Kelsey Turcotte - Palo Alto Networks, Inc. Mark D. McLaughlin - Palo Alto Networks, Inc. Steffan C. Tomlinson - Palo Alto Networks, Inc. Mark Anderson - Palo Alto Networks, Inc..

Matthew George Hedberg - RBC Capital Markets LLC Michael Turits - Raymond James & Associates, Inc. Pierre C. Ferragu - Sanford C. Bernstein & Co. LLC Andrew James Nowinski - Piper Jaffray & Co. Philip Winslow - Wells Fargo Securities LLC Jayson A. Noland - Robert W. Baird & Co., Inc.

Ken Talanian - Evercore Group LLC Sterling Auty - JPMorgan Securities LLC Gregg Moskowitz - Cowen and Company, LLC John DiFucci - Jefferies LLC Gabriela Borges - Goldman Sachs & Co. Walter H. Pritchard - Citigroup Global Markets, Inc. Karl E. Keirstead - Deutsche Bank Securities, Inc. Catharine A. Trebnick - Dougherty & Co. LLC Jonathan F.

Ho - William Blair & Co. LLC Fatima Aslam Boolani - UBS Securities LLC Saket Kalia - Barclays Capital, Inc..

Good day, everyone, and welcome to the Palo Alto Networks Fiscal Second Quarter 2017 Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Kelsey Turcotte, Vice President, Investor Relations. Please go ahead, ma'am..

Thank you. Good afternoon, and thank you for joining us on today's conference call to discuss Palo Alto Networks fiscal second quarter 2017 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 and Chief Executive Officer; and Steffan Tomlinson, our Chief Financial Officer. This afternoon, we issued a press release announcing our results for the fiscal second quarter ended January 31, 2017. If you would like a copy of the release, you can access it online on our website.

We would 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 third quarter and full-year fiscal 2017, our competitive position and the demand and market opportunity for our products and subscriptions, our ability to drive outsized growth rates, trends in certain financial results and operating metrics, our initiatives, plans and investments regarding our sales productivity, success and timing of integration of our newly acquired products and innovations in our product, subscription and support offerings.

These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control which could cause actual results to differ materially from those anticipated by these statements.

These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future and we undertake no obligation to update these statements after this call.

For a more detailed description of factors that could cause actual results to differ, please refer to our Quarterly Report on Form 10-Q, filed with the SEC on November 22, 2016, and our earnings release posted a few minutes ago on our website and 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.

For 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.

We'd also like to inform you that we will be presenting at the Morgan Stanley Technology, Media & Telecom Conference on Thursday, March 2; and the Raymond James & Associates 38th Annual Institutional Investors Conference on Tuesday, March 7.

And finally, once we have completed our formal remarks, we will be posting them to our Investor Relations website under Quarterly Results. And with that, I'll turn the call over to Mark..

six new hardware appliances designed to enable customers to deploy next-generation security from large data centers to small branches, all managed centrally by a new and faster version of Panorama.

These appliances provide faster performance for deep visibility into and control over all traffic, including encrypted traffic, which is becoming an increasingly strategic need for effective security. Three new VM-Series models to add to the existing four we currently offer, creating the broadest range of cloud security offerings in the market.

This enables a wider range of deployment types and even greater integration with Amazon Web Services, Microsoft Azure, and VMware NSX to deliver scale, redundancy, and automation that allows customers to easily build cloud-centric architectures.

The industry's first multi-method, scalable and automated approach designed to prevent credential-based theft and abuse by attackers. Credential theft has become an increasingly popular tool for attackers as it often allows them to bypass a number of other difficult steps in the attack lifecycle.

Our new capabilities include the unique ability to prevent sending password-based corporate credentials to unauthorized sites and an innovative approach to policy-based multi-factor authentication enforced at the network level to prevent the re-use of stolen credentials.

And several new threat prevention capabilities, including automatic command and control signature generation; a new custom, built from the ground up advanced hypervisor and bare metal analysis capabilities in WildFire; and MineMeld integration with AutoFocus allowing for third-party feeds to be easily correlated with our data for deeper analysis and automated protection using groundbreaking machine learning.

In summary, we continue to see positive reaction to our approach in our platform and strong market traction. And we believe in our ability to address the execution issues I noted earlier, allowing us to continue to drive outsized market share gains. With that, I will turn the call over to Steffan..

Thank you, Mark. Before I start, I'd like to note that except for revenue and billings figures, all financial figures are non-GAAP and growth rates are compared to the prior-year periods unless stated otherwise. Let me start by saying we are disappointed that we fell below our revenue guidance range for Q2.

In the quarter, we reported revenue of $422.6 million, an increase of 26%. Looking at the geographic mix of revenue, the Americas grew 28% and accounted for 69% share, EMEA grew 27% and accounted for 19% share, and APAC grew 14% and accounted for 12% share. Product revenue of $168.8 million was essentially flat compared to the prior year.

We anticipated that Q2 product growth would be weak due to a difficult year-over-year comparable, but product revenue fell below our expectations due to the execution issues Mark discussed as well as some customers more than we anticipated delaying purchasing decisions based on the significant product release in early February.

Subscription and support revenue is now on an annual run-rate north of a $1 billion and continues to grow at very high rates. Q2 SaaS-based subscription revenue of $134.3 million increased 59%. Attach rates grew to 2.6 subscriptions per device shipped, up from 2.3 in the prior year period. And subscription renewal rates are greater than 90%.

Support revenue of $119.5 million, increased 48% and we enjoy approximately 100% renewal rates on support. In total, subscription and support revenue of $253.8 million, increased 54% and accounted for a 60% share of total revenue. Turning to billings, Q2 billings of $561.6 million, increased 22%.

The dollar weighted contract duration for new subscriptions and support billings in the quarter was 3 years compared to 2.7 years in the prior-year period as customers increasingly commit to our platform as their long-term security architecture. For the first half of fiscal 2017, billings of $1.1 billion increased 27% year-over-year.

Product billings were $334.3 million, up 6% and accounted for 31% of total billings. Subscription billings were $395.9 million, up 41% and support billings were $348.3 million, up 39%. Subscription and support billings accounted for 69% of total billings in the first half of fiscal 2017 compared to 63% in the first half of fiscal 2016.

In Q2, total deferred revenue of $1.5 billion, increased 61%. Moving on to margins. Q2 gross margin was 78.6%, an increase of 140 basis points compared to last year. The increase was driven by improvements in recurring subscription and support gross margins, offset by a product gross margin decline of 50 basis points year-over-year.

Looking forward we expect there will be fluctuations in product gross margin, particularly with the recent introduction of our new products when we typically see a decline in product gross margin for a few quarters. Q2 operating expenses were $249 million, or 58.9% of revenue.

Operating margin was 19.7% in Q2, representing 120 basis points of improvement year-over-year. Net income for the quarter grew 51% year-over-year to $59.6 million. Non-GAAP EPS grew 47% to $0.63 per diluted share. On a GAAP basis for the second quarter, net loss was $60.6 million or $0.67 per basic and diluted share.

Turning to cash flows and balance sheet items, Q2 cash flow from operations of $214.3 million increased 39% year-over-year. Capital expenditures in the quarter were $44.7 million, including $31.1 million of CapEx related to our new headquarters. Free cash flow for Q2 was $169.6 million, up 24% at a margin of 40.1%.

Excluding CapEx related to our new headquarters, free cash flow was $200.7 million, up 46% year-over-year at a margin of 47.5%. We finished January with cash, cash equivalents and investments of $2.1 billion.

And I am pleased to announce that the board of directors has authorized a $500 million increase to our existing share repurchase program and extended the end date of the program to December 31, 2018. This brings the total amount authorized under the current program to $1 billion.

During the second quarter, we purchased approximately 900,000 shares of common stock at an average price of $132 a share, leaving a balance of approximately $830 million available for ongoing repurchases. DSOs were 78 days, within the previously provided range of 70 days to 80 days.

As we look toward the future, we remain committed to our long-term strategy to capture market share within our financial framework of growth and profitability. We are not satisfied with our productivity and know we have work ahead of us to maximize our potential.

Turning to guidance and modeling points, this afternoon, we announced that we have acquired privately held LightCyber for $105 million in cash. LightCyber expands our Next-Generation Security Platform with its highly automated and accurate behavioral analytics technology.

And while we will continue to offer the LightCyber products and to support existing customer implementations, we expect to make LightCyber available as a non-attached subscription by the end of the calendar year.

For fiscal 2017, LightCyber's contribution to revenue will be immaterial and we expect to invest approximately $5 million per quarter in both Q3 and Q4, primarily in R&D and platform integration.

For the third quarter of fiscal 2017, our guidance anticipates that there will be some disruption as we implement changes to our go-to-market playbook and as a result, sales productivity will remain below our originally planned productivity levels in the second half.

We expect revenue to be in the range of $406 million to $416 million, an increase of 17% to 20%. Incorporating the approximately $0.04 earnings per share impact from LightCyber, we expect non-GAAP EPS to be in the range of $0.54 to $0.56, an increase of 17% to 22% year-over-year.

Excluding the LightCyber impact, non-GAAP EPS is expected to be in the range of $0.58 to $0.60, an increase of 26% to 30%, using 93 million to 95 million shares. We expect Q3 product revenue to be in the range of $145 million to $148 million.

Based on our current pipeline analysis, we anticipate billings growth to trail revenue growth in each of Q3 and Q4 by approximately 10 percentage points to 15 percentage points. Our current view for the full fiscal 2017 is an annual revenue growth of approximately 25% and essentially flat product revenue growth for the year.

We anticipate annual non-GAAP operating margin to increase approximately 170 basis points to 180 basis points relative to fiscal year 2016 non-GAAP operating margin of 17.3%, as reported.

Included in the 170-basis-point to 180-basis-point improvement is at least 100 basis points of organic operating margin expansion and 130 basis points to 140 basis points positive impact from the deferred commissions change, offset by approximately 60-basis-point headwind from LightCyber.

We expect full-year non-GAAP EPS to be in the range of $2.45 to $2.50, which includes a $0.07 impact from LightCyber, and a share count of 94 million to 96 million shares.

And we expect CapEx and free cash flow margin to be the range of $160 million to $170 million and 35% to 40% respectively, which includes approximately $100 million related to our new headquarters of which we expect approximately $35 million to fall into Q3.

Excluding CapEx from the new headquarters, free cash flow margin is expected to be at least 40%. Structurally, our hybrid-SaaS model combined with operational discipline continues to drive strong deferred revenue, revenue and free cash flow generation. With that, I will turn the call back over to Mark..

We appreciate you being on the call today. In summary, while we are excited and confident about the future, we know we have work to do to improve our execution and operational discipline. We will navigate the near-term challenges while executing on our strategy of being the leading global enterprise security provider.

And with that, we will open the call up for questions. Operator, please go ahead..

Thank you. We'll go to Matt Hedberg with RBC Capital Markets..

Hey, guys. Thanks for taking my questions. Mark, in your prepared remarks, you talk about reorg'ing your go-to-market model.

I wonder if you could talk a little bit more specifically about changes you plan to make and how long should we expect some of these to start producing the desired results?.

Sure, Matt. Thanks. Great question. So, we need to do three basic things here from a go-to-market perspective on the items I talked about. The first is we have to go back and do account mapping or remap the accounts from a coverage perspective because we have the account coverage blurred right now in a way that's not helping us.

Second thing we're going to have to do is reallocate the resources to properly align with that account coverage. And then the third thing is to make sure we've got the right people with the right skills in the right seat. So, it's a pretty big effort we have to undertake here. We started it already.

We expect to be working through that in the second half and hopefully we'll see the benefits of that as we come out of the back half of the year into fiscal 2018..

And that's great. I'm sure we'll hear more it as we move. And I guess maybe drilling down specifically on the sales and marketing line item, I'm just kind of curious what you think in terms of capacity adds here.

I know productivity's lower than you expect here, but did you still expect to add capacity, maybe at a lower rate to sort of map to the billings growth, or just trying to get a sense for capacity adds..

Yeah, it's a good question, Matt. So, what we're very focused on is productivity at this point, right. So, we've brought a lot of people in in the tail half of fiscal 2016, twice as many as we've done before. So, we're going to continue to add some heads into this from a go-to-market perspective.

We'll slow that rate down in the back half of the year, but we're primarily interested in increasing the productivity and the conversion in the pipeline. So that's our main effort..

Our next question comes from Michael Turits with Raymond James..

Hey, guys. It's Michael Turits.

I'm trying to understand exactly how you think the sales strategy was wrong because it seems like it's made sense to the extent that you were increasing the breadth of the product portfolio and you were going through a very staged process of first adding vertical overlays and then getting rid of them and then integrating those new product sales capabilities into the existing sales force, which seems like a very deliberate process strategy for what you've been doing.

So, what really was the disconnect? And how are you planning to do things differently?.

Yeah, Michael. It's Mark. So, we have been running our playbook very successfully for quite some time, as I said, and we continue to run that in fiscal 2017. What we did incorrectly as we look back on this, and it's biting us now, is just the magnitude of what we did coming out of 2016 into 2017 in the rate of territory splits.

And I'll give you some other examples as well. In the hopes of driving higher productivity on investments, we moved broad swaths of customer base into inside sales and resourced that accordingly.

That turned out to not be the boost to productivity we thought so as an example, we had to bring big swaths of customer accounts from a mapping perspective back into territories, have the right people in the chairs in order to execute on those.

So we know the playbook has worked for us in the past, and we think we realize what we've done incorrectly with that playbook and we're going to go fix it..

And I guess just to continue on the same bent, any change in the channel strategy relative to this?.

No. We like our channel a lot. Channel's been very good to us, and we've got great relationships with the channel so we're not going be changing that strategy..

Our next question comes from Pierre Ferragu with Bernstein..

Hi. Thank you for taking my question.

Mark, what's giving you confidence and what's your level of confidence that like your disappointing productivity and disappointing sales performance is an issue that really comes from internal problems and that it is not also simply related to the fact that maybe your competitive environment has been evolving and you're facing competitors there who are like catching up and putting their game together? And then on the productivity front, so if you had like product sales this quarter that were about in line with where they were last year, you have like a significantly higher number of salespeople in the organization today.

Could you give us a sense of how much bigger you are today in terms of sales organization compared to one year ago? And then if you could maybe give us a sense of how did the sales force basically waste this productivity? So where did their time go? Where did their efforts go? And then which led them to see lower productivity?.

Yeah, sure, Pierre. Let me see if I can track all that. Let me start in with the first one. On the competitor front, we watch that very closely. We believe and have believed for some time that we have the best technical leadership in the market today.

We vastly increased that with the new product launch we did on February 7, which is very well attended, and the addition of the LightCyber is an example into the family as well. The issues that we're dealing with we think are primarily execution oriented and that we can go address those things. We've seen continued progress in the market.

We just did another quarter of 2,000 net new customers, increasing the lifetime value as well, Very, very high customer sat scores and Net Promoter Scores as well. So, the feedback from the market seems very positive. This is something it appears that we've done to ourself and something that we can fix.

On the size of the sales force, to give you some example, we brought in more than twice as many folks into the sales organization as we progressed through fiscal 2016 than we did in 2015 and added some more in Q1 of 2017 as well.

So the rate and pace was a lot higher, and in hindsight realizing that that is something that has created challenges for us and we're going to go fix that.

And on your last question as far as what are people working? Everybody is working very hard and very diligently, but the amount of relationship changes that occurred, these various account coverage moves that we made is very high. So when you're moving the relationships around and trying to build on those relationships, it's hard.

And at a minimum, we would see something like we're seeing now. We should have seen this earlier, but inaccuracies in forecasting about where things are in the pipeline, as people are getting closer and closer to that customer over time..

Thanks, Mark..

Thank you, Pierre..

We'll go to Andrew Nowinski with Piper Jaffray..

All right. Thanks. I wanted to ask about a comment you made about the delayed purchase decisions that customers made with regard to the new products that you launched in the quarter.

Given the performance improvements in the new products, you would think that it would compel those customers to move forward with Palo Alto, but your guidance suggests the opposite.

So, I guess can you help us understand why the deals that were delayed due to the new product launch would not come through in the April quarter?.

Hey, Andrew. It's a good question. It's possible they may. The new products have been received very well from customers' feedback. So far we've had a fantastic launch and they are really good. As Steffan mentioned, we did see some customers delaying purchases.

We got to the end of the second quarter in January, we're always trying to walk a very fine line on bringing new products to market and when you do that. We certainly wouldn't want to bring to market at the end of the quarter, so we brought them out right in the beginning.

You may have noticed we did a lot of advertising, not specifically about the products, but that something big was coming. So that's always hard to get that right towards the beginning of a launch. As far as folks coming into the third quarter, we expect the products to sell very well, and we think they're fantastic.

Unfortunately, what we have is the execution issues are going to overweight any goodness in that for some time, and we have to work through those execution issues..

Okay.

And then given all the new products in virtual solutions you launched a few weeks ago, can you just give us your thoughts on the pending refresh cycle this year and how we should think about that with regard to your expectations for the remainder of the year?.

Yes. As we've said in the past, we think we have a very significant refresh opportunity in front of us, and that, of course, hasn't changed. I think, the new products is going help on that. It's going to be up against the headwind of the execution stuff we just mentioned.

But kind of putting that in perspective, so if you look at all the cohorts or classes of customers as far as from 2008 to 2012, it's about a little over 8,000 total. The 2013 class in and of itself is 6,000, and it grows from there. So I think we've got a lot of refresh opportunity in front of us. That hasn't changed. We're confident about that.

But we got to work through these other issues to really get the benefit of that..

We'll now hear from Philip Winslow with Wells Fargo Securities..

Thanks, guys. Just to build on that. Two questions I guess. On the refresh side, how do you think the changes to the go-to-market strategy may be effective, the timing of that refresh at all? Obviously it averages about call it five years, but things can slip.

Did any of the changes impact call it existing customers in your thinking of sort of your cadence of refreshing those? And then also, one of the things you talked about in the past too was service provider wins.

Wonder if you can just double click on that space a little bit? Sort of what's happened year-to-date? How you're thinking about the second half?.

Yeah, sure, Phil. On the first question on the refresh. Well, having execution headwinds doesn't help at all of course. But we're very confident that people are going to – want to going to refresh on the new product line.

The new product line is really good and it provides three or four different opportunities from a refresh perspective, and it's clearly designed to do it that way. But again, it's going to be up against this just getting our act together from a go-to-market perspective, and implementing the changes we need to implement.

I'll let Mark Anderson answer the service provider question..

Yeah, hey, Phil. As you know we started focusing on service provider about a year and a half ago, and it's going very well, especially given the new product map that we have for virtualized products going much smaller, and much bigger, is really going to help us quite substantially in our managed services business with those customers.

So we feel very good about where we are, and the team is ramping very nicely..

Got it. Thanks, guys..

Thanks, Phil..

And Jayson Noland with Baird has our next question..

Okay. Great. Mark, I wanted to ask your thoughts on the industry backdrop coming out of RSA. Does it seem like how 2017 budgets are getting better year-on-year? And then clarity. There's a lot of new players in the industry. It seems crowded and combative at some points.

Maybe if you could talk about budgeting? And then how people are going to spend their money? Thanks..

Yeah, sure. A very good question, Jayson. Lots and lots of vendors up there, and lots of people showed up at RSA which is I think a good thing in the sense of there needs to be a lot of innovation in the security industry. But I'll answer your question in two different ways.

First from a backdrop perspective, it seems like securities still remains a priority and spending is good on security. So what we're facing here is things that we've created ourselves here, not so much a spending issue in security.

I think on the second front, it's becoming more apparent and I can see it (33:31) at RSA about what the consumption model of all that innovation is going to look like over time. And what I mean by that is very clear that the age of the platform for security, we invented that in the first place and we're doing very well against that.

And I think people are going to increasingly consume all that innovation through platforms. There's going to be less and less platform companies out there. And a lot of the smaller companies who are highly innovative will become parts of those platforms evidenced by the LightCyber acquisition this afternoon.

Whether it's through acquisition or partnerships, I think more and more is going to happen over time..

Thank you..

Thank you..

Our next question will come from Ken Talanian with Evercore ISI..

Hi, guys. Thanks for taking my question. First off, just wondering, could you give us a sense if there are any changes that you've noticed in the go to market approaches by your competitors? And, really, I'm thinking about Cisco here, in particular..

No, the competition has been fierce for a long time, Ken. And I think it will continue to be that way. People buy usually on three angles. Security, reduction in complexity and cost and different players in the market have gone after different levels there. Ours is kind of top-down, which is security, reduction in complexity, and at a very good cost.

Other people approach from a different angle, but haven't noticed anything different from the competitive landscape in that regard..

Okay. And then also, based on your guidance for next quarter, it looks like product growth might actually decline both sequentially and year-over-year. So one, just curious if that's directionally correct? And then if you could give us a sense for what product growth will do in fiscal 2017 overall..

Yeah, sure, Ken. Yeah, we, of course, we anticipated and we said this before that we thought that Q2 would be the low point from a product growth perspective year-over-year. And unfortunately, we were inaccurate in that regard because of the things we're facing here.

But we also believe those things are within our control and we can fix them and that we will be able to get back on track from a product growth perspective..

Okay..

Now we'll go to Sterling Auty with JPMorgan..

Yeah, thanks. Hi, guys.

Would you say that the execution issues were evident throughout the quarter? Or did they manifest later in the quarter? And the reason I'm asking just given the good results we saw out of off quarter companies like Barracuda and the December quarter earnings from everybody else, did this manifest late in the quarter?.

Yeah, great question, Sterling. I think, we could actually back it up a little further from a Q1 perspective, and what we saw in Q1, which we talked to you guys about as well, which was the first two months being on track and then seeing some slowdown in month three, in our case is specific to some large deals.

In hindsight, looking back on that and looking for a pattern in that, that's what we saw play out in Q2 as well. We had a good November, right on track. We had good December, right on track and then we saw a slowdown but on a much broader base in January. So that's what it looked like as far as the Q2 playing out from a linearity perspective..

And even though you said the sales execution changes would outweigh any pickup from stuff that was frozen waiting for the new products, is there a way to at least quantify how much business you felt rose and waited for the new appliances in PAN 8 launch?.

Yeah, I don't think it was that much. I mean, if you look at – we're not happy that we came in under the guide, right, in Q2 on that, but we weren't that far away from it.

So it's not that much and it's also very hard to tease through like what's related to the execution and then what people are saying specifically on product delays, so it's a little bit difficult to say..

Got it. Thank you..

Thanks, Sterling..

And Gregg Moskowitz with Cowen & Company..

Okay. Thank you. I had a question for Steffan. If I recall correctly at your last Analyst Day, you talked about Palo Alto being in high growth mode and put out expectations to continue to grow 30% or more for the foreseeable future.

Obviously, you've guided to 25% growth for fiscal 2017 and the question really is did these results change your view looking forward of where Palo Alto sits on the growth and maturity curve?.

Yeah, so we just came off a quarter where we posted 26% year-over-year growth and clearly we're not satisfied with that. We've identified execution issues that we're in the process of working through, and we have a high level of confidence they're within our control and we can fix them.

We need to get through that work before we call the ball on future levels of growth. But I can tell you that we feel very confident in returning to growth. And we get these execution issues fixed and we'll be in a much better position going forward..

Okay. Thank you..

And we'll go to John DiFucci with Jefferies..

Thank you. From our calculations, anyway, new business growth was very modest for the second consecutive quarter. And I know you're talking a lot about your missed execution, but you're really not the only ones to have some challenging quarters over the last year or so.

I mean even Check Point has had a couple of quarters – had some challenging periods before that.

I guess, Mark, if there's anything else other than missed execution, what else might be happening out there that could be affecting your results?.

That's a great question, John. So I think – well, a couple things on this; one on the new business side. We have to acquire new customers; and we have to expand in our existing customer base as well. And so we always watch both of those, and the bulk of the business obviously as we get bigger will come from expansion.

We just acquired 2,000 new customers in the quarter, so it seems like from a customer acquisition and win-rate perspective and the environment, it's been healthy. It continues to be healthy.

And what we're seeing now is the slowdown from a conversion perspective on the expansion downstream, which makes sense to us as we look back onto the go-to-market motions we made about changing these relationships around.

So existing relationships got changed around a lot within two, three different times in a short period of time is going create some anxiety from the customer account coverage perspective. And that's where we see the slowdown, and the conversion is down through the expansion business..

Okay. Okay. And then one area in particular that we've been hearing more about is just trying to protect east-west traffic which, as you know, it's not something that everybody does and it's not something everybody does broadly. But I think it's generally thought of, Palo Alto Networks actually does it very well compared to others.

At the same time, it's an area where we do hear people questioning how much they're going to need to do that, especially if they start to move workloads to the cloud.

Are you seeing anything around that today?.

We're actually seeing an increase in east-west traffic, interest and protection. And the reason, it's actually is related to the cloud as well because at the same time people are on a journey to the cloud, they're also doing lots of data center work to virtualize and optimize data centers.

When they do that, they use a lot of virtualization inside those data center environments, which means that they're going to micro-segment all those environments inside of the data center, which is great. But then you have to also be able to protect the information, and it traverses east-west through those micro segments, not just north-south.

So we're actually seeing a continually building use case for that or ever since we started off with that with VMware NSX, which has been pretty successful for us..

Our next question will come from Gabriela Borges with Goldman Sachs..

Great. Thanks for taking the question. Maybe just a little more on the assumptions that are going into guidance for the back half, if I could.

Steffan, you mentioned that you are accounting for sales productivity being below the originally planned productivity levels, but how does that compare to the productivity levels you're seeing today? And similar question for the timing of deal cycles and how long you're assuming deal cycles take to close. Thank you..

Yeah, good question, Gabriela. When we're looking at sales productivity relative to our plan, we are looking at high single-digit delta between what the planned productivity was and what it's actually forecasted to be.

And we're factoring that into our guidance for the second half, and we're purposefully being prudent and cautious around the guide because we understand that the execution issues will take a while to get through. We're actively working on those remediations right now and we factor that into the guide.

And when you look at timing of sales cycle elongation, we've seen elongating sales cycles. We called that out in Q1. We saw an extension of that in Q2 but on a much broader base. So we're clearly not satisfied with the year-over-year growth that we're posting.

And we feel like after we make the execution fixes, sales elongation should contract a little bit, and sales productivity should increase..

Thank you. And Walter Pritchard with Citi has our next question..

Thanks. Mark, I guess, a question for you. I look at the metric on new customer adds, 2,000, looks pretty good.

I'm wondering as we look at the results in the context of the new customer adds and the sales changes or the sales disruption, it would seem like the sales disruption might impact your ability to bring in new customers, and yet that metric was good.

Could you give us some color on how you saw the impact here ripple across the existing customer base? The new customer base? Maybe there's a deal size issue that was a part of it as well? Just trying to round that all together..

Sure thing. Walter. So we just put up another 2,000 net acquisition quarter, which is good. We have to make some assumptions as we play out the second half of the year with the execution issues as to how that would impact things. We will see how that plays out. It's a little too early to call that right now.

But as I was telling John a little earlier on his question as well, we have to get two things right. We have to get the net new customer acquisition right, and then even more importantly, we have to get the expansion right in the existing customer bases.

And if you move the relationships around inside of there, it can create longer timeframes that you know what's happening from a deal perspective and accurately forecast when you are going to get the ball over the line. And I think that's the area where we broke things and we're going to go fix them..

And then just a follow-up for Steffan. On the duration, you talked about three years which it sounds like is an average. Did you open up a program or anything that drove – because if three years is the average, it sounds like there could be a substantial number of customers who are actually finding duration that's longer than three years.

Was there something that was done programmatically either this year or in the quarter to drive that higher?.

There was nothing done programmatically to drive it higher. This is a dollar weighted calculation. mot a simple average or just number of customers. So we always see that customers – we've been seeing this trend over time. Customers are asking us to standardize for multi-year periods on our architecture.

We view that as a positive indicator of our technology lead. And so there's nothing new from an incentive standpoint to encourage that behavior. It's more customer driven..

We'll go to Karl Keirstead with Deutsche Bank..

Thank you. I've got two questions, both on the guidance. First, your guidance suggests the second half of fiscal 2017 should see about 20% growth. And maybe I'll throw this one to Mark. Do you think that's a realistic target for fiscal 2018? Do you think you can hit 20% growth next fiscal year? And then the second one is for Steffan.

Steffan, you mentioned that – if I heard you correctly, the billings growth should be less than revenue growth by 10 to 15 percentage points in the back half. So if the back half revenue growth is 20 percentage points, you're suggesting that the billings growth should be 5% to 10%.

And given that your subscription and maintenance billings are tracking close to 40%, it's almost hard to get the billings growth all the way down to 5% to 10%, and maybe I'm missing something you could help me with? Thank you..

Yeah, I'll take the first one, Karl. So we're not happy with the guidance we've put out there, we're working to fix that, of course. And we have a number of issues we got to go work on. We're going to progress through that through the back half of the year and expect that will get us back on track.

We need to go sort that out, and we'll come back to you as fast as we can with much better answers on a long-term basis for fiscal 2018. We don't think that would be prudent right now to set that out there..

Yeah, and from a billings growth standpoint, and you look at how that translates to revenue, let me start by saying it all really begins with sales productivity. And with sales productivity tracking high single-digits below our plan, that translates into much lower billings growth.

If you remember, if you look at the composition of our billings we get in the first half of 2017, about 69% was subscription support and renewal. When you look at revenue, we're effectively indicating that product revenue is going be flat for the full year fiscal 2017 versus 2016.

We're still anticipating high levels of subscription and support growth from a revenue standpoint.

But because sales productivity is tracking so far below where we had originally planned, and we're intentionally taking corrective steps to fix that problem, we're anticipating much lower billings growth during this transition period as we're trying to correct the problems.

And after we correct the problems, we should see a return to much healthier billings growth than what we're seeing today and what we're forecasting for the balance of the fiscal year..

Got it. Okay. Thank you both. That's helpful..

Thanks, Karl..

We'll continue on to Catharine Trebnick with Dougherty..

Oh, hi. Thank you so much for taking my question. You had said that the product revenue growth was expected to be now flat year-over-year.

Outside the execution issues you discussed, how much of that flat growth would be attributed to your VM-Series and the rapid adoption of migration of the cloud by your enterprise customers? And then the second piece of that, did I hear you correctly that you said the channel was okay? So am I to assume that your competing overlay sales teams perhaps caused some of the execution issues and inaccuracy in your reporting? Thank you..

Yeah, hey, Catharine. It's always good to hear from you. On the cloud side, I don't think the product growth for the second half has anything to do with the cloud. That's actually been a good opportunity for us. In a lot of ways, a lead generator.

It's always when there is something new, whether it's virtualization or cloud, in this case for mobility, we've been able to exploit that opportunity is another reason to talk to Palo Alto Networks where somebody may not otherwise and start doing business with them in the first place and do more business over time and that's what we've been seeing.

So we're not happy about the product guide for the second half of the year. We don't believe that's due to the cloud, I'm going let Mark Anderson take the channel question..

Yeah, so let me just add on a little bit to what Mark said. Firstly, the overlay team, there's no confusion, Catharine, in what our overlay teams are doing. It's primarily technical sales overlaying our core sales teams to help them sell Traps, sell into the cloud environment, sell Aperture and AutoFocus. We're very happy with the way that's going.

I think as far as the channel goes, the channel is a very good channel, as we said before. They're executing very well. We're onboarding new channel partners like AWS and Microsoft Azure. Our service provider channels continues to get better. All of this execution rests on me.

It rests on the sales team, and definitely know what we're doing to fix it and we're going to be fixing it as we go on through the fiscal year..

We'll now hear from Jonathan Ho with William Blair..

Hey, guys.

Just wanted to understand with a little bit more granularity, were there any particular geographies or market segments that we should be on the watch for, where the sales execution challenges were more pronounced?.

Hey, Jonathan. No, this is across the board. But it may be obvious but I'll state it anyway that with the Americas being such a large contributor to the business today, that's where we would see the most impact..

Got it.

And then just in terms of the account coverage shift, how long do you expect that to take to really re-establish the results? And do you see the potential to sort of get back to growth once these issues have been corrected?.

So from a timing perspective, we're underway with the activities that I talked about a little earlier. We'll be prosecuting those through the back half of the year. And we would hope to have them all finished by the back half of the year and we'd be able to come out of the year and into fiscal 2018 in a better position than we are.

I was saying a little earlier, we've got a lot of stuff to sort out here. We know we can do better than we are today and what we're guiding. But it would be too early for us and really not prudent to try to call out what it may be into next year..

Got it. Thank you..

Thanks, Jon..

And we'll go to Fatima Boolani with UBS..

Hi. Thanks for taking the question. Question for you, Mark, just with respect to the new product lineup. It was obviously one of the bigger launches you've had in the last several years and you did talk about some purchasing positives with respect to the customer base.

I'm wondering if you can help us drill down on how you are managing the forecasts for any potential trade-down effects? Or just generally how you were thinking about that?.

Sure. That's a very good question. So, whenever we introduce new hardware, we're expecting movement from existing hardware products to new ones. So in all these cases some customers are going to move up. Some will move across. Some are going to move down.

It's just inevitable that it's going to occur so we have to try to take all that into account when we're forecasting. So with the introduction of the PA-220, the 800 and the 5200 series as the main things we just brought to market.

We expect we're going to see a lot of movement with the new hardware platforms and we're going to see two incremental opportunities. One is going to be the refresh as we were talking about a little earlier, and they also give us a chance to just get new competitive wins with these hardware capabilities.

And just, I think something we also have to think about we have here is that when you are thinking through trade down the impacts, you want to make sure that's minimal. So it's our job to make sure we're offering customers a really compelling reason to want a higher capacity and performance for us.

We see our very high attach rates and use of subscriptions. We're seeing increasingly growing need for SSL decryptions, so customers are looking for a lot more powerful systems like the ones that we just introduced. So that's art and science there. We hopefully get both of them right..

And a quick follow up, if I may. You still demonstrated a fair bit of confidence around the installed base to refresh dynamics.

Could you parse out qualitatively for us to what extent that confidence is tied to the base doing sort of upsizing on the hardware refresh versus incremental subscription attach rates? And this just in the context of the 2.6 percentage point attach rate, which didn't really change much versus the past six months..

Sure. So they're related very much, so we have – the attach rates have been up year-over-year from 2.3 percentage point to 2.6 percentage point. And of course, they're attaching the hardware device itself. So when we think about refresh opportunities, we're giving customers a lot to progress towards from a refresh perspective.

And we're also hoping that as happened in the past, that people would attach subscriptions at very high rates when they do that. And then we also have a great opportunity just to win new business as well with the new hardware along with the growing capabilities with platform as well..

Our next question comes from Saket Kalia with Barclays..

Hey, guys. Thanks for fitting me in here. Hey, first, Mark, maybe just for you, obviously, you talked about execution challenges a bunch kind of impacting pipeline close rates.

But can you just qualitatively talk about overall pipeline growth in the second quarter?.

Yeah, that's a really good question, Saket. So from a pipeline perspective, we have done in the past, we're continuing to do a very nice job in demand generation. So we have a very good pipeline in terms of the size of the pipeline. We think the quality of the pipeline is very good as well.

What we're seeing though is the conversion of the pipeline, so it's not really a demand generation issue; it's really just making sure that we get it converted in the timeframe it's going to get converted. But the pipeline's good..

Got it. And then for my follow up, it sounds like maybe one of the execution challenges besides increasing segmentation was maybe moving some accounts to inside sales which might have created some noise.

I'm sure that there were a multitude of things with as complex of a sales organizations you have, but would you say that that was maybe one tangible item that contributed to some of the challenges this quarter?.

Yeah, there are multiple things there, I can't remember who asked that question before, but as an example of something that we've always done in the running of this playbook was increasingly segment the market; in this case, in trying to drive increasingly higher levels of productivity and better return on investment, we've moved a broad swath of customers into the inside sales organization and resourced that accordingly, the folks who used to be in what we call (56:40).

So just think of it simply along those ways. And that's really not working out, so as just one example of things we need to do is we need to map those accounts back from where they were back into those territories. Make sure we got the right people focused on them and make sure we realign the resources appropriately..

Got it. Very helpful. Thanks, guys..

Thank you, Saket..

Thank you. And at this time, I'd like to turn the conference back over to Mr. Mark McLaughlin for any additional or closing remarks..

Great. Thanks, operator. I appreciate that. Before I close, I'd like to thank the Palo Alto Networks team for their dedication and our customers and partners for the opportunity to work with them. And I'd really like to welcome the LightCyber team to the company.

And we take the responsibility of helping the world's largest organizations solve their most critical security challenges very seriously and we appreciate your support. Thank you very much..

Thank you. And, ladies and gentlemen, again, that does conclude today's conference. Thank you all again for your participation..