Kelsey Turcotte - VP, IR Mark McLaughlin - Chairman, President and CEO Steffan Tomlinson - EVP and CFO Mark Anderson - SVP, Worldwide Field Operations.

Andrew Nowinski - Piper Jaffray Saket Kalia - Barclays Capital Michael Turits - Raymond James Gregg Moskowitz - Cowen and Company Brent Thill - UBS Catharine Trebnick - Dougherty Shaul Eyal - Oppenheimer Michael Baresich - Credit Suisse Jayson Noland - Robert Baird Gray Powell - Wells Fargo Walter Pritchard - Citi Joel Fishbein - BTIG Michael Kim - Imperial Capital Sterling Auty - JPMorgan Rob Owens - Pacific Crest Securities Scott Zeller - Needham Tal Liani - Bank America-Merrill Lynch Keith Weiss - Morgan Stanley Karl Keirstead - Deutsche Bank.

Good day, everyone, and welcome to the Palo Alto Networks Fiscal First Quarter 2016 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Kelsey Turcotte, Vice President of Investor Relations. Please go ahead..

Great. Thank you very much. Good afternoon, and thank you for joining us on today's conference call to discuss Palo Alto Networks fiscal first quarter 2016 financial results. This call is being broadcast live over the web and can be accessed on the Investors section of our website at investors.paloaltonetworks.com.

With me on today's call are Mark McLaughlin, our Chairman, President, and Chief Executive Officer; and Steffan Tomlinson, our Chief Financial Officer. This afternoon we issued a press release announcing our results for the fiscal first quarter ended October 31, 2015. If you'd like a copy of the release, you can access it online at our website.

We'd like to remind you that, during the course of this conference call, management will make forward-looking statements, including statements regarding our financial outlook for the fiscal second quarter of 2016, the spending environment and market opportunity for our products and services, demand for our products and services from both new and existing customers, certain financial results and operating metrics, our growth rate, operating leverage, ability to expand market share, product and service development, and the timing and impact of new releases, expected benefits of our partnerships and our competitive position.

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 these 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 factors that could cause actual results to differ, please refer to our annual report on Form 10-K filed with the SEC on September 17th, 2015, and our earnings release posted a few minutes ago on our website on the SEC's 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.

Historical periods, we have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the supplemental financial information that can be found in the Investors section of our website located at investors.paloaltonetworks.com.

For planning purposes, we expect our second quarter fiscal year 2016 earnings conference call to be held after the market closes on Thursday, February 25.

We'd also like to inform you that we will be presenting at the Credit Suisse 19th Annual Technology Conference on December 2nd, the Raymond James Technology Investors Conference on December 7th, the Barclays Technology, Media and Telecommunications Conference on December 9th and the 18th annual Needham Growth Conference on January 13th.

And finally, at the conclusion of today's conference call we will be of posting our prepared remarks to our Investor Relations website under quarterly results. And with that, I'll turn the call over to Mark..

Thank you, Kelsey, and thank you, everyone, for joining us this afternoon. I'm pleased to report that we had a great start to fiscal 2016. In the first quarter, revenue grew 55% year-over-year to a record $297 million, while billings grew 61% year-over-year to $388 million.

These are the highest first-quarter year-over-year growth rates we have reported since going public. Our Q1 non-GAAP operating margin expanded to 16.7% and non-GAAP earnings per share of $0.35 more than doubled year-over-year. We continue to post industry leading growth rates at scale for a number of reasons.

First, security remains a strategic consideration embedded in virtually every IT decision for both fundamental and new requirements, like cloud and mobility. As a result, the demand environment remains very healthy, and as we look ahead, we expect this to continue to be the case.

Second, legacy products continue to give way to true next generation technology. It is increasingly evident to organizations globally that retrofitted legacy technology is not the same as purpose-built next generation security capabilities. And third, point solutions continue to give way to prevention platforms.

Customers and prospects understand and appreciate the high value associated with the only true platform in the market that natively provides prevention, as opposed to the alternative of legacy products or point solutions, which cannot provide prevention and add more complexity and cost.

As a result of these factors, Palo Alto Networks has established itself as the leader in next generation security. This is increasingly evident in our size, continued rapid market share gains, and global brand recognition, as customers respond well to our vision and technology.

We are very proud to now be serving over 28,000 customers across the globe, who are choosing Palo Alto Networks as their strategic security partner for the future. And we're not resting here. We know that our success is due to our intense focus on solving the hardest security problems for the most demanding customers.

With this in mind, we are always improving our prevention platform and capabilities, further distancing ourselves from the competition.

Some examples of these efforts include our continued momentum in the APT prevention space, as evidenced by the fact that we added the second highest number of new WildFire customers in the company's history during Q1. We now can count well over to 8,000 WildFire customers, including over half of the Fortune 100.

The introduction in August of PA 7080, our 200-gig chassis. We are very pleased with early customer reception and the PA 7080 was the cornerstone to several large Q1 deals.

The September launch of Aperture, our new service that is designed to safely enable the use of sanctioned SaaS applications, and AutoFocus, our threat intelligence service that is designed to provide real-time correlation and relevance for threats across our large and growing customer base.

Interest in both is high, and we are pleased to see these services being adopted in Q1 by multiple customers across diverse verticals. We also continued to execute well in the endpoint security market with Traps.

Customers such as a US-based media conglomerate and a European specialist in financial services adopted Traps in Q1, because of our unique endpoint prevention capabilities. Customers and prospects appreciate the power that comes from our platform approach, with protection at all stages of the attack life cycle, from the network to the end point.

We believe no other competitor can match these capabilities, and we feel very good about our position in the quickly-evolving endpoint space. And we are leading the way in providing next generation security for customers, regardless of whether the deployment model is on prem, in private, public, or hybrid cloud environments.

Our pioneering work with the virtualization capabilities of our VM series has led to good growth, and we now have over 1,000 customers utilizing our VM series offering, and strong demand for our cloud offerings with partners such as VMware for NSX and AWS for public cloud deployments.

Reflecting this strong demand environment, we continue to see customer engagements increasing in number, scope and size. For example in Q1, we conducted over 140 executive meetings at our briefing center in Santa Clara, the highest number ever for the company.

And again, we added well over 1,000 new customers, including one of the world's largest software companies based in EMEA, where we beat Check Point, among others, for their global security business, a high profile US government agency that adopted Traps for next generation endpoint deployment in a very competitive bake-off, and where we also sold AutoFocus; one of the largest biopharmaceutical companies in the world, where we replaced Check Point and beat Cisco in a seven-figure data center deal, and a large US-based financial services company where we beat Cisco in a seven-figure global perimeter deal.

Our technology differentiation and best-in-class customer satisfaction is also reflected in the continued expansion of our customer lifetime value. To make our top 25 customer lifetime value list in Q1, a customer had to have spent a minimum of $10.1 million with us in lifetime value, compared to $6.1 million in the prior-year period.

Also, as an indication of the rapid expansion inside our customer base, all of these top 25 customers made a purchase in the quarter, as they continued to invest in our next-generation security platform.

It takes a lot to win, expand and service customers in such a rapid growth trajectory at this scale, and we have always been and continue to be intensely focused on effectively scaling our business. This includes our people, where we continue to attract the best talent in the industry to work at Palo Alto Networks.

In Q1, we added more than 350 team members across the organization. Our partners, where we continue to expand our global coverage model, with some of the largest most respected channel partners to provide our customers with the best sales experience and value-added services.

These relationships are very important to us, and we see our partners as an extension of our sales team, and a reflection of our culture and values.

Our go-to-market capabilities, where we continue to execute against the large market opportunity in front of us, with the world's best demand generation, sales and marketing professionals, and our customer support teams, who continually delight our customers with the best service and support in the industry.

We are serious about our mission as a company to prevent cyber attacks, in order to maintain our way of life in the digital age. We are grateful for the trust our customers place in us, and the opportunity to do something very important for them, and we are cognizant that our success is based on having the best people and technology in the world.

Looking ahead, we feel very good about the state of the business. The spending environment remains robust. The market opportunity is significant and growing, our pipeline heading into Q2 is healthy, and we are confident in our ability to continue to execute against the opportunity and widen the gap between us and the competition.

With that, I'll turn the call over to Steffan..

product, subscriptions and support, all grew well in Q1. Q1 product revenue of $147.7 million increased 46% over the prior year. Growth was healthy across our product portfolio. In particular, the PA 7050 and PA 7080 chassis continued to help accelerate growth in the high end data center market.

Recurring services revenue of $149.5 million, increased 65% over the prior year, and accounted for a 50% share of total revenue. Looking at the two components of recurring services revenue, the first component is our SaaS-based subscription revenue of $73.6 million, which increased 69% over the prior year.

Support and maintenance revenue, the second component of recurring services, was $75.9 million, an increase of 61% over the prior year. Billings in Q1 were $388 million, an increase of 61% year over year.

Total deferred revenue grew to $804.5 million in Q1, an increase of 71% year over year and 13% sequentially, underscoring the power of our hybrid SaaS model, and increasing visibility into future revenue streams.

Total gross margin for Q1 was at the high end of our target range of 75% to 78%, at 77.9%, an increase of 110 basis points compared to last year, and a decrease of 40 basis points sequentially. Product gross margin was 76.7%, an increase of 160 basis points year over year and a decrease of 110 basis points sequentially.

The sequential decline was due in part to product mix. Over time, we expect there will be fluctuations in product gross margin. Services gross margin for Q1 was 79%, an increase of 40 basis points year over year and 20 basis points sequentially.

Services gross margin continues to benefit in part from ongoing growth of our high margin subscription services. Total headcount at the end of the quarter was 2,998, up from 2,637 at the end of the prior quarter. We continue to add talent across the business as we scale to support our growth.

For the quarter, research and development expense was 11.4% of revenue, increasing approximately $3.9 million sequentially, to $34 million. The increase was primarily due to headcount. Sales and marketing expense for Q1 was 43.8% of revenue, decreasing approximately $6.7 million sequentially to $130.1 million.

This was primarily due to a decrease in sales commissions related to our strong fiscal '15 year-end performance. General and administrative expense for Q1 was 6% of revenue, increasing approximately $2.4 million sequentially to $17.7 million.

The increase was driven in part by consulting and outside services related to projects in the G&A organization, as well as headcount additions. In total, Q1 operating expenses were $181.8 million, or 61.2% of revenue. Q1 non-GAAP operating margin was 16.7%, representing growth of 610 basis points year over year, and 260 basis points sequentially.

Net income for the quarter was $31.6 million or $0.35 per diluted share, using 90.7 million shares compared with net income of $12.8 million or $0.15 per diluted share in Q1 2015. Our effective non-GAAP tax rate for Q1 was 38%. On a GAAP basis for the first quarter, net loss was $38.7 million or $0.45 per basic and diluted share.

This compares with a Q1 2015 GAAP net loss of $30.1 million, or $0.38 per basic and diluted share. We finished October with cash, cash equivalents and investments of $1.5 billion. Cash flow from operations, free cash flow and free cash flow margin for Q1 were $146.7 million, $127.2 million, and 42.8% respectively.

Capital expenditures in the quarter totaled $19.5 million. The accounts receivable balance was at $196.4 million in Q1, down from $212.4 million in Q4. DSOs increased sequentially by four days and year-over-year by three days to 62 days.

Turning to guidance, in Q2 fiscal '16, we expect revenue to be in the range of $314 million to $318 million, which represents 44% to 46% growth year-over-year. We expect non-GAAP EPS to be in the range of $0.38 to $0.39 per share, using 91 to 92 million shares. Before I conclude, I'd like to highlight a number of considerations for modeling purposes.

Due to continued strong growth, seasonality has been difficult to forecast, but we believe that fiscal Q2 and Q4 will show our strongest sequential revenue growth. We continue to expect to exit Q4 fiscal '16 at a 22% to 25% non-GAAP operating margin, which was the target range and date we set at the time of our IPO in 2012.

To achieve this objective, we continue to expect sequential non-GAAP operating margin expansion, with the majority of the acceleration into the back half of fiscal 2016. The effective non-GAAP tax rate for fiscal '16 will be 38%.

We continue to expect CapEx for fiscal '16 to be in the range of $85 million to $90 million, which includes investments in infrastructure, cloud services, and facilities, to support the growth of our business.

We expect free cash flow margin to be greater than 30% throughout fiscal '16, and finally, our share count is expected to increase by approximately 1% to 2% per quarter. With that, I'll turn the call back over to the operator for Q&A..

Thank you. [Operator Instructions] And we'll go first to Andrew Nowinski of Piper Jaffray..

Great. Congrats on another great quarter, guys..

Thank you..

Maybe just real quick here, billings growth remains strong, and it continues to outpace revenue growth.

So based on some of the customer discussions you've had so far, I'm wondering if you can give us any color with regard to what your customer security budgets are looking like in 2016, and whether the growth will be more dependent on market share gains, or whether you can see a benefit from an improving spending environment? And I have a follow-up, too.

Thanks..

It's Mark. I think we're seeing a mix of those things. What we've seen for quite some time is that, when given an opportunity to get in front of the customer in the first place, regardless of the insertion point, we have demonstrated the ability to come in and displace and incumbent and expand with that over time.

So that's a big driver of business, obviously. Then in addition to that, with security being so important globally as a consideration for companies, there's also new spend opportunities from a CAGR perspective. We do very well there, as well. We benefit from both of those..

Okay. And then geographically, your mix from EMEA and APAC remained largely unchanged, and the growth remains below that of the Americas.

Do you have to increase hiring in those regions to drive growth, or will that come more from the channel and distributors?.

What we're seeing with North America as our most mature market where we started, and the company just continued amazing growth in an area where we still have so much untapped potential for the company, the US being the largest economy in the world, a lot of focus on cyber security.

So it's great to see the biggest market continue to grow at those rates. In addition to that, we're posting very nice growth rates in EMEA and APAC as well, as you can see from the results.

Those are both areas where we continue to invest as well, not only from a brand recognition perspective, but sales and distribution capabilities as well, so things look good..

And we'll go next to Saket Kalia of Barclays Capital..

Hi, guys. Thanks for taking my questions here.

First, maybe for Steffan, Steffan, can you talk a little bit about linearity in the quarter? I would imagine August was slow seasonally, but do you have any qualitative color on maybe how September and October may be, compared to some of your prior years?.

Yes, linearity was basically consistent with prior fiscal Q1s. It was maybe modestly a little bit more back-end loaded, mainly because August is a slow month. We also have our sales kickoff meeting that happens, and we're coming off what was a phenomenal Q4, and we want to get everything set up.

September and October were very strong, and we had a very nice conclusion to the quarter..

Got it. Got it. And for my follow-up, for Mark. Mark, couple nice deals involving Traps.

Can you just give us an update as of start the year, if you can comment on growth or size? But more importantly, where are customers in that decision process, about shifting to that next-gen endpoint platform?.

Yes, I think the – first of all, it's a big market opportunity, it's about a $5 billion market, and I would not -- I don't think it's an understatement to say that's up for grabs substantially. There's a lot of activity in the space. What we're hearing more and more from customers is a recognition of two things.

First is the legacy endpoint technology just is not doing the job for them. It's pretty obvious. The second thing is, they're not looking for yet one more point solution or one more thing to put on an endpoint. They very much like and the platform story, and it resonates very well with them.

What we're hearing customers say is we like the fact Traps actually does prevention, not just yet another detection capability, and that it's natively integrated into the platform so it connects my network and the endpoints together, so it's a powerful story..

Got it. Thanks very much..

Thanks, Saket..

And we'll go next to Michael Turits of Raymond James..

Hey, guys. Good afternoon. Two questions. First, it's been sort of a mixed quarter amongst a lot of the security companies that reported, and you put up a very consistent and strong quarter.

Is there any kind of change in the nature of spending in security that you're seeing?.

That's a good question. I think something that we believed for quite some time and I think it will definitely play out in the future, whether a quarter shows progression, I would never call something on one quarter, but we're pretty convicted that a few things are happening.

One is that legacy technology is definitely giving way to next-generation technology. The second is that point solutions are giving away to platforms, right? And then the third is that the primary focus being I’ll call it downstream response remediation, giving way to upstream prevention.

So if you put those three things together, if you are able to ring the bell on all three of those, the way Palo Alto can do, I think we would continue to distance ourselves from the competition. Other players can ring one, two of those bells, but nobody else is ringing three of them. That's why we continue to outpace everybody..

And then on legacy displacement, it sounded like things seemed strong. Some of the other players, including Cisco, seem to be cleaning up their act a bit, and Fortinet has obviously been strong over a multi-quarter period.

Is there any change in competitive landscape, especially around legacy displacement?.

I haven't seen that, generally. What we've seen is a couple things. One, I've heard Cisco saying they are now serious about security. I've heard that a few times in the last few years. But we only really take our cue from what our customers tell us.

And what our customers are telling us is that you can't retrofit legacy technology by buying companies and popping them on top of each other, and come out with a next generation of platform capability, and that just sounds like more cost and complexity. We continue to beat Cisco handily quarter after quarter, as we've done this last quarter.

I would note some other players who, a while back, have touted that the problem is not technology, it's a lack of sales and marketing costs, have invested heavily in that, and doesn't really look like their growth rates are supporting that statement, looks more like a technology issue to me. Again, I would never call something on one quarter..

And we'll go next to Gregg Moskowitz of Cowen and Company..

Okay. Thank you. Congratulations on a good quarter. I thought it was really impressive that all of your top 25 customers made a purchase this quarter.

I know it may be a little difficult to generalize, Mark, but what did these customers buy this quarter? Were they primarily maintenance renewals? Were they healthy additional appliance purchases? Were they strong subscription upsells on existing deployments, any color there would be appreciated?.

Sure, Gregg. That's a great question. The answer not surprisingly is all of the above. We have lots of customers who just continue to expand with us in different portions of their network environment.

Lots of customers continue to add subscription services that they didn't start with in the beginning, and some, of course, are doing maintenance renewals as well. It's really a mix of all those things.

But as we mentioned before, the expansion part of our business is, the majority of our business is growing very, very nicely, and you can see our customers and large customers just continue to buy more and more from us over time..

Okay. Great. And then just as a follow-up, if you can comment, Mark, on the quarterly performance in federal that would be great..

Yes. Good question. So Fed's a great market for us. We had a very nice quarter there, and good strong end to the Fed year, so we're very pleased with it..

Okay. Thanks very much..

Thanks, Gregg..

And we'll go next to Brent Thill of UBS..

Thanks. Mark, just on WildFire, you mentioned that you had a great quarter there.

I'm just curious what you're seeing with some of the point solutions, and are you seeing an increasing rate of customers turning off and deciding to be part of the Palo Alto family? Can you just walk through the dynamics there?.

Yes, sure, Brent. What we're seeing is a across the board, regardless of what subscription service we're talking about, there's a clear desire for folks to have a high degree of prevention orientation, and have that to be native in one platform.

You have to - when we look at our platform, and the capabilities of every aspect of the platform, we'll stack them up all day long to any best of breed provider on their capabilities, and WildFire, in that case, performs very, very well. And in addition to that, which is unmatched, it's part of the platform.

The platform is more powerful, because of every piece that's part of it, and each of the pieces are more powerful, because they're in the platform, and that's the reason why customers are coming to this so rapidly, as you can see from the numbers.

Then on top of that, we network the whole thing, which means we can rapidly share what we find from one customer's perspective, with thousands and thousands of other customers, which increases the probability that the next time an unknown threat comes across somebody's network, we saw it somewhere else, and we just stop it right away.

It's really a combination of those things that's driving WildFire..

And for Steffan, this is the third quarter in a row, the accelerating deferred revenue, one of the highest growth rates you've seen.

Can you just help us understand what you're seeing there in the buildup of that DR?.

What we're seeing is the resonance of our platform really taking hold. We're seeing increasing subscription attach rates. Over time, we are seeing high renewal rates for both support and subscriptions. And the fact that we are truly a platform play, plays to our strength, and that's playing out in the deferred revenue line.

As you mentioned, total deferred revenue grew 71% year-over-year. That was one of the highest growth rates that we've had in about eight or nine quarters. So it's a further affirmation of the business model, and the power of the platform..

And we'll go next to Catharine Trebnick of Dougherty..

Thank you for taking my question. I have a question on your virtual edition. You talked about 1,000 customers. There's several private companies out there, vArmour, et cetera, and can you just quickly say what your advantages are in that sector and how well you're doing? Maybe more details on that. Thank you..

Yes, sure, Catharine. Yes, there is a few very important differences. The first is that the virtualized series we have, the virtualization of everything we offer, right, so you have to start with next generation technology versus legacy stateful inspection technology.

Other competitors in the market have virtualized stateful inspection firewalls, which means they are equivalent technically to a stateful inspection firewall.

We have virtualized our entire next generation enterprise security platform, so that's the primary difference between us and all comers in that case, whether they be some large existing legacy providers, or any of the new ones..

Okay.

And that's where you're really seeing the accelerated movement with Amazon and then the NSX with VMware, correct?.

Yes. What we're seeing there, Katherine, that's a great question, is that as things move around, like the network becomes more amorphous in nature, applications move off network, users move off network, cloud computing, all the things that are big macro trends.

What we're seeing there is that it's very important to have virtualized capabilities, because you need to move those virtualized capabilities around very quickly and have a very good degree automation amongst them.

It's the combination of that, that's really enticing our customers to use us, and we noted how fast the VM series is growing, and that's just one indicator of how forward leaning we are into the virtualized space and the adoption rate there..

And we'll go next to Shaul Eyal of Oppenheimer..

Thank you. Hi, guys, congrats on strong results and outlook. Mark, so you mentioned 140 executive meetings during the quarter.

Are these Board people joining meetings? Are you seeing the level of attendees according of seniority of those participants hitting a level higher?.

Yes, the engagement level for us has been high and continues to be high into the company and I should have been more specific. What I meant there was what we call executive briefings. We have an executive briefing center here in Santa Clara.

When we bring somebody in for an executive briefing, it's usually folks are coming in for a minimum of four hours, perhaps eight hours.

So they spend an entire day with us with a big portion of their senior technology executive team, sometimes executives outside the technology team as well, and we get an opportunity to hear what their needs are, what their strategy is, we'll do a deep dive on our road map, bring in our technical experts, and these are fantastic.

The feedback on this from customers is really great. They very much find it to be a useful, useful amount of their time, and they also get the opportunity to do actual testing in our lab. We'll take them right across the hallway, and they get to test as much as they want, so it's very useful.

I just wanted to note that because with 140 of these in the last quarter, that is the biggest number we've ever done. We're literally bursting at the seams. We had to knock down a couple of walls about three months to add more space down there, so it's just something that's a great demand generator for us..

Great. And for Steffan, so good news, tax rate at 38% is not and probably cannot be going any higher. I know I keep giving you a hard time on this one.

How do we bring it down to be slightly more in line with some of your technology-related peers?.

Well, the 38% is a non-GAAP effective tax rate, if you look at the actual GAAP tax rate or cash tax rate, it's in the low single digits, or it's even negative. The non-GAAP tax rate is a place holder that we've put out there for modeling purposes. We do believe that non-GAAP tax rate will come down over time, most likely to the high 20s or low 30s.

And I'll just leave it at that..

And we'll go next to Philip Winslow of Credit Suisse..

Hi, guys, this is Michael Baresich on for Phil. Congrats on the great quarter. Question about the attach rate of subscriptions.

Can you give us some color on where it was, and are there any changes in attach that you'd note this quarter?.

Hey, Michael. Attach rates are good and increasing. We talked about that at the end of the fourth quarter. I think we said the attach rates at that point across the board were 2.2, and that attach rates, we would expect those to go up. Again, we'll give more detail about that later in the year, but they continue to rise..

The other thing is, it's not just about the attach rates of the four subscription services, but we have Traps, AutoFocus and Aperture, our three subscription services that are coming into play, and that is also providing incremental business opportunity from us, which is starting to show up in deferred revenue and billings..

Great. And that actually leads into my follow-up.

Could you give us an update on the customer feedback on AutoFocus so far?.

Yes, it's great. Michael, this is Mark. We had hundreds and hundreds and hundreds of customers in the beta before we rolled that out, and a lot of them now are looking for purchasing decisions. We sold AutoFocus in Q1 to a number of those customers. So far the feedback is -- they say this is very impressive.

This is taking a lot of data and making it very relevant for me in a very fast basis, so I can make decisions with my least leverageable resource I have in the company, which is my people..

And we'll go next to Jayson Noland of Robert Baird..

Thank you. And I'll add my congratulations. I wanted to ask first on the potential for a refresh that was mentioned last quarter. There were 4,000 new customers from F '09 to F '11.

Have you started to see the refresh in early F '16?.

Jayson, its Mark. We have seen our own customer base refreshing, as well. As you noted, the couple cohorts we discussed before actually 2009 and 2010, which is a bit less than 2,000 customers against a 28,000 customer base. Of course, we're very pleased to see customers refresh that technology.

We'd expect that to continue over time, as more of the base matures. But the biggest driver of the business today is the expansion inside of those customers, not just the refreshes. So they're all expanding, or pretty much all been expanding at very healthy rates.

On top of that, when these bigger numbers of cohorts kick in, from a refresh perspective, that should be a tailwind for us..

Okay. That makes sense. Steffan, I wanted to ask a follow-up on the gross margin. You're already at the top of the range.

I assume with mix shift, would that potentially go above the range in fiscal '16, or is this an opportunity to invest to take more share?.

We feel good about the 75% to 78% gross margin range for the rest of this fiscal year. It's something that we've - that line item in our target model was actually up, increased at our last analyst day, reflecting, again, the power of the model, with our subscriptions business being close to, call it software type gross margins.

That provides a good backstop to that range of 75% to 78%. So for the rest of the fiscal year we feel good about that. And then, at some point, we will update our target model, and we'll look at all the line items in that model, including gross margin..

And we'll go next to Gray Powell of Wells Fargo..

Great. Thanks for taking the question. Just one from my end.

So as your operating margins scale from 14% in Q4 last year into your target range of 22% to 25%, how should we think about your ability to maintain heightened billings growth, and then how does productivity of new salespeople factor into your thinking there?.

Yes. So I'll take the second part first, which is the productivity of our sales force is one of the key drivers of our business. We have now much more than 50% of our quota-carrying salespeople being fully ramped versus ramping, and we continue to see that trend going forward.

So that plays a key role in the overall, both productivity and capacity of our overall sales organization. And we have done, I think, a decent job of managing growth and profitability.

We continually balance that on a quarter by quarter basis, and you saw that we've again reiterated our 22% to 25% non-GAAP operating margin exiting Q4 fiscal '16, and we don't give guidance more than one quarter out relative to billings or revenue.

But we feel like we can -- we are optimally set up to continue to take a lot of market share, but doing it in a profitable manner. What we've also said is, this is a growth and profitability story. It's not a growth or profitability story. So we continue to manage that dynamic, and we're doing what's in the best interest of our business..

Understood. That's very helpful. Thank you..

And we'll go next to Walter Pritchard with Citi..

Thanks.

Mark, can you talk about the 7080 opportunity, and where your -- what sort of business are you winning that you weren't able to win before, or is that a continuation of what you had with the 7050?.

Walter, I'd put it more in a continuation bucket. What we're seeing in general is throughput requirements just continue to rise for companies in general, with more applications that are heavier throughput hogs. The second thing we're seeing is a lot of work in data centers as people are moving to next generation data centers, as well.

And a third area we see progress is in the service provider market. So it's a combination of all three of those things that have us selling well with the 7000 series, which now includes the 7080 as well..

Okay, and then Steffan, on the end point side is there a thought to at some point breaking that business out if it gets large enough, or I don't know, would love to hear, just we're trying to track it to some degree, and understanding it's small at this point..

What we're thinking about right now is giving visibility in terms of number of customers, and we plan on doing that on a semi-annual basis. When the endpoint business gets very large, we'll consider breaking it out.

But right now it's part of the overall platform, which is why at least in the, call it, near to medium term, we'll continue to give color commentary on it, but not break it out specifically in terms of revenue..

And we'll go next to Joel Fishbein of BTIG..

Good afternoon, guys. Just a follow-up on Aperture, a space that's been consolidating here. Gartner calls it the CASB space, I hate that name. I know it's very, very early but it could be a big opportunity.

Could you just go into some detail about it, and what you're thinking there?.

Joel, its Mark. So let me -- for background, let me say what the market is, right? As data users and things move around, as the traditional concept of the network gets more amorphous over time, one of the areas that's important is where's your data, and what applications are being used.

So if you're using an application that's not on your network, and the user is connecting to it not through the network, then the ability to apply network security processes to it, and policies to it is limited because there's no visibility on it.

So that's the problem, right? What Aperture does is it uses API hooks to stand in the shoes of the credentialed user in a major third-party sanctioned SaaS application that has really great technology that is looking for anomalies based on users' end data and the ability to identify and quickly fix it. That's what it does.

Naturally, we think that is part of a prevention platform. It's important, but it doesn't deserve to be outside of the platform, and I don't think customers want to be buying yet more devices and complexity to put in their network to solve that use case. And that's what they've very clearly told us, and that's why we made a move into that market..

So do you think that there won't be so-called a broker anymore in the middle, that you'll be one of the people that will be providing that as a service?.

Yes, I think that somebody had to -- what we're talking about is in a sense somebody had to broker your data for you. We're just trying to do is make sure you can control the data in the first place, you don't need to add another third party in the process to do that. That just adds complexity..

And we'll go next to Michael Kim of Imperial Capital..

Can you talk a little about the opportunity with the manned security service providers and early progress with new partners like Trustwave, and how you see that developing and where that's giving you an opportunity to leverage into new segments of the market?.

Sure, Michael. So, there's, as you know, some customers will choose to outsource portions of the security operations into managed security service providers, definitely seeing a growth in that business. And almost all of the large MSS providers know how to work with and manage Palo Alto capabilities.

Where there's a distinguishing factor that's really good for as MSS providers is what the Palo Alto Networks platform spits off, for lack of a better term, is way, way different and superior than just reading blogs off of firewalls.

When they're working with Palo Alto Networks' platform they have a capability and ability to do something of high value for customers as opposed to low value, just reading logs.

Another aspect to that we think is interesting is to take AutoFocus as a tool, and have those MSS providers use AutoFocus and provide even more valuable intelligence to their customers as a result of that sale.

We think there's some interest there, and as you noted, we are working with some of the providers there to be forward leaning like Trustwave..

Great.

And then switching gears, can you talk a little about how the partnership with Tanium is progressing and was that a contributor to WildFire customers in the quarter?.

The partnership is going very well. So just for background for everybody, quickly what we did with Tanium was back in September, we did work for quite some time with them, and then in September we bought out the connection between the Tanium capabilities and WildFire.

That's important, because indicators of compromise that WildFire is finding can be automatically sent to Tanium, and it can look for it in a highly automated way as well, as opposed to have to figure out what to look for. Similarly, we're taking things off of the end point that Tanium sees, back into WildFire, for processing as well.

It's a very symbiotic relationship. The feedback we've heard, so it's a technology relationship, let me start with that, it's a not a SKU, right? But the feedback we've heard from our field, from their field and customers is that makes a lot of sense, particularly when you're thinking about end points and are saying, I'd like to prevent things.

I want to detect things, I couldn't prevent them. I want to isolate them, and I want to remediate them in a highly automated way, if I was unable to prevent them. That technical combination is pretty powerful..

And we'll go next to Sterling Auty of JPMorgan..

So given it's the first quarter and you had sales kick off, can you highlight for us any tweaks or changes that you made in your go-to-market, whether it be distributors, and what each one is focused on, or addition or subtraction, or any changes to the reseller program?.

Sterling, its Mark. A few things that came out of, I'll call it hopefully the seamless growth of the business through rapid growth phases, and we're always paying attention to that, clearly it's on the go-to-market distribution side.

So Mark Anderson continues to do a fantastic job of managing a large and growing sales force through splitting territories rapidly. He formed a new theatre [ph] for service providers as well, so we've got a lot of focus on that. We continue to work very well with our large distributor partners and reseller partners.

I think we mentioned on the last call that we had over 500 of them in attendance for sales kick-off, treating them just like our own sales team from a training perspective. And those relationships continue to grow very nicely over time..

Then just as a follow-up, you talked about the relationship with Tanium, but it does seem to be a bit of a morphing in terms of how enterprise are thinking about the endpoint security strategy.

Is there any pieces of the technology puzzle on the endpoint that you feel at the moment that you don't have, that you would have to go through some sort of build versus buy analysis?.

I think most importantly what you would do with the endpoint if you could, is you'd prevent an attack. That is by far the highest value order bid, and the things that we're solving for constantly, and that's what we're doing with Traps. That's why we bought Cyvera in the first place.

That's why we did the integration to WildFire, and that's why we're making a lot of leaps and strides on our capabilities, along those lines. There are downstream things from that, that if you couldn't prevent, you would like to be able to do, like things I mentioned.

But we're very, very focused on prevention, and think we've got all the tools to do that..

And we'll go next to Rob Owens with Pacific Crest Securities..

Curious about the strength in short-term deferred. Is much of that unshipped product, or is that all subscription related? Just trying to get a sense of the first quarter's velocity..

It's a mix of both products and subscription and support. And by definition, if you have a one-year subscription and maintenance contract, that goes into short-term. If it's a multiyear, it goes into long-term.

But if you look at the demand that we're seeing across the board, I would tell you that the vast majority of all of our deferred is subscriptions and support, and there's very little, because we are a book and ship business..

Great. And Steffan, I appreciate the guidance one quarter at a time.

Now that over half your business is coming from subscription-related items, why not give an annual number?.

We constantly look at different models for guidance, but given our business and the growth rates, we feel comfortable giving one quarter out. We always leave the door open for looking at alternative models, but this approach has served us well, and we feel like it's a good indicator of what the environment looks like.

The other thing I'll tell you is, we also give modeling points on our earnings calls, which gives some more color commentary around the overall health and growth of the business. So we try to give a little bit of a hybrid approach, when it comes to guidance..

And we'll go next to Keith Weiss of Morgan Stanley. Mr. Weiss, your line is open. Please go ahead. Mr. Weiss, please pick up your handset or press your mute function, I am unable to hear you. And we'll go next to Scott Zeller of Needham..

Hi, thanks. Wanted to ask about the velocity of deals.

Can you tell us if you're seeing any change in sales cycles, or if you're seeing a need for more signoffs at all in deals?.

Did you say signoffs?.

Signoffs, yes..

Okay. Deal velocity's good. We said for actually quite some time that the -- from a start to finish on average things take about 90 days, some of those much longer, we get some big organizations, government organizations, and some can be shorter. About 90 days. That really hasn't changed for us.

From a signoff perspective, the only thing we've seen signoff wise, which is a good thing, that slows deals down occasionally, is deals are getting bigger. The bigger they get, the higher they go in the organization, in order to get signoff.

And we're fine with that, because we definitely don't mind having visibility, this gets to the CFO, CEO level sometimes in some of these companies because we want to be the strategic security provider for these companies..

Since you don't comment on ASPs, is there anything you can give us regarding your comment, Mark, around deals getting bigger, or any color, if you're not willing to offer an ASP..

Sure. What we have said around the ASPs is they tend to be in the mid-five figure range. They continue to be there. They continue to increase over time. So that's been a pretty consistent trend for us, year-over-year.

The reason we don't put a lot of focus into ASP from a reporting perspective is we're way more interested in lifetime value of customers, and that's because usually we're coming in, we're taking somebody out of the equation from a displacement perspective, and a customer's going to give us a shot to do something.

The first shot in that may be a relatively minor shot, but over time we continue to grow and grow and grow into the account, and that's why the ASPs would be not as indicative of the health of the business, I don't think, as lifetime value. Although like I said, ASPs continually increase year-over-year..

And we'll next to Tal Liani of Bank of America-Merrill Lynch..

I want to go back to the question on the PA 7080. What do you think -- the market, the high end market has different dynamics, and we see Juniper back in the market with new high end solution. Some companies are kind of established in this space, Cisco and Juniper and Check Point.

What do you bring to this market that is different than what's available today now? And can you elaborate maybe on the competitive pressures, how are they different at this side of the market versus the general side of the market?.

Paul, its Mark. I'd say from a difference perspective it's basically doing what we've been doing for 10 years, which is the difference between legacy technology and the next generation. And we pioneered that, and we're the only ones who are doing that, not using stateful inspection technology.

From a throughput perspective, what we've seen with the 7000 series, like I said, is an increasing demand from customers as they go to next generation data centers, application usage increases from a throughput perspective, is they want that next generation security.

They want it at very high speeds as well, which is fantastic, and an opportunity for us. But at the end of the day, what we've been doing is the same thing we've been doing for a decade now. That's clearly working in the market. We haven't seen any resurgence of anybody, frankly, in the market.

And you can see that from our results compared to everybody else's..

We ask that you limit yourself to one question. And we'll go next to Keith Weiss of Morgan Stanley..

Hi, guys. Sorry about the technical difficulties. So thanks for taking the question, and a very nice quarter. I wanted to go a little bit more broadly into sort of the idea that next generation security platform, and really talk about the distribution side of that.

You talked a little bit about the executive briefings and going higher in terms of what your sales guys are doing to engage at a higher level, more strategic level with your customers.

How do you get your partner channel on board with that as well? How do you get those guys up the ramp to be able to be helping you guys sell a more strategic sale into the customers, because partners have always been a very important part of the story here..

Keith, its Mark Anderson here. That's a good question. You may have read, last year, we made the decision to involve all of our partners, give them the ability to participate in our internal sales training.

So whether it's having 548 of them at our sales kickoff meeting in August, whether it's having a couple hundred engineers come to our tech summits, or every month having 10 to 15 sales engineers and account managers participate in our monthly new hire, they're learning the exact same curriculum as our field salespeople, because they're an extension of our field sales team.

The objective there clearly is to get them to do more of the lifting farther down the field than we've seen in the past, and we think, so far, internal expectations are being exceeded there. So the other thing is, we're now, I think, a lot more relevant to these bigger model partners.

So large cloud companies, large telcos, large systems integrators, more and more want to work with us and build out services to sell to their large customers. So it's a big focus for us. We're really ramping up the worldwide channels team, and feel very strongly that it's only going to get better..

And we'll go next to Karl Keirstead of Deutsche Bank..

Thanks and congratulations on a great quarter. This question is for Steffan. Steffan, the difference between your non-GAAP operating margins of 17%, and your free cash flow margins of 43%, actually widened out in Q1.

I'm wondering if you can remind us of the factors that are likely to cause this gap to narrow throughout the fiscal year, as your guidance suggests? Thank you..

The factors that will contribute it to narrow over time is, we will become a cash taxpayer over, call it over time, and right now, we have very limited cash taxes that we're paying. So that's probably the primary thing.

What we've given as a guidepost is, we've talked about our target operating model of 22% to 25%, which again, we believe that we'll get to exit in Q4 of fiscal '16. What we've said is, we think that our free cash flow margin should track 5 to 8 points above the top end of that range. That is a guidepost, and we'll continue to refresh that over time.

I'll also tell you that, in this quarter, we had exceptional free cash flow margins at north of 42%. Part of that over performance was driven in part by a really exceptionally strong quarter in Q4, where we had billings and revenue growth that were at al -time highs. And we got the benefit of that cash collection in Q1.

So that's one of the reasons why the spread widened in Q1, because of the strong sequential benefit that we got from Q4 billings..

And that concludes today's question-and-answer session. At this time, I will turn the call back to Mark McLaughlin for any additional or closing remarks..

Thanks, operator, and thanks everybody for joining us this afternoon. We're really excited about the future, and I'd like to thank our customers, partners and the entire Palo Alto Networks team for their hard work and support in Q1. We're looking forward to seeing many of you in December, and we hope everyone has a great Thanksgiving. Thank you..

This does conclude today's conference. We thank you for your participation. You may now disconnect..