strong growth seasonality has been difficult to forecast but we believe that over the longer term fiscal Q2 and Q4 may show our strongest revenue growth.

As a reminder, in fiscal year 2015 we expect to invest approximately $25 million or $0.18 to $0.19 per share in Traps, our advanced endpoint protection offering with the level of investment skewed to the back half of the year.

Consistent with what we said last quarter, we expect cap ex for fiscal year 2015 to be in the range of $45 million to $50 million for the year and as we said previously, we continue to expect to exit Q4 2015 with a low teens non-GAAP operating margin and to exit Q4 fiscal 2016 at a 22% to 25% non-GAAP operating margin.

With that, I’ll turn the call back over to the operator for Q&A..

I just wanted to kind of talk a little bit about Traps.

Can you talk a little bit about the – you mentioned some early wins there, a little bit about the reception you got from the market and also the opportunity you do have then when you combine it with WildFire and how the sales force is able to upsell and cross sell them?.

Yes, we’re very excited about Traps. As you know, we brought that back to market in late September, so we had it in the market for about six weeks in the quarter, and the reception has been very strong.

Just from an interest level, like we said, we closed a number of deals in the quarter in October and also one that I just wanted to note just because it was a good sized deal, mid six figure deal, it was highly competitive where the customer had already given the PO to somebody else, took it back and gave it to us once they saw that it worked.

That customer, to your point about WildFire integration, was an existing Palo Alto customer running WildFire. When they saw that work together with WildFire, they were extremely impressed with that.

So I think it’s a great completion to the platform concept that we’ve been talking about and selling for a while that’s primarily geared towards prevention and now we can demonstrate that on the endpoint as well, and like I said, the early indications seem very positive..

Your next question comes from Matthew Niknam – Goldman Sachs..

Just a little more broadly, I just have a question on customer activity, can you talk about whether you’re seeing any pull forward of demand from calendar ’15 into calendar ’14? Then secondly, how are you starting to see demand among customers shape up as you head into the next calendar year?.

I think it’s a little difficult to say if there’s pull in. The security market is very strong right now, you can see that in our results, other folks’ results, it’s a good market to be in.

We span the end of the year in this quarter, so we don’t have an impact of folks trying to pull spending in, but as a general matter what we’re seeing is increased attention, increased spending from folks and definitely a desire to have prevention capabilities, and I think that’s why we’re selling so well..

Then just one follow up on international, any color you can provide on what’s driving the acceleration in growth in EMEA and APAC this quarter?.

If you look at how our revenue breaks down across the theaters, you can see that North America, our most mature theater, continues to grow at a very, very healthy rate, and as we’ve said in the past, we invested in the theaters outside the North America, after North America not surprisingly as we grew and matured the company, and I think some of those investments are paying off now over in Europe.

We’ve done a lot of things there under Mark Anderson’s leadership with major accounts, global accounts, all the playbook we’ve been running in North America, he’s been running now in Europe with some good success.

Also, I just wanted to note as well, we had talked before about increasing our distribution relationships with some of the best folks in the world, we mentioned Westcon before on a previous call where we expanded our relationship globally and the real focus of that to start off was in Europe, and early indications on that are really great growth well in excess of 300% in a short period of time on a year-over-year basis, so we’re happy with that relationship and other major global players like that that we’re working with on a global basis..

One follow-on point Matt is with international being a little bit over 30% of our business this quarter, we see that there’s a very big continued growth opportunity across both EMEA and APAC, and we feel that we’re still in the very early innings of getting to that growth..

[Operator Instructions] Your next question comes from Keith Weiss – Morgan Stanley..

I am going to turn two questions into one, but if you could just talk about sort of how you’re doing with sales into existing customer base in terms of going back and getting existing customers to take on more product, whether it would be more subscriptions like WildFire or maybe using a virtualized appliance like where you have VMware? Then question number two, as you guys start to get more mature and you start to actually refresh your own customer base, maybe you could talk to us just a little about how those refreshers are going, how well you’re able to sustain value or add value on the refresh of guys already within your customer base?.

Yes, they’re somewhat related. On the first point, and I’ll call that the wallet share question, we’re seeing a couple of things. The first is a continued increase in subscription rates and attach rates across the board as our customers continue to understand the value of using everything that the platform brings to bear in the battle for security.

So, really healthy as you can see from our subscription services business, attach rates continue to go up.

Then in addition to that, we also are bringing to market from a product perspective, things that can satisfy folks needle up and down the chain if you will and inside their enterprise so the PA-7050 at the high end selling well, we just introduced the 3060 for datacenter use cases for midsized enterprises, and then the addition of Traps as well to complete the platform.

I think that’s all taking effect, but at the end of the day people are really buying into the platform concept and the prevention capabilities that it brings.

On the second portion of your question, on the refresh opportunity we watch our customer very, very closely and all of our customer cohorts are growing in lifetime value overtime and in the earlier ones which we look at in 2009 and 2010, we can see the indication of refresh cycles beginning there and the ability to upsell those folks as well when they’re usually buying a bigger piece of hardware to upsell them on more subscription services because they’re understanding that platform story.

I think all of that is working very well for us..

Your next question comes from Shaul Eyal – Oppenheimer..

Two quick questions on my end, Mark just your thinking about FishNet and Accuvant’s recent [teaming] up, how does that impact your business?.

I think we’ll continue to see consolidation in that part of the industry. I don’t think it’s a bad thing for us, both of those are very good partners of ours and have been increasing their business over time. A combination brings more to bear from what they can do for us as a large vendor in the market so I think that’s probably a good thing..

Thanks for reaffirming the operating margin targets as you exit fiscal ’16 but as we think about further means of lifting up EPS down the road, what’s the current thinking about tax rate? How could that maybe lowered down and in turn lift up EPS?.

Well currently we have a static non-GAAP tax rate of 38%.

What we’ve done over the past couple of year is we’ve committed to an international cost sharing structure for our IP and with that type of structure in place as we become a full taxpayer longer term down the road, we would expect to see our tax rate most likely be in the high 20% range which would be a lift to EPS.

As it relates to non-GAAP in the near term over the next year or so we’ll evaluate the static tax rate of 38% and we’ll probably revisit that a year from now and at that point we’ll have had that static tax rate for about two years..

Your next question comes from Brent Thill – UBS..

Just a question on the relationship between product and services. You had good upside on services and on the product side you were just a little bit [indiscernible].

I’m curious what you’re seeing there as it relates to the services side? Another question as it relates to that, is you look at the manage the fence as a service and how you think you’ll benefit as that seems like it’s early, but there’s a bit opportunity for you in that segment of the business?.

On the product services side we came off of a screaming fourth quarter as you may recall and we’re very happy to see sequential growth across the board Q4 to Q1. We’re very happy with how that turned out. The services side of our business is about 47% of our business right now, continues to grow over time.

We like that a lot, the services show stickiness with the customers, it has higher margins so we really like that trend. At the same time we continue to grow the product revenue at a very high rate as well. I think both of those cylinders are firing very well on our hybrid model.

On the services side, your managed services question, we love services obviously, it’s 47% of the business and growing. We really like the idea of providing what used to be a hardware based security as subscription services and we like that model a lot.

We’re not in the MSS business today, lots of people are in that business and they’ll have to run our products and provide it on a managed services basis so we think we understand that segment of the market pretty well..

Your next question comes from Karl Keirstead – Deutsche Bank..

I’ve got a question about the cash flow performance which was extraordinary in the quarter and the operating cash flow margin tracked way above what your non-GAAP operating margin was.

I’m just wondering if you could give us a little bit of guidance in how to model cash flow? If you look out a year let’s say fiscal ’16, or you can pick the period, what should the relationship be between the operating cash flow margin and your non-GAAP operating margin?.

Well, first of all our cash flow is benefitted this quarter by a great billing cycle in Q4 and very good linearity in Q1. The fact that we drove 35.9% free cash flow margin in the quarter was great. Longer term we’ve been giving folks a guideline around at our target model of 22% to 25% non-GAAP operating margin.

Free cash flows we estimate should be 5% to 8% above.

We’ll continue to refine that down the road but that’s something where we believe free cash flow margin will be above operating margins mainly because operating margins candidly are a lagging indicator of profitability because we have the hybrid SAS revenue model where we take revenues ratably for a large swap of the business but we also take in period expenses for sales commissions.

So, free cash flow is a very meaningful indicator or profitability for us. We believe it’s a differentiating factor from a business model standpoint and the fact that we’re able to post great positive free cash flow while growing top line revenue and billings way above market rate of growth, we feel very good about the power of the business model..

If I could ask my follow up on another metric and that’s the attach rate for the subscriptions. Obviously, that was a big growth engine in the October quarter.

Are you able to bracket for us what the attach rates are for some of the more mature subscription modules?.

Yes, we’ve reported overall attach rates every six months. The last time we talked about this during the last quarter we said on an overall basis it’s 2.1 up from 1.9 the prior previous time we had spoken about that, and attach rates continue to grow for us. That’s because all the subscription services continue to grow very nicely.

Some of the more mature ones, [indiscernible] prevention are in the 80 something percent category of attach and we think a number of these services can reach high maturity rates..

Your next question comes from Rob Owens – Pacific Crest Securities..

I’m curious, as we’re seeing security clearly accelerate here the last couple of quarters not only for you guys but the industry in general, what do you guys think the budget is coming from? What other areas are seeing less spend at this point?.

You know, it’s hard to say what might not be getting funded. We definitely see an increase in security budgets across the boards and that’s on a global basis as well.

The reports that I’ve looked at are pretty clearly indicating that people are figuring out that they have to spend money here and it sounds like they’re going to continue to do that in the future with security being one or two of the top priorities.

I don’t actually track all the other stuff close enough to know who might be shorted for that but somehow people are figuring out how to spend here..

Then as we look at your strong customer acquisition numbers the last couple of quarters showing some acceleration here, who are you seeing most from a displacement standpoint? With everyone kind of adopting a next generation firewall marketing campaign, who are you seeing most competitively these days?.

It really hasn’t changed in quite some time. I know everybody has jumped on the marketing bandwagon for next generation but there’s a few things that I think become increasingly evidence in the market.

The first is when it’s time to show up and really prove that to folks we’ve consistently been the only ones who have been able to show true next generation firewall capabilities. Even more importantly now is the concept of next generation security platform that does prevention.

So not only just next generation firewall but really, really distancing ourselves from everybody else in the market who don’t even have that first capability set and continue to fall further behind on the whole platform concept in prevention. That is across the board.

When we look at our win rates across the board, we’re taking business from everybody in the market today and that looks like that will continue for quite some time..

Your next question comes from Philip Winslow – Credit Suisse..

You guys talk about pretty good success in getting larger and larger deals, what’s really driving that here? Is it really the attach rates of just more and more subscription services? You mentioned the 1.8 to 2.1 that you guys talked about last quarter, [indiscernible] appliances so you can actually go into more and more datacenter deals, or how do you just think about the mix of that? Then, just one quick follow up..

It’s actually a mix of a number of things. The first and probably most important is the acceptance of Palo Alto Networks as a major player in the enterprise security market and understanding that platform capability set as having end-to-end protection prevention capabilities.

As a general matter, people are more inclined to just buy more from us in size and scope and do it on an earlier basis than they have in the past. Then for the existing customers that have been working with us for a while, the ability to march them up from an attach rate perspective has been demonstrated over time.

So it’s really a combination of those few things that are just driving higher – more times at bat, higher initial sales, and then increasing the ability to sell subscriptions in there so the lifetime value continues to go up..

Then just one quick follow up for Steffan, the exit rate for fiscal ’16 that you talked about, maybe if you could just remind us about what sort of that model looks like, sales and marketing as a percentage of revenue and gross margins, etc., so we kind of have an idea of how the model evolves in your mind?.

Well it starts with gross margin, our forecasted range exiting Q4 of fiscal ’16 is 73% to 76%, sales and marketing as a percentage of revenue is 33% to 36%, R&D is 13% to 14%, and G&A is 5% to 6% leading to a range of 22% to 25% non-GAAP operating margin.

When you look at where we are today as a business we are either at or within sniffing distance of all those line items except for sales and marketing and as practitioners of the business, we constantly evaluate growth versus profitability and the fact that we’re growing at 10 times at the rate of the market and much faster than the rate of the competition we are committed to delivering profitability over time but we don’t want to strive to get to be as profitable as possible because we would be leaving a great opportunity on the table.

That’s our viewpoint on it and we’ve been pretty consistent – we’ve been very consistent since the time we went public around the target model exiting Q4 of FY16..

Your next question comes from Walter Pritchard – Citigroup..

Can you talk about on the attach of subscriptions, you mentioned the threat prevention where it is in the approaching 80%, we can kind of do the math on WildFire, as we think about WildFire and other subscriptions that you have, could they approach the 80% or how should we think about the potential peak of attach on those?.

Yes, I think particularly WildFire as an example is a close first cousin to threat prevention when you kind of think about what it does and then particularly when those two things work together, so I think we can see pretty high attach rates on the WildFire.

The other ones are already selling very well at very high attach rates and we have Global Protect which is doing nicely. It’s still our smallest one, as I think the market works through what mobile security is going to look like in the future.

We like that one a lot but we think it’s going to take some time for folks to come to the understanding of how mobile security should be done. Then on top of that, we have Traps as well which is not – it’s not an attach rate as you know, but I think of it as our fifth service from a financial perspective and we have great expectations for that..

Just a follow up to that, should we think about Traps as kind of the next driver here in terms of attach so to speak or do you have in your back pocket other subscription services that might start becoming meaningful that we don’t have released or maybe sort of fledging in beta or something like that over the next couple of years?.

I think about Traps as a fifth service here even though it won’t have an attachment rate concept to it and we’re always evaluating additional subscription services and we have a high bar [indiscernible] those folks have had value in in the past, ideally they’re delivered with hardware, can be assumed into our platform in very elegant, graceful, and a highly integrated way so we’re constantly evaluating things that could fit that bill and I would expect us to have more services in the future..

Your next question comes from Gray Powell – Wells Fargo..

Just a couple if may. Maybe starting off with a bigger picture question, I think in about four maybe five years, you’ve been able to take a high single digit share of the network security market and a much higher flow share of new growth.

How should we think about the opportunity in endpoint security and what do you see as the gaining factors of driving share gains in that market?.

We’re still single digit players in the close to $19 billion addressable market opportunity if you look out a couple of years from today as far as the size of the market, and that is for enterprise security of which the endpoint is a portion of that.

For us, that’s a completely untapped portion of that addressable market opportunity and I think we have two things going for us there. The first is that Traps itself is high disruptive. It is truly doing prevention on endpoint, something nobody has seen before and it’s very, very effective.

In addition to that, when it’s working with the rest of the network security platform it really gives you end-to-end protection prevention across the entire network. So, we think it’s the combination of those two things that will help us drive penetration into the endpoint market and be able to do so at high growth rates.

On the flip side, we love Traps as well because it also is a great benefit to our existing customers or folks who would look at us just for network security so we think it’s also going to benefit us from a sales perspective on the network side of the business. So, those two things working in tandem are pretty nice for us..

One more if I may, can you help us just think about the scalability of Palo Alto’s management console as we think about the potential for you guys to do larger deals? Along those lines, how many appliances can customers manage in some of your largest deployments today?.

On the management platform which we call Panorama is very, very scalable. I think a few years ago some of our competition would like to say that it was somehow a limiting factor for us.

We put a lot of time and attention to that over the last few years both on the software side and also we introduced a hardware platform that Panorama can run on as well the M-100 so that we can have lots of scalability around that. I have not heard a customer in years bring up management platform as any buy in objections.

As far as the capability set, it can manage thousands of devices right now and the deployments out there today are 500 plus devices usually running on Panorama so I don’t think there are any limitations at all..

Your next question comes from Scott Zeller – Needham & Company..

I just wanted to go back to the budget question from earlier.

Could you tell us how often you’re now seeing line items called out for cyber security when you’re competing for deals? If you do see that in opportunity, does that typically mean a larger deal I’m assuming?.

I think we’re seeing the transition that is in play, and this will take some time, into hearing the word cyber security generally used by C suite executives on the technology side so CIOs, CISO, conversations.

But at the same time dealing with people who are actually rolling up their sleeves in operating technology who talk in terms of the network and things that have to run in the network so that’s an evolution of those two things over time.

When people are talking about cyber security, we like that a lot of course because we say, “In cyber security prevention should be your ultimate objective and if you want to future proof your organization in order to do protection and prevention all the way from the network down to the endpoint, then we’ve got the answer to that.” When they bring the operating guys into the room, to really dig into that we’re also able to have very fantastic conversations with them about each aspect of that so they might want to talk about the firewall, we can talk about the firewall, if they want to talk about the endpoint, we talk about the endpoint, talk about IPS, we can talk about IPS, we can talk about all the capabilities after that at both a C suite executive level as well as people who actually have to run stuff at the end of the day, so it’s working well..

Your next question comes from Andrew Nowinski – Piper Jaffray..

I think last quarter you had about 3,000 WildFire paying customers, I’m just curious to know if that changed this quarter and whether Traps can be driving some of that demand for WildFire? Then I just have a quick follow up..

We were just shy of 4,000 paying customers so a great quarter for us in customer addition on paid WildFire.

I think Traps has not been in the market long enough to be influencing WildFire sales, probably the opposite as some of the deals we saw were around Traps in the quarter, but those two things working in conjunction should help each other out over a long term basis..

Then can you just talk about whether WildFire is predominately having success when the customer is already a Palo Alto customer or whether it’s drawing you into some new deals where the customer doesn’t already have a Palo Alto firewall?.

It’s both. Both situations.

We’ve found that if you’re an existing Palo Alto Networks customer not yet using WildFire, the idea that you can do real time malware prevention for known threats and then very, very fast detection and downstream kill chain impacts for malware that is zero day, is a very compelling conversation and of course, we also get to say, “You already bought the infrastructure to support that capability set so you should use WildFire.” In addition to that, when we go into new opportunities and they’re not using our technology at all yet, we very much talk to the platform and the prevention capabilities of the platform and when people hear that, if they’re going to purchase Palo Alto Networks for the first time, they’re inclined to buy WildFire along with that first purchase because they want that advanced persistent threat detection right up front..

Your next question comes from Aaron Schwartz – Macquarie..

On the target operating margins, I know you just mentioned and you talked about it before the sales and marketing is really the area for leverage, the question I have is how do you think about the mix between indirects and direct sales, presumably indirect is going to play a part there in the greater leverage and historically a lot of channel partners might be a little bit more network centric with security.

Are there things or what are the milestones to continue to ramp the indirect side to get to your target margins or are the target margins just a factor of top line growth and you can get there independent of any mix in the channel?.

There are definitely two things that play there, two of which you just said. The first is we are continuing to build out our channel infrastructure.

We have a great partner Ecosystem, and as we invest in the channel, train the channel, the percentage of deals that the channels can close with as little touch from Palo Alto Networks as possible, that will be more leverage for us in the model. We will be getting more revenue growth by virtue of having more channel partners out there.

We’ve always described our sales model as a high touch indirect fulfillment type model so literally close to 100% of deals get fulfilled through the channel but we have a great direct touch sales force that sells side-by-side with the channels.

So what we’ve done in the past, under Mark Anderson’s leadership, is we’ve done account segmentation with looking at global 2000 accounts and major accounts, and in those instances we have very nice high touch direct sales folks, sometimes working in concert with the channel partners as well doing those deals.

For deals that are outside of the very large enterprises, we’re going to be looking more towards our indirect partners to take more of that business from beginning to end. Additionally, how we get to that target sales and marketing line is we’ll have more tramped sales people than ramping sales people over time.

That’s a key component and the fact that we have such a great lifetime value concept where once we acquire a customer and we’re able to sell more to the install base, those repeat sales that happen come at a lower cost of sales to the company.

So strategically we have the direct and indirect function but we also have more ramped people than ramping and other elements that I just covered..

Your next question comes from Hendi Susanto – Gabelli & Company..

A question for Steffan, your R&D was 11.9% in Q1 and 12.3% in fiscal year in 2014 which are below your midterm target of 13% to 15%.

Could you give some insight on whether we can expect R&D as a percentage of revenue to be below that target in the near future? Additionally, services gross margin was very strong, I’m wondering whether we are seeing the uplift of favorable mix towards subscription and operating leverage in service business that we can expect to continue?.

Well, for R&D we keep the filter very tight around the folks who are bringing into the company and we are committed to making the best investments that we can. Our commitment to innovation within R&D has translated very well into new production introductions really changing the game on competition.

Overtime, we feel like in order to sustain the innovation engine we should be around call it 13% or 14%, so there’s going to be some lumpiness as we get there. Additionally, on R&D we’re starting to really build out the Traps team in Tel Aviv, that was prior to our Cyvera acquisition so we are going to see more investment in that business as well.

So, I can’t really comment on the specific near term but we feel good about our target model and we feel like to adequately be committed to innovation you have to be in call it the 13% to 14% range. On the topic of services gross margins, there are two elements to services gross margins.

The first is we are definitely getting the benefit of increasing attached rates to subscriptions and remember, subscriptions are software type gross margins so as we get more subscription revenue that will definitely translate into higher services gross margins.

The other part of the services gross margins is the customer support organization and that’s really people and systems intensive.

What we are starting to see are early days of getting some scale in that group and you can imagine with the sheer number of customers we’ve acquired, we’ve been adding well over 1,000 customers per quarter now for 12 quarters in a row, we need to be investing in that customer support organization but we’re doing it prudently.

So we believe pound-for-pound we have the best customer support organization on the planet and now we’re starting to see some leverage. We’re getting two positive tailwinds in services gross margins..

Your next question comes from Erik Suppiger – JMP Securities..

On Traps, I was wondering can you give us a sense for how that might scale and maybe give us a sense relative to WildFire? You’ve talked about that market size as being significantly bigger but I think you had a different sales model for that so you’re starting to see the elements there, when could we see Traps maybe start to exceed the customer base that you have for WildFire?.

A couple of thoughts around that. The first is that by having Traps in the first place and entering into the endpoint security market, the additional to the addressable market opportunity is anywhere between $4 billion to $5 billion depending on who’s numbers you look at.

Though the endpoint security market is a larger market than what we’ve seen folks who have tried to triangulate on the market called [indiscernible] where WildFire specifically may fall into which have seen anywhere from $1 billion to $2 billion market opportunity.

They’re just different addressable market opportunities in the first place with Traps being a broader one just as far as what the market looks like in terms of size.

Given that, we like that market a lot and as I said a little bit earlier when those two things are operating together it’s a killer offering for folks because you’re getting real time exploit prevention, you’re getting real time malware prevention for known threats, and you’re getting very, very fast turnaround for unknown threats both at the network and on the enterprise so we’re thinking about those two things together.

As far as what we expect to see from Traps, we like the early interest in the market, we like the fact that we’re closing deals already.

We think given the subscription model and the time it will take to ramp the sales and a few other things, that we’ll see meaningful revenue contribution in fiscal ’16 and sales billing throughout the back half of fiscal ’15 but we’re very excited about this opportunity..

Your next question comes from Michael Turits – Raymond James..

Just on WildFire and Traps, in each of those two products who are you specifically going up against in deals with each of those products?.

On the WildFire situation, when people think about that they usually think about advanced persistent threats and there are some folks who would position themselves in the market as more comprehensive so that way all the standard network security competitors, we’re seeing CISCO, Juniper, Checkpoint who have offerings in that space as well, so that’s more our platform will beat them on a head-to-head basis relative to any of their point solutions that they have.

Then the most direct competition we see as far as the standalone player there would be [Fire Ring]. On Traps, the big players in that market are the legacy folks in [Nantech] trend, and MacAfee and ultimately a big part of the market opportunity is in that legacy space.

There’s a host of next gen endpoint folks out there today as well that we’re competing with who are trying to land next to, as a complement to some of those legacy guys as a first step so we’re competing in both cases legacy – but probably today more and more on the next gen guys who are competing for the space on the endpoint to do something new..

Your next question comes from Jeff Kvaal – Northland..

I have two questions and Steffan they both may be for you actually.

I’m wondering if you could comment on number one, the linearity in the quarter, it looks like it was great, could you talk about why linearity is improving and should we expect it to revert to last year’s level at some point? Then secondarily, if you wouldn’t mind, could you tell us more about what was in the consulting element of the G&A uptick and particularly if it’s going to be recurring?.

Linearity in the quarter was very good. Why it’s happening is we are getting a broader pipeline heading into each quarter which is nice and the close rates have been very robust so we’re able to close deals earlier because of the technological differentiation and the power of the platform that we have in addition to great sales execution.

So we’ve had the differentiation that we’ve always had but now we have more feet on the street, more firepower, and we’re able to close deals earlier.

It’s too soon to tell whether or not the linearity will continue to be at these levels, but certainly in our fiscal Q2, one of the interesting things about a company like ours that has a quarter end in January is December typically is a strong month because of calendar year end budget flush so we’d expect to do a very good portion of our business through month two and we’ll see if that holds up this year and there are no indications that it won’t.

As far as consulting services, at the end of the last fiscal year we had a couple of consulting projects roll off and in Q1 we had some come back on mainly in the tax area that we started to make some investments in.

As we build out that organization we’re relying on some external consultants and then also we got some other, I’ll call it discreet projects, that we’re working on all with the intent of helping us get more scale going forward so think of it as finance and accounting projects as well in order to get more future leverage.

So there’s a little bit of quarterly [indiscernible] around projects rolling off and some projects starting and that’s what you really saw.

As far as will it increase at the same rate, certainly not over time because we’re looking at a target model of 5% to 6% for G&A so directionally over time that should go down but there will be quarterly [indiscernible]..

Ladies and gentlemen that does conclude our question and answer session. I’ll now turn the call back over to Mark McLaughlin for closing comments..

Thanks everybody for being on the call this afternoon. We had a great start to the year and we’re really energized for the opportunity we see as we move into fiscal ’15 and beyond. We think we’re at the right market, the right time, with marketing leading protection and prevention technology.

We would like to thank Palo Alto Networks’ team for all their hard work and support, for all of our customers and partners as we continue our march to be the leading enterprise security provider in the world. I wish everyone a happy and healthy Thanksgiving holiday. Thanks for being with us..

Ladies and gentlemen that does conclude today’s conference and we thank you for your participation..