10-Q 1 panw-1312016x10qq216.htm 10-Q 10-Q


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_____________________ 
Form 10-Q
 _____________________
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended January 31, 2016
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from             to             
Commission File Number 001-35594
Palo Alto Networks, Inc.
(Exact name of registrant as specified in its charter)
 
 
Delaware
20-2530195
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
4401 Great America Parkway
Santa Clara, California 95054
(Address of principal executive office, including zip code)
(408) 753-4000
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
x
Accelerated filer
¨
Non-accelerated filer
¨ (Do not check if a smaller reporting company)
Smaller reporting company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  ¨   No   x
The number of shares outstanding of the registrant’s common stock as of February 17, 2016 was 88,370,472.
 




TABLE OF CONTENTS

 
 
 
 
 
Page
 
PART I - FINANCIAL INFORMATION
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
 
PART II - OTHER INFORMATION
 
Item 1.
Item 1A.
Item 6.
 

- 2 -


PART I
ITEM 1.
FINANCIAL STATEMENTS
PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in millions, except per share data)
 
January 31, 2016
 
July 31, 2015
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
413.2

 
$
375.8

Short-term investments
551.4

 
413.2

Accounts receivable, net of allowance for doubtful accounts of $0.8 and $0.7 at January 31, 2016 and July 31, 2015, respectively
254.4

 
212.4

Prepaid expenses and other current assets
88.1

 
72.6

Total current assets
1,307.1

 
1,074.0

Property and equipment, net
92.6

 
62.9

Long-term investments
631.1

 
538.8

Goodwill
163.5

 
163.5

Intangible assets, net
48.7

 
52.7

Other assets
73.6

 
73.3

Total assets
$
2,316.6

 
$
1,965.2

Liabilities, temporary equity, and stockholders’ equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
32.5

 
$
13.2

Accrued compensation
71.2

 
79.8

Accrued and other liabilities
44.0

 
28.2

Deferred revenue
541.2

 
423.9

Convertible senior notes, net
497.5

 
487.1

Total current liabilities
1,186.4

 
1,032.2

Long-term deferred revenue
387.6

 
289.8

Other long-term liabilities
72.3

 
67.4

Commitments and contingencies (Note 5)


 


Temporary equity
77.5

 
87.9

Stockholders’ equity:
 
 
 
Preferred stock; $0.0001 par value; 100.0 shares authorized; none issued and outstanding at January 31, 2016 and July 31, 2015

 

Common stock and additional paid-in capital; $0.0001 par value; 1,000.0 shares authorized; 88.4 and 84.8 shares issued and outstanding at January 31, 2016 and July 31, 2015, respectively
1,195.4

 
988.7

Accumulated other comprehensive loss
(0.7
)
 
(0.1
)
Accumulated deficit
(601.9
)
 
(500.7
)
Total stockholders’ equity
592.8

 
487.9

Total liabilities, temporary equity, and stockholders’ equity
$
2,316.6

 
$
1,965.2

 
See notes to condensed consolidated financial statements.

- 3 -


PALO ALTO NETWORKS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in millions, except per share data)
 
 
Three Months Ended
 
Six Months Ended
 
January 31,
 
January 31,
 
2016
 
2015
 
2016
 
2015
Revenue:
 
 
 
 
 
 
 
Product
$
169.9

 
$
115.6

 
$
317.6

 
$
217.1

Services
164.8

 
102.1

 
314.3

 
192.9

Total revenue
334.7

 
217.7

 
631.9

 
410.0

Cost of revenue:
 
 
 
 
 
 
 
Product
44.9

 
30.7

 
83.7

 
59.8

Services
49.3

 
28.7

 
89.7

 
53.0

Total cost of revenue
94.2

 
59.4

 
173.4

 
112.8

Total gross profit
240.5

 
158.3

 
458.5

 
297.2

Operating expenses:
 
 
 
 
 
 
 
Research and development
74.0

 
47.0

 
133.7

 
84.3

Sales and marketing
187.6

 
122.8

 
345.9

 
229.2

General and administrative
34.2

 
27.0

 
65.0

 
46.0

Total operating expenses
295.8

 
196.8

 
544.6

 
359.5

Operating loss
(55.3
)
 
(38.5
)
 
(86.1
)
 
(62.3
)
Interest expense
(5.8
)
 
(5.5
)
 
(11.6
)
 
(11.0
)
Other income, net
2.5

 
0.3

 
4.7

 
0.7

Loss before income taxes
(58.6
)
 
(43.7
)
 
(93.0
)
 
(72.6
)
Provision for (benefit from) income taxes
3.9

 
(0.7
)
 
8.2

 
0.5

Net loss
$
(62.5
)
 
$
(43.0
)
 
$
(101.2
)
 
$
(73.1
)
Net loss per share, basic and diluted
$
(0.72
)
 
$
(0.53
)
 
$
(1.18
)
 
$
(0.91
)
Weighted-average shares used to compute net loss per share, basic and diluted
86.6

 
80.8

 
85.8

 
80.1


See notes to condensed consolidated financial statements.


- 4 -


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

 
Three Months Ended
 
Six Months Ended
 
January 31,
 
January 31,
 
2016
 
2015
 
2016
 
2015
Net loss
$
(62.5
)
 
$
(43.0
)
 
$
(101.2
)
 
$
(73.1
)
Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Change in unrealized gains (losses) on investments
(0.3
)
 
0.2

 
(0.6
)
 
0.3

Comprehensive loss
$
(62.8
)
 
$
(42.8
)
 
$
(101.8
)
 
$
(72.8
)

See notes to condensed consolidated financial statements.

- 5 -


PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in millions)
 
Six Months Ended
 
January 31,
 
2016
 
2015
Cash flows from operating activities
 
 
 
Net loss
$
(101.2
)
 
$
(73.1
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Share-based compensation for equity based awards
174.8

 
95.3

Depreciation and amortization
19.5

 
12.9

Amortization of investment premiums, net of accretion of purchase discounts
1.6

 
1.5

Amortization of debt discount and debt issuance costs
11.5

 
11.0

Excess tax benefit from share-based compensation arrangements
(0.5
)
 
(1.3
)
Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
(42.0
)
 
0.3

Prepaid expenses and other assets
(8.3
)
 
(32.4
)
Accounts payable
13.6

 
(1.9
)
Accrued compensation
(8.6
)
 
4.4

Accrued and other liabilities
25.0

 
21.8

Deferred revenue
215.1

 
113.3

Net cash provided by operating activities
300.5

 
151.8

Cash flows from investing activities
 
 
 
Purchases of investments
(610.2
)
 
(587.2
)
Proceeds from sales of investments
134.4

 
2.0

Proceeds from maturities of investments
228.0

 
109.9

Purchases of property, equipment, and other assets
(36.9
)
 
(12.1
)
Net cash used in investing activities
(284.7
)
 
(487.4
)
Cash flows from financing activities
 
 
 
Proceeds from sales of shares through employee equity incentive plans
21.1

 
23.5

Excess tax benefit from share-based compensation arrangements
0.5

 
1.3

Net cash provided by financing activities
21.6

 
24.8

Net increase (decrease) in cash and cash equivalents
37.4

 
(310.8
)
Cash and cash equivalents—beginning of period
375.8

 
653.8

Cash and cash equivalents—end of period
$
413.2

 
$
343.0


See notes to condensed consolidated financial statements.

- 6 -


 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Description of Business and Summary of Significant Accounting Policies
Description of Business
Palo Alto Networks, Inc. (the “Company,” “we,” “us,” or “our”), located in Santa Clara, California, was incorporated in March 2005 under the laws of the State of Delaware and commenced operations in April 2005. We offer a next-generation security platform that empowers enterprises, service providers, and government entities to secure their organizations by safely enabling the increasingly complex and rapidly growing number of applications running on their networks and by preventing breaches in real-time that stem from targeted cyber attacks.
Basis of Presentation
The accompanying condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles, consistent in all material respects with those applied in our Annual Report on Form 10-K for the fiscal year ended July 31, 2015, filed with the Securities and Exchange Commission on September 17, 2015. Our condensed consolidated financial statements include our accounts and our wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Our condensed consolidated financial statements are unaudited, but include all adjustments of a normal recurring nature necessary for a fair presentation of our quarterly results. We have made estimates and judgments affecting the amounts reported in our condensed consolidated financial statements and the accompanying notes. The actual results that we experience may differ materially from our estimates. Certain prior period amounts have been reclassified to conform to current period presentation.
Our condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes in our Annual Report on Form 10-K for the fiscal year ended July 31, 2015.
Summary of Significant Accounting Policies
There have been no material changes to our significant accounting policies as of and for the six months ended January 31, 2016, as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended July 31, 2015.
Recent Accounting Pronouncements
In April 2015, the Financial Accounting Standards Board (“FASB”) issued new authoritative guidance on fees paid in a cloud computing arrangement. The standard requires customers in a cloud computing arrangement to evaluate whether the arrangement includes a software license. If the arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If the arrangement does not include a software license, the customer should account for the arrangement as a service contract. The standard is effective for us for our first quarter of fiscal 2017 and will be applied on either a prospective or retrospective basis. We are currently evaluating adoption methods and whether this standard will have a material impact on our condensed consolidated financial statements.
In April 2015, the FASB issued updated authoritative guidance to simplify the presentation of debt issuance costs. The amended standard requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the related debt liability, consistent with the presentation of debt discounts, instead of being presented as an asset. The amended standard is effective for us for our first quarter of fiscal 2017 and will be applied on a retrospective basis. We do not expect the adoption of the standard will have a material impact on our condensed consolidated financial statements.
In May 2014, the FASB issued new authoritative guidance on revenue from contracts with customers. The new standard provides principles for recognizing revenue for the transfer of promised goods or services to customers with the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard also requires significantly expanded disclosures about revenue recognition. The FASB subsequently delayed the effective date of the standard by one year and as a result, the standard is now effective for us for our first quarter of fiscal 2019 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within the guidance; or (ii) retrospective with the cumulative effect of initially applying the guidance recognized at the date of initial application and providing certain additional disclosures as defined per the guidance. Early adoption as of the original effective date is permitted. We are currently evaluating adoption methods and whether this standard will have a material impact on our condensed consolidated financial statements.

- 7 -


2. Fair Value Measurements
We categorize assets and liabilities recorded at fair value on our condensed consolidated balance sheets based upon the level of judgment associated with inputs used to measure their fair value. The categories are as follows:
Level 1—Inputs are unadjusted quoted prices in active markets for identical assets or liabilities.
Level 2—Inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the assets or liabilities, either directly or indirectly through market corroboration, for substantially the full term of the financial instruments.
Level 3—Inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. The inputs require significant management judgment or estimation.
The following table presents the fair value of our financial assets and liabilities using the above input categories as of January 31, 2016 and July 31, 2015 (in millions):
 
 
January 31, 2016
 
July 31, 2015
 
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Short-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 
$

 
$

 
$

 
$

 
$

 
$
1.0

 
$

 
$
1.0

Corporate debt securities
 

 
127.3

 

 
127.3

 

 
97.8

 

 
97.8

U.S. government and agency securities
 

 
424.1

 

 
424.1

 

 
314.4

 

 
314.4

Total short-term investments
 

 
551.4

 

 
551.4

 

 
413.2

 

 
413.2

Long-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 

 
5.4

 

 
5.4

 

 

 

 

Corporate debt securities
 

 
167.2

 

 
167.2

 

 
92.9

 

 
92.9

U.S. government and agency securities
 

 
458.5

 

 
458.5

 

 
445.9

 

 
445.9

Total long-term investments
 

 
631.1

 

 
631.1

 

 
538.8

 

 
538.8

Total assets measured at fair value
 
$

 
$
1,182.5

 
$

 
$
1,182.5

 
$

 
$
952.0

 
$

 
$
952.0

Refer to Note 4. Convertible Senior Notes for the carrying amount and estimated fair value of our convertible senior notes as of January 31, 2016.
3. Investments
The following tables summarize the unrealized gains and losses and fair value of our available-for-sale investments as of January 31, 2016 and July 31, 2015 (in millions):
 
January 31, 2016
 
Amortized Cost 
 
Unrealized Gains
 
Unrealized Losses
 
Estimated Fair Value
Certificates of deposit
$
5.4

 
$

 
$

 
$
5.4

Corporate debt securities
294.9

 
0.1

 
(0.5
)
 
294.5

U.S. government and agency securities
882.9

 
0.2

 
(0.5
)
 
882.6

Total
$
1,183.2

 
$
0.3

 
$
(1.0
)
 
$
1,182.5


- 8 -


 
July 31, 2015
 
Amortized Cost 
 
Unrealized Gains
 
Unrealized Losses
 
Estimated Fair Value
Certificates of deposit
$
1.0

 
$

 
$

 
$
1.0

Corporate debt securities
190.9

 

 
(0.2
)
 
190.7

U.S. government and agency securities
760.2

 
0.3

 
(0.2
)
 
760.3

Total
$
952.1

 
$
0.3

 
$
(0.4
)
 
$
952.0

Unrealized losses related to these investments are due to interest rate fluctuations as opposed to credit quality. In addition, we do not intend to sell and it is not likely that we would be required to sell these investments before recovery of their amortized cost basis, which may be at maturity. As a result, there were no other-than-temporary impairments for these investments at January 31, 2016 and July 31, 2015.
The following table summarizes the amortized cost and fair value of our available-for-sale investments as of January 31, 2016, by contractual years-to-maturity (in millions):
 
Amortized Cost
 
Fair Value
Due within one year
$
551.6

 
$
551.4

Due between one and three years
631.6

 
631.1

Total
$
1,183.2

 
$
1,182.5

4. Convertible Senior Notes
Convertible Senior Notes
On June 30, 2014, we issued $575.0 million aggregate principal amount of 0.0% Convertible Senior Notes due 2019 (the “Notes”). The Notes mature on July 1, 2019, unless converted or repurchased in accordance with their terms prior to such date. The Notes do not contain any financial covenants and we cannot redeem the Notes prior to maturity.
The Notes are convertible for up to 5.2 million shares of our common stock at an initial conversion price of approximately $110.28 per share of common stock, subject to adjustment. Holders of the Notes may surrender their Notes for conversion at their option at any time prior to the close of business on the business day immediately preceding January 1, 2019, only under the following circumstances:
if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is greater than or equal to 130% of the conversion price for the Notes on each applicable trading day (the “sale price condition”);
during the five business day period after any five consecutive trading day period, in which the trading price per $1,000 principal amount of Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate for the Notes on each such trading day (the “trading price condition”); or
upon the occurrence of specified corporate events.
On or after January 1, 2019, holders may convert all or any portion of their Notes at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date regardless of the foregoing conditions. Upon conversion, holders will receive cash equal to the aggregate principal amount of the Notes to be converted, and, at our election, cash and/or shares of our common stock for any amounts in excess of the aggregate principal amount of the Notes being converted.
The sale price condition was initially met during the fiscal quarter ended April 30, 2015. The sale price condition continued to be met through the fiscal quarter ended January 31, 2016, and as a result, holders may convert their Notes at any time during the fiscal quarter ending April 30, 2016. Accordingly, the net carrying amount of the Notes was classified in current liabilities and a portion of the equity component representing the conversion option was classified as temporary equity in our condensed consolidated balance sheets as of January 31, 2016. The portion of the equity component classified as temporary equity is measured as the difference between the principal and net carrying amount of the Notes.

- 9 -


The following table sets forth the components of the Notes as of January 31, 2016 and July 31, 2015 (in millions):
 
January 31, 2016
 
July 31, 2015
Liability:
 
 
 
Principal
$
575.0

 
$
575.0

Less: debt discount, net of amortization
77.5

 
87.9

Net carrying amount
$
497.5

 
$
487.1

 
 
 
 
Equity (including temporary equity)
$
(109.8
)
 
$
(109.8
)
The total estimated fair value of the Notes was $840.2 million and $994.8 million at January 31, 2016 and July 31, 2015, respectively. The fair value was determined based on the closing trading price per $100 of the Notes as of the last day of trading for the period. We consider the fair value of the Notes at January 31, 2016 and July 31, 2015 to be a Level 2 measurement. The fair value of the Notes is primarily affected by the trading price of our common stock and market interest rates. As of January 31, 2016, the if-converted value of the Notes exceeded its principal amount by $278.7 million.
The following table sets forth interest expense recognized related to the Notes (dollars in millions):
 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2016
 
2015
 
2016
 
2015
Amortization of debt discount
$
5.2

 
$
5.0

 
$
10.4

 
$
10.0

Amortization of debt issuance costs
0.6

 
0.5

 
1.1

 
1.0

Total interest expense recognized
$
5.8

 
$
5.5

 
$
11.5

 
$
11.0

 
 
 
 
 
 
 
 
Effective interest rate of the liability component
4.8
%
 
4.8
%
 
4.8
%
 
4.8
%
Note Hedges
To minimize the impact of potential economic dilution upon conversion of the Notes, we entered into convertible note hedge transactions (the “Note Hedges”) with respect to our common stock concurrent with the issuance of the Notes. The Note Hedges cover up to 5.2 million shares of our common stock and are exercisable upon conversion of the Notes. The Note Hedges will expire upon maturity of the Notes. The Note Hedges are separate transactions and are not part of the terms of the Notes. Holders of the Notes will not have any rights with respect to the Note Hedges. The shares receivable related to the Note Hedges are excluded from the calculation of diluted earnings per share as they are antidilutive.
Warrants
Separately, but concurrently with our issuance of the Notes, we entered into transactions whereby we sold warrants (the “Warrants”) to acquire up to 5.2 million shares of our common stock at a strike price of approximately $137.85 per share, subject to adjustments. The shares issuable under the Warrants will be included in the calculation of diluted earnings per share when the average market value per share of our common stock for the reporting period exceeds the strike price of the Warrants. The Warrants are separate transactions and are not part of the Notes or Notes Hedges, and are not remeasured through earnings each reporting period. Holders of the Notes and Note Hedges will not have any rights with respect to the Warrants.
For more information on the Notes, the Note Hedges, and the Warrants, refer to Note 7. Convertible Senior Notes of Notes to Consolidated Financial Statements included in Part II, Item 8 of our Annual Report on Form 10-K for the fiscal year ended July 31, 2015.
5. Commitments and Contingencies
Leases
We lease our facilities under various non-cancelable operating leases, which expire through the year ending July 31, 2028.
In May 2015, we entered into three lease agreements for approximately 752,000 square feet of corporate office space in Santa Clara, California to serve as our future corporate headquarters. In October 2015, we entered into a fourth lease agreement for approximately 310,000 square feet of additional office space at the same location. The fourth lease will commence in December

- 10 -


2017 and expire in April 2028, however, the site is currently under construction and as a result, the lease commencement date may change based on progress of the construction project. The fourth lease agreement contains a rent holiday period, scheduled rent increases, lease incentives, and renewal options which allow the lease term to be extended through April 2046. Rental payments under the fourth lease agreement are approximately $101.2 million over the initial lease term. For more information on the three lease agreements entered into in May 2015, refer to Note 8. Commitments and Contingencies of Notes to Consolidated Financial Statements included in Part II, Item 8 of our Annual Report on Form 10-K for the fiscal year ended July 31, 2015.
The following table presents details of the aggregate future non-cancelable minimum rental payments under our operating leases as of January 31, 2016 (in millions):
 
Amount
Fiscal years ending July 31:
 
Remaining 2016
$
12.0

2017
25.0

2018
28.2

2019
41.8

2020
45.9

2021 and thereafter
350.6

Committed gross lease payments
503.5

Less: proceeds from sublease rental
6.6

Net operating lease obligation
$
496.9

Contract Manufacturer Commitments
Our independent contract manufacturer procures components and assembles our products based on our forecasts. These forecasts are based on estimates of demand for our products primarily for the next 12 months, which are in turn based on historical trends and an analysis from our sales and product marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate supply, we may issue forecasts and orders for components and products that are non-cancelable. As of January 31, 2016, our purchase commitments under such orders were $39.0 million, excluding obligations under contracts that we can cancel without a significant penalty. 
Litigation
We are subject to legal proceedings, claims, and litigation arising in the ordinary course of business, including intellectual property litigation. Such matters are subject to many uncertainties and outcomes are not predictable with assurance. We accrue for contingencies when we believe that a loss is probable and that we can reasonably estimate the amount of any such loss.
To the extent there is a reasonable possibility that a loss exceeding amounts already recognized may be incurred and the amount of such additional loss would be material, we will either disclose the estimated additional loss or state that such an estimate cannot be made. As of January 31, 2016, we have not recorded any significant accruals for loss contingencies associated with such legal proceedings, determined that an unfavorable outcome is probable or reasonably possible, or determined that the amount or range of any possible loss is reasonably estimable.

- 11 -


6. Equity Award Plans
Stock Option Activities
A summary of the activity under our stock plans during the reporting period and a summary of information related to options exercisable, vested, and expected to vest are presented below (in millions, except per share amounts):
 
Options Outstanding 
 
Number
of
Shares
 
Weighted-
Average
Exercise
Price Per Share 
 
Weighted-
Average
Remaining
Contractual
Term
(Years)
 
Aggregate
Intrinsic
Value
Balance—July 31, 2015
3.3

 
$
13.74

 
6.2
 
$
562.9

Options granted

 

 
 
 
 
Options forfeited

 

 
 
 
 
Options exercised
(0.8
)
 
12.20

 
 
 
 
Balance—January 31, 2016
2.5

 
$
14.16

 
5.8
 
$
339.9

Options vested and expected to vest—January 31, 2016
2.5

 
$
14.15

 
5.8
 
$
339.7

Options exercisable—January 31, 2016
2.3

 
$
13.51

 
5.7
 
$
316.3

Restricted Stock Unit (RSU) Activities
A summary of the activity under our stock plans during the reporting period and a summary of information related to RSUs vested and expected to vest are presented below (in millions, except per share amounts):
 
RSUs Outstanding
 
Number
of
Shares
 
Weighted-
Average
Grant-Date Fair Value Per Share
 
Weighted-
Average
Remaining
Contractual
Term
(Years)
 
Aggregate
Intrinsic
Value
Balance—July 31, 2015
7.2

 
$
95.66

 
1.2
 
$
1,334.8

RSUs granted
2.3

 
170.24

 
 
 
 
RSUs vested
(1.7
)
 
81.41

 
 
 
 
RSUs forfeited
(0.3
)
 
93.67

 
 
 
 
Balance—January 31, 2016
7.5

 
$
121.61

 
1.2
 
$
1,117.5

RSUs vested and expected to vest—January 31, 2016
7.1

 
$
120.88

 
1.2
 
$
1,057.1

Restricted Stock Award (RSA) Activities
During the three months ended January 31, 2016, we issued 1.1 million restricted shares of common stock to our employees with a grant-date fair value of $170.97 per share. The awards will vest over a period of three years from the date of grant. As of January 31, 2016, all of the restricted shares of common stock remained unvested and outstanding.


- 12 -


Share-Based Compensation
The following table summarizes share-based compensation included in costs and expenses (in millions):
 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2016
 
2015
 
2016
 
2015
Cost of product revenue
$
1.6

 
$
1.0

 
$
2.9

 
$
1.7

Cost of services revenue
10.5

 
5.1

 
17.5

 
8.6

Research and development
34.9

 
19.0

 
59.9

 
33.0

Sales and marketing
39.4

 
21.7

 
66.6

 
37.5

General and administrative
15.5

 
10.1

 
27.9

 
14.6

Total
$
101.9

 
$
56.9

 
$
174.8

 
$
95.4

At January 31, 2016, total compensation cost related to unvested share-based awards not yet recognized was $924.1 million, net of estimated forfeitures. This cost is expected to be amortized on a straight-line basis over a weighted-average period of approximately three years.
7. Income Taxes
Our provision for income taxes for the three and six months ended January 31, 2016 reflects an effective tax rate of (6.9)% and (8.9)%, respectively. Our effective tax rates for these periods were negative as we recorded a provision for income taxes on quarter and year to date losses. The key components of our income tax provision primarily consist of foreign income taxes, withholding taxes, U.S. federal and state income taxes, and amortization of our deferred tax charges. Our effective tax rate differs from the U.S. statutory tax rate primarily due to foreign tax losses which derive no benefit, non-deductible share-based compensation, and changes in our valuation allowance. As compared to the same periods last year, our effective tax rate changed primarily due to an increase in non-deductible share-based compensation, changes in our valuation allowance against deferred tax assets, and amortization of our deferred tax charges.
Our provision for (benefit from) income taxes for the three and six months ended January 31, 2015 reflects an effective tax rate of 1.6% and (0.6)%, respectively. Our effective tax rate for the six months ended January 31, 2015 was negative as we recorded a provision for income taxes on year to date losses. Our effective tax rate differs from the U.S. statutory tax rate primarily due to foreign tax losses which derive no benefit, non-deductible share-based compensation, and foreign income and withholding taxes.
In December 2015, the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”) was signed into law. Among its provisions, the PATH Act retroactively extends the bonus depreciation and other corporate tax incentives through December 31, 2019, and permanently extends the federal research and development credit. The adjustment to our deferred tax assets as a result of the PATH Act was fully offset by our valuation allowance. The income tax benefit derived from the PATH Act for the fiscal year ending July 31, 2016 is dependent on actual results for the year.
8. Net Income (Loss) Per Share
Basic net income (loss) per share is computed by dividing net income (loss) by basic weighted-average shares outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by diluted weighted-average shares outstanding, including potentially dilutive securities.
The following table presents the computation of basic and diluted net loss per share of common stock (in millions, except per share data):
 
Three Months Ended
 
Six Months Ended
 
January 31,
 
January 31,
 
2016
 
2015
 
2016
 
2015
Net loss
$
(62.5
)
 
$
(43.0
)
 
$
(101.2
)
 
$
(73.1
)
Weighted-average shares used to compute net loss per share, basic and diluted
86.6

 
80.8

 
85.8

 
80.1

Net loss per share, basic and diluted
$
(0.72
)
 
$
(0.53
)
 
$
(1.18
)
 
$
(0.91
)

- 13 -


The following securities were excluded from the computation of diluted net loss per share of common stock for the periods presented as their effect would have been antidilutive (in millions):
 
Three and Six Months Ended
 
January 31,
 
2016
 
2015
RSUs
7.5

 
7.7

Convertible senior notes
5.2

 
5.2

Warrants related to the issuance of convertible senior notes
5.2

 
5.2

Options to purchase common stock
2.5

 
4.5

RSAs
1.1

 

ESPP shares
0.1

 
0.1

Total
21.6

 
22.7

ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. The following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things: expectations regarding drivers of and factors affecting growth in our business; statements regarding trends in billings, our mix of product and services revenue, cost of revenue, gross margin, cash flows, operating expenses, including future share-based compensation expense, income taxes, investments and liquidity; expected recurring revenues resulting from expected growth in our installed base; the sufficiency of our existing cash and investments to meet our cash needs for the foreseeable future; and other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements generally can be identified by words such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “predicts,” “projects,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q, and in particular, the risks discussed under the caption “Risk Factors” in Part II, Item 1A of this report and those discussed in other documents we file with the Securities and Exchange Commission (“SEC”). We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.
Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is organized as follows:
Overview. A discussion of our business and overall analysis of financial and other highlights in order to provide context for the remainder of MD&A.
Key Financial Metrics. An analysis of our generally accepted accounting principles (“GAAP”) and non-GAAP key financial metrics, which management monitors to evaluate our performance.
Results of Operations. A discussion of the nature and trends in our financial results and an analysis of our financial results comparing the three and six months ended January 31, 2016 to the three and six months ended January 31, 2015.
Liquidity and Capital Resources. An analysis of changes in our balance sheets and cash flows, and a discussion of our financial condition and our ability to meet cash needs.
Contractual Obligations and Commitments. An overview of our contractual obligations, contingent liabilities, commitments, and off-balance sheet arrangements outstanding as of January 31, 2016, including expected payment schedule.
Critical Accounting Estimates. A discussion of accounting policies that require critical estimates, assumptions, and judgments.
Recent Accounting Pronouncements. A discussion of expected impacts of impending accounting changes on financial information to be reported in the future.

- 14 -


Overview
We have pioneered the next-generation of security with our innovative platform that empowers enterprises, service providers, and government entities to secure their organizations by safely enabling the increasingly complex and rapidly growing number of applications running on their networks and by preventing breaches that stem from targeted cyber attacks. Our platform uses an innovative traffic classification engine that identifies network traffic by application, user, and content. As a result, it provides in-depth visibility into all traffic and all applications at the user level in order to control usage, content, risks, and cyber threats. Our security platform consists of three major elements: our Next-Generation Firewall, our Advanced Endpoint Protection, and our Threat Intelligence Cloud. Our Next-Generation Firewall delivers application, user, and content visibility and control, as well as protection against network-based cyber threats, through our proprietary hardware and software architecture that is integrated within the firewall. Our Advanced Endpoint Protection prevents cyber attacks that aim to exploit software vulnerabilities on a broad variety of fixed and virtual endpoints and servers. Our Threat Intelligence Cloud provides central intelligence capabilities, security for software as a service (“SaaS”) applications, and automated delivery of preventative measures against cyber attacks.
The network-based element of our platform is delivered in the form of a physical or virtual appliance and includes a suite of subscription services. The cyber attack prevention capabilities of our platform are delivered in the form of subscription services that can be used either in the public cloud or in a private cloud using a dedicated appliance. Our subscription services can be easily activated on any of our appliances without requiring additional hardware or processing resources, thereby providing a seamless implementation path for our end-customers.
For the second quarter of fiscal 2016 and 2015, revenues were $334.7 million and $217.7 million, respectively, representing year over year growth of 53.8%. All three components of our hybrid SaaS revenue model experienced year over year growth, led by revenue from subscription services, which grew 68.2% to $84.3 million, followed by support and maintenance services, which grew 55.1% to $80.5 million, and product, which grew 46.9% to $169.9 million.
Our growth reflects the increased adoption of our hybrid SaaS revenue model, which consists of product, subscriptions, and support and maintenance. We believe this model will enable us to benefit from recurring revenues as we continue to grow our installed end-customer base. As of January 31, 2016, we had sold our products and services to more than 30,000 end-customers in over 140 countries. Our end-customers represent a broad range of industries including education, energy, financial services, government entities, healthcare, Internet and media, manufacturing, public sector, and telecommunications, and include some of the largest Fortune 100 and Global 2000 companies in the world.
Product revenue is generated from sales of our appliances, primarily our Next-Generation Firewall, which is available in physical and virtualized form. Our Next-Generation Firewall incorporates our proprietary PAN-OS operating system, which provides a consistent set of capabilities across our entire product line. Our products are designed for different performance requirements throughout an organization, ranging from our PA-200, which is designed for enterprise remote offices, to our top-of-the-line PA-7080, which was released in August 2015 and is especially suited for service provider customers. The same firewall functionality that is delivered in our physical appliances is also available in our VM-Series virtual firewalls, which secure virtualized and cloud-based computing environments.
Services revenue is generated from sales of subscriptions and support and maintenance, which together provide us with a source of recurring services revenue. Our subscriptions include two new services released during the first quarter of fiscal 2016: our Aperture subscription service, which provides content control for IT-sanctioned SaaS applications that are used to store and share end-customer’s data, and our AutoFocus cyber threat intelligence service, which provides prioritized actionable intelligence on targeted cyber attacks. Our subscriptions provide our end-customers with real-time access to the latest antivirus, intrusion prevention, web filtering, and modern malware prevention capabilities across fixed and mobile devices.
We maintain a field sales force that works closely with our channel partners in developing sales opportunities. We use a two-tier, indirect fulfillment model whereby we sell our products and services to our global distributor channel partners, which, in turn, sell our products and services to our reseller network, which then sell to our end-customers. We leverage our appliances to sell SaaS subscription services to meet our customers’ evolving security requirements. When end-customers purchase an appliance, they typically purchase one or more of our subscriptions for additional functionality, as well as support and maintenance in order to receive ongoing security updates, upgrades, bug fixes, and repairs.
We believe that the growth of our business and our short-term and long-term success are dependent upon many factors, including our ability to extend our technology leadership, grow our base of end-customers, expand deployment of our platform and services within existing end-customers, extend the length of service terms within existing end-customers, and focus on end-customer satisfaction. To manage any future growth effectively, we must continue to improve and expand our information technology and financial infrastructure, our operating and administrative systems and controls, and our ability to manage headcount, capital, and processes in an efficient manner. While these areas present significant opportunities for us, they also pose challenges and risks that we must successfully address in order to sustain the growth of our business and improve our operating results.

- 15 -


Key Financial Metrics
We monitor the key financial metrics set forth in the tables below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts, and assess operational efficiencies. We discuss revenue, gross margin, and the components of operating loss and margin below under “—Results of Operations.”
 
January 31, 2016
 
July 31, 2015
 
(in millions)
Total deferred revenue
$
928.8

 
$
713.7

Cash, cash equivalents, and investments
$
1,595.7

 
$
1,327.8

 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2016
 
2015
 
2016
 
2015
 
(dollars in millions)
Total revenue
$
334.7

 
$
217.7

 
$
631.9

 
$
410.0

Year over year percentage increase
53.8
 %
 
54.3
 %
 
54.1
 %
 
52.3
 %
Gross margin percentage
71.9
 %
 
72.7
 %
 
72.6
 %
 
72.5
 %
Operating loss
$
(55.3
)
 
$
(38.5
)
 
$
(86.1
)
 
$
(62.3
)
Operating margin percentage
(16.5
)%
 
(17.7
)%
 
(13.6
)%
 
(15.2
)%
Billings (non-GAAP)
$
459.0

 
$
282.8

 
$
847.0

 
$
523.3

Cash flow provided by operating activities


 


 
$
300.5

 
$
151.8

Free cash flow (non-GAAP)


 


 
$
263.6

 
$
139.7

Deferred Revenue. Our deferred revenue consists of amounts that have been invoiced but have not been recognized as revenue as of the period end. The majority of our deferred revenue balance consists of subscription and support and maintenance revenue that is recognized ratably over the contractual service period. We monitor our deferred revenue balance because it represents a significant portion of revenue to be recognized in future periods.
Cash Flow Provided by Operating Activities. We monitor cash flow provided by operating activities as a measure of our overall business performance. Our cash flow provided by operating activities is driven in large part by sales of our products and from up-front payments for both subscriptions and support and maintenance services. Monitoring cash flow provided by operating activities enables us to analyze our financial performance without the non-cash effects of certain items such as depreciation, amortization, and share-based compensation costs, thereby allowing us to better understand and manage the cash needs of our business.

- 16 -


Free Cash Flow (non-GAAP). We define free cash flow, a non-GAAP financial measure, as cash provided by operating activities less purchases of property, equipment, and other assets. We consider free cash flow to be a profitability and liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after the purchases of property, equipment, and other productive assets, can be used for strategic opportunities, including investing in our business, making strategic acquisitions, and strengthening the balance sheet. A limitation of the utility of free cash flow as a measure of our financial performance and liquidity is that it does not represent the total increase or decrease in our cash balance for the period. In addition, it is important to note that other companies, including companies in our industry, may not use free cash flow, may calculate free cash flow in a different manner than we do, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a comparative measure. A reconciliation of free cash flow to cash flow provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:
 
Six Months Ended January 31,
 
2016
 
2015
 
(in millions)
Free cash flow (non-GAAP):
 
 
 
Net cash provided by operating activities
$
300.5

 
$
151.8

Less: purchases of property, equipment, and other assets
36.9

 
12.1

Free cash flow (non-GAAP)
$
263.6

 
$
139.7

Net cash used in investing activities
$
(284.7
)
 
$
(487.4
)
Net cash provided by financing activities
$
21.6

 
$
24.8

Billings (non-GAAP). We define billings, a non-GAAP financial measure, as total revenue plus the change in deferred revenue during the period. We consider billings to be a key measure used by management to manage our business given our hybrid SaaS revenue model, and believe billings provides investors with an important indicator of the health and visibility of our business because it includes services revenue, which is recognized ratably over the subscription period or the period in which the services are expected to be performed, as the case may be, and product revenue, which is recognized at the time of shipment, provided that all other revenue recognition criteria have been met. We consider billings to be a useful metric for management and investors, particularly if we continue to experience increased sales of subscriptions and strong renewal rates for subscriptions and support and maintenance services, and as we monitor our near term cash flows. While we believe that billings provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management, it is important to note that other companies, including companies in our industry, may not use billings, may calculate billings differently, may have different billing frequencies, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of billings as a comparative measure. A reconciliation of billings to revenue, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:
 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2016
 
2015
 
2016
 
2015
 
(in millions)
Billings (non-GAAP):
 
 
 
 
 
 
 
Total revenue
$
334.7

 
$
217.7

 
$
631.9

 
$
410.0

Add: change in total deferred revenue
124.3

 
65.1

 
215.1

 
113.3

Billings (non-GAAP)
$
459.0

 
$
282.8

 
$
847.0

 
$
523.3


- 17 -


Results of Operations
The following table summarizes our results of operations for the periods presented and as a percentage of our total revenue for those periods based on our condensed consolidated statements of operations data. The period to period comparison of results is not necessarily indicative of results for future periods.
 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2016
 
2015
 
2016
 
2015
 
Amount
 
% of Revenue
 
Amount
 
% of Revenue
 
Amount
 
% of Revenue
 
Amount
 
% of Revenue
 
(dollars in millions)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
169.9

 
50.7
 %
 
$
115.6

 
53.1
 %
 
$
317.6

 
50.3
 %
 
$
217.1

 
53.0
 %
Services
164.8

 
49.3
 %
 
102.1

 
46.9
 %
 
314.3

 
49.7
 %
 
192.9

 
47.0
 %
Total revenue
334.7

 
100.0
 %
 
217.7

 
100.0
 %
 
631.9

 
100.0
 %
 
410.0

 
100.0
 %
Cost of revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
44.9

 
13.4
 %
 
30.7

 
14.1
 %
 
83.7

 
13.2
 %
 
59.8

 
14.6
 %
Services
49.3

 
14.7
 %
 
28.7

 
13.2
 %
 
89.7

 
14.2
 %
 
53.0

 
12.9
 %
Total cost of revenue
94.2

 
28.1
 %
 
59.4

 
27.3
 %
 
173.4

 
27.4
 %
 
112.8

 
27.5
 %
Total gross profit
240.5

 
71.9
 %
 
158.3

 
72.7
 %
 
458.5

 
72.6
 %
 
297.2

 
72.5
 %
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
74.0

 
22.1
 %
 
47.0

 
21.6
 %
 
133.7

 
21.2
 %
 
84.3

 
20.5
 %
Sales and marketing
187.6

 
56.0
 %
 
122.8

 
56.5
 %
 
345.9

 
54.7
 %
 
229.2

 
55.9
 %
General and administrative
34.2

 
10.3
 %
 
27.0

 
12.3
 %
 
65.0

 
10.3
 %
 
46.0

 
11.3
 %
Total operating expenses
295.8

 
88.4
 %
 
196.8

 
90.4
 %
 
544.6

 
86.2
 %
 
359.5

 
87.7
 %
Operating loss
(55.3
)
 
(16.5
)%
 
(38.5
)
 
(17.7
)%
 
(86.1
)
 
(13.6
)%
 
(62.3
)
 
(15.2
)%
Interest expense
(5.8
)
 
(1.7
)%
 
(5.5
)
 
(2.5
)%
 
(11.6
)
 
(1.8
)%
 
(11.0
)
 
(2.7
)%
Other income, net
2.5

 
0.7
 %
 
0.3

 
0.1
 %
 
4.7

 
0.7
 %
 
0.7

 
0.2
 %
Loss before income taxes
(58.6
)
 
(17.5
)%
 
(43.7
)
 
(20.1
)%
 
(93.0
)
 
(14.7
)%
 
(72.6
)
 
(17.7
)%
Provision for (benefit from) income taxes
3.9

 
1.2
 %
 
(0.7
)
 
(0.3
)%
 
8.2

 
1.3
 %
 
0.5

 
0.1
 %
Net loss
$
(62.5
)
 
(18.7
)%
 
$
(43.0
)
 
(19.8
)%
 
$
(101.2
)
 
(16.0
)%
 
$
(73.1
)
 
(17.8
)%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Number of employees at period end
 
 
 
 
 
 
 
 
3,343

 
 
 
2,083

 
 
Revenue
We derive revenue from sales of our products and services. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured.
Our total revenue is comprised of the following:
Product Revenue. Product revenue is derived primarily from sales of our appliances. Product revenue also includes revenue derived from software licenses of Panorama, GlobalProtect, and the VM-Series. We recognize product revenue at the time of shipment, provided that all other revenue recognition criteria have been met. As a percentage of total revenue, we expect our product revenue to vary from quarter to quarter based on seasonal and cyclical factors.
Services Revenue. Services revenue is derived primarily from sales of our subscriptions and support and maintenance. Our contractual subscription and support and maintenance terms are typically one year, although we also offer three to five year terms. We recognize revenue from subscriptions and support and maintenance over the contractual service period. As a percentage of total revenue, we expect our services revenue to vary from quarter to quarter and increase over the long term as we introduce new subscriptions, renew existing services contracts, and expand our installed end-customer base.

- 18 -


 
Three Months Ended January 31,
 
 
 
 
 
Six Months Ended January 31,
 
 
 
 
 
2016
 
2015
 
Change
 
2016
 
2015
 
Change
 
Amount
 
Amount
 
Amount
 
%
 
Amount
 
Amount
 
Amount
 
%
 
(dollars in millions)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
169.9

 
$
115.6

 
$
54.3

 
46.9
%
 
$
317.6

 
$
217.1

 
$
100.5

 
46.3
%
Services
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subscription
84.3

 
50.1

 
34.2

 
68.2
%
 
157.9

 
93.8

 
64.1

 
68.4
%
Support and maintenance
80.5

 
52.0

 
28.5

 
55.1
%
 
156.4

 
99.1

 
57.3

 
57.9
%
Total services
164.8

 
102.1

 
62.7

 
61.6
%
 
314.3

 
192.9

 
121.4

 
63.0
%
Total revenue
$
334.7

 
$
217.7

 
$
117.0

 
53.8
%
 
$
631.9

 
$
410.0

 
$
221.9

 
54.1
%
Revenue by geographic theater:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Americas
$
229.7

 
$
147.1

 
$
82.6

 
56.2
%
 
$
441.0

 
$
278.9

 
$
162.1

 
58.1
%
EMEA
62.1

 
44.8

 
17.3

 
38.4
%
 
115.8

 
83.3

 
32.5

 
39.0
%
APAC
42.9

 
25.8

 
17.1

 
66.7
%
 
75.1

 
47.8

 
27.3

 
57.3
%
Total revenue
$
334.7

 
$
217.7

 
$
117.0

 
53.8
%
 
$
631.9

 
$
410.0

 
$
221.9

 
54.1
%
Product revenue increased $54.3 million, or 46.9%, for the three months ended January 31, 2016 compared to the three months ended January 31, 2015, and increased $100.5 million, or 46.3%, for the six months ended January 31, 2016 compared to the six months ended January 31, 2015. The increases in both periods were driven by increased demand for our higher end appliances. The change in product revenue due to pricing was not significant for either period.
Services revenue increased $62.7 million, or 61.6%, for the three months ended January 31, 2016 compared to the three months ended January 31, 2015, and increased $121.4 million, or 63.0%, for the six months ended January 31, 2016 compared to the six months ended January 31, 2015. The increases in both periods were due to increased sales to new and existing end-customers. The mix between subscription revenue and support and maintenance revenue will fluctuate over time, depending on the introduction of new subscription offerings, renewals of support and maintenance services, and our ability to increase sales to new and existing customers. The change in services revenue due to pricing was not significant for either period.
With respect to geographic theaters, the Americas contributed the largest portion of the increase in revenue for the three and six months ended January 31, 2016 compared to the three and six months ended January 31, 2015, due to its larger and more established sales force compared to our other theaters. Revenue from both Europe, the Middle East, and Africa (“EMEA”) and Asia Pacific and Japan (“APAC”) increased for the three and six months ended January 31, 2016 compared to the three and six months ended January 31, 2015, due to our investment in increasing the size of our sales force and number of channel partners in these theaters.
Cost of Revenue
Our cost of revenue consists of cost of product revenue and cost of services revenue.
Cost of Product Revenue. Cost of product revenue primarily includes costs paid to our third-party contract manufacturer. Our cost of product revenue also includes amortization of intellectual property licenses, product testing costs, warranty costs, shipping costs, and personnel costs, which consist of salaries, benefits, bonuses, and share-based compensation associated with our operations organization. In addition, our cost of product revenue also includes allocated costs, which consist of certain facilities, depreciation, benefits, recruiting, and information technology costs that we allocate based on headcount. We expect our cost of product revenue to increase as our product revenue increases.
Cost of Services Revenue. Cost of services revenue includes personnel costs for our global customer support and technical operations organizations, amortization of acquired intangible assets, allocated costs, and uniform resource locator (“URL”) filtering database service fees. We expect our cost of services revenue to increase as our installed end-customer base grows.

- 19 -


 
Three Months Ended January 31,
 
 
 
Six Months Ended January 31,
 
 
 
 
 
2016
 
2015
 
Change
 
2016
 
2015
 
Change
 
Amount
 
Amount
 
Amount
 
%
 
Amount
 
Amount
 
Amount
 
%
 
(dollars in millions)
Cost of revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
44.9

 
$
30.7

 
$
14.2

 
46.7
%
 
$
83.7

 
$
59.8

 
$
23.9

 
40.0
%
Services
49.3

 
28.7

 
20.6

 
71.4
%
 
89.7

 
53.0

 
36.7

 
69.2
%
Total cost of revenue
$
94.2

 
$
59.4

 
$
34.8

 
58.7
%
 
$
173.4

 
$
112.8

 
$
60.6

 
53.8
%
Includes share-based compensation of:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
1.6

 
$
1.0

 
$
0.6

 
72.5
%
 
$
2.9

 
$
1.7

 
$
1.2

 
72.2
%
Services
10.5

 
5.1

 
5.4

 
105.8
%
 
17.5

 
8.6

 
8.9

 
103.1
%
Total share-based compensation included in cost of revenue
$
12.1

 
$
6.1

 
$
6.0

 
100.6
%
 
$
20.4

 
$
10.3

 
$
10.1

 
98.0
%
Cost of product revenue increased $14.2 million, or 46.7%, for the three months ended January 31, 2016 compared to the three months ended January 31, 2015, and increased $23.9 million, or 40.0%, for the six months ended January 31, 2016 compared to the six months ended January 31, 2015. The increases in both periods were due to an increase in product unit volume.
Cost of services revenue increased $20.6 million, or 71.4%, for the three months ended January 31, 2016 compared to the three months ended January 31, 2015, due to increases in personnel costs of $10.5 million related to headcount growth, allocated costs of $3.2 million, and third-party professional services costs of $2.6 million to expand our customer service capabilities to support our growing installed end-customer base.
Cost of services revenue increased $36.7 million, or 69.2%, for the six months ended January 31, 2016 compared to the six months ended January 31, 2015, due to increases in personnel costs of $19.0 million related to headcount growth, allocated costs of $5.7 million, and third-party professional services costs of $4.0 million to expand our customer service capabilities to support our growing installed end-customer base.
Gross Margin
Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including the average sales price of our products, manufacturing costs, the mix of products sold, and the mix of revenue between products and services. For sales of our products, our higher end firewall products generally have higher gross margins than our lower end firewall products within each product series. For sales of our services, our subscriptions typically have higher gross margins than our support and maintenance. We expect our gross margins to fluctuate over time depending on the factors described above.
 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2016
 
2015
 
2016
 
2015
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
(dollars in millions)
Gross profit:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
125.0

 
73.5
%
 
$
84.9

 
73.5
%
 
$
233.9

 
73.6
%
 
$
157.3

 
72.5
%
Services
115.5

 
70.2
%
 
73.4

 
71.9
%
 
224.6

 
71.5
%
 
139.9

 
72.5
%
Total gross profit
$
240.5

 
71.9
%
 
$
158.3

 
72.7
%
 
$
458.5

 
72.6
%
 
$
297.2

 
72.5
%
Product gross margin was flat for the three months ended January 31, 2016 compared to the three months ended January 31, 2015. Services gross margin decreased 170 basis points for the three months ended January 31, 2016 compared to the three months ended January 31, 2015, driven by headcount growth within our global customer support organization in order to support our growing installed end-customer base.
Product gross margin increased 110 basis points for the six months ended January 31, 2016 compared to the six months ended January 31, 2015, driven by our continued focus on material cost reductions. Services gross margin decreased 100 basis

- 20 -


points for the six months ended January 31, 2016 compared to the six months ended January 31, 2015, driven by headcount growth within our global customer support organization in order to support our growing installed end-customer base.
Operating Expenses
Our operating expenses consist of research and development, sales and marketing, and general and administrative expense. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, share-based compensation, and with regard to sales and marketing expense, sales commissions. Our operating expenses also include allocated costs, which consist of certain facilities, depreciation, benefits, recruiting, and information technology costs that we allocate based on headcount. We expect operating expenses to increase in absolute dollars and decrease over the long term as a percentage of revenue as we continue to scale our business. As of January 31, 2016, we expect to recognize approximately $924.1 million of share-based compensation expense over a weighted-average period of approximately three years, excluding additional share-based compensation expense related to any future grants of share-based awards. Share-based compensation expense, net of forfeitures, is recognized on a straight-line basis over the requisite service periods of the awards.
Research and Development. Research and development expense consists primarily of personnel costs. Research and development expense also includes prototype related expenses and allocated costs. We expect research and development expense to increase in absolute dollars as we continue to invest in our future products and services, although our research and development expense may fluctuate as a percentage of total revenue.
Sales and Marketing. Sales and marketing expense consists primarily of personnel costs, including commission costs. We expense commission costs as incurred. Sales and marketing expense also includes costs for market development programs, promotional and other marketing costs, travel costs, professional services, and allocated costs. We continue to increase the size of our sales force and have also substantially grown our sales presence internationally. We expect sales and marketing expense to continue to increase in absolute dollars as we increase the size of our sales and marketing organizations to increase touch points with end-customers and to expand our international presence, although our sales and marketing expense may fluctuate as a percentage of total revenue.
General and Administrative. General and administrative expense consists of personnel costs for our executive, finance, human resources, legal, and information technology organizations, professional services, and certain non-recurring general expenses. Professional services consist primarily of legal, auditing, accounting, and other consulting costs. We expect general and administrative expense to increase in absolute dollars due to additional costs associated with accounting, compliance, insurance, and investor relations, although our general and administrative expense may fluctuate as a percentage of total revenue.
 
Three Months Ended January 31,
 
 
 
 
 
Six Months Ended January 31,
 
 
 
 
 
2016
 
2015
 
Change
 
2016
 
2015
 
Change
 
Amount
 
Amount
 
Amount
 
%
 
Amount
 
Amount
 
Amount
 
%
 
(dollars in millions)
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
$
74.0

 
$
47.0

 
$
27.0

 
57.5
%
 
$
133.7

 
$
84.3

 
$
49.4

 
58.6
%
Sales and marketing
187.6

 
122.8

 
64.8

 
52.7
%
 
345.9

 
229.2

 
116.7

 
50.9
%
General and administrative
34.2

 
27.0

 
7.2

 
27.3
%
 
65.0

 
46.0

 
19.0

 
41.6
%
Total operating expenses
$
295.8

 
$
196.8

 
$
99.0

 
50.3
%
 
$
544.6

 
$
359.5

 
$
185.1

 
51.5
%
Includes share-based compensation of:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
$
34.9

 
$
19.0

 
$
15.9

 
84.0
%
 
$
59.9

 
$
33.0

 
$
26.9

 
81.6
%
Sales and marketing
39.4

 
21.7

 
17.7

 
81.2
%
 
66.6

 
37.5

 
29.1

 
77.4
%
General and administrative
15.5

 
10.1

 
5.4

 
53.1
%
 
27.9

 
14.6

 
13.3

 
92.2
%
Total share-based compensation included in operating expenses
$
89.8

 
$
50.8

 
$
39.0

 
76.7
%
 
$
154.4

 
$
85.1

 
$
69.3

 
81.6
%
Research and development expense increased $27.0 million, or 57.5%, for the three months ended January 31, 2016 compared to the three months ended January 31, 2015, due to an increase in personnel costs of $23.9 million, largely due to headcount growth, and an increase in allocated costs of $2.5 million.

- 21 -


Research and development expense increased $49.4 million, or 58.6%, for the six months ended January 31, 2016 compared to the six months ended January 31, 2015, due to an increase in personnel costs of $43.5 million, largely due to headcount growth, and an increase in allocated costs of $4.6 million.
Sales and marketing expense increased $64.8 million, or 52.7%, for the three months ended January 31, 2016 compared to the three months ended January 31, 2015, due to an increase in personnel costs of $44.9 million, largely due to headcount growth, an increase in allocated costs of $8.2 million, an increase in travel and entertainment costs of $4.0 million, and an increase in demand generation activities, trade shows, and other marketing activities of $1.6 million.
Sales and marketing expense increased $116.7 million, or 50.9%, for the six months ended January 31, 2016 compared to the six months ended January 31, 2015, due to an increase in personnel costs of $79.0 million, largely due to headcount growth, an increase in allocated costs of $14.7 million, an increase in travel and entertainment costs of $8.2 million, and an increase in demand generation activities, trade shows, and other marketing activities of $3.2 million.
General and administrative expense increased $7.2 million, or 27.3%, for the three months ended January 31, 2016 compared to the three months ended January 31, 2015, due to an increase in personnel costs of $7.4 million, largely due to headcount growth.
General and administrative expense increased $19.0 million, or 41.6%, for the six months ended January 31, 2016 compared to the six months ended January 31, 2015, due to an increase in personnel costs of $18.0 million, largely due to headcount growth.
Other Income, Net
Other income, net includes interest income earned on our cash, cash equivalents, and investments, foreign currency remeasurement gains and losses, and foreign currency transaction gains and losses.
 
Three Months Ended January 31,
 
 
 
 
 
Six Months Ended January 31,
 
 
 
 
 
2016
 
2015
 
Change 
 
2016
 
2015
 
Change 
 
Amount
 
Amount
 
Amount
 
%
 
Amount
 
Amount
 
Amount
 
%
 
(dollars in millions)
Other income, net
$
2.5

 
$
0.3

 
$
2.2

 
NM
 
$
4.7

 
$
0.7

 
$
4.0

 
NM
Other income, net increased $2.2 million and $4.0 million for the three and six months ended January 31, 2016 compared to the three and six months ended January 31, 2015, due to an increase in interest income and higher foreign currency remeasurement gains.
Provision for (Benefit from) Income Taxes
Provision for (benefit from) income taxes consists primarily of income taxes in foreign jurisdictions in which we conduct business, withholding taxes, federal and state income taxes in the United States, and amortization of our deferred tax charges. We maintain a full valuation allowance for domestic deferred tax assets, including net operating loss carryforwards and tax credits.
 
Three Months Ended January 31,
 
Six Months Ended January 31,
 
2016
 
2015
 
2016
 
2015
 
(dollars in millions)
Provision for (benefit from) income taxes
$
3.9

 
$
(0.7
)
 
$
8.2

 
$
0.5

Effective tax rate
(6.9
)%
 
1.6
%
 
(8.9
)%
 
(0.6
)%
We recorded an income tax provision for the three and six months ended January 31, 2016, due to federal, state, and foreign income taxes, withholding taxes, and amortization of our deferred tax charges. The provision for income taxes increased for the three and six months ended January 31, 2016 compared to the three and six months ended January 31, 2015, primarily due to an increase in non-deductible share-based compensation, changes in our valuation allowance against deferred tax assets, and amortization of our deferred tax charges.

- 22 -


Liquidity and Capital Resources
 
January 31, 2016
 
July 31, 2015
 
(in millions)
Working capital (1)
$
120.7

 
$
41.8

Cash, cash equivalents, and investments:
 
 
 
Cash and cash equivalents
$
413.2

 
$
375.8

Investments
1,182.5

 
952.0

Total cash, cash equivalents, and investments
$
1,595.7

 
$
1,327.8

______________
(1)
The net carrying amount of the Notes was classified in current liabilities in our condensed consolidated balance sheets as of January 31, 2016 and July 31, 2015. Refer to Note 4. Convertible Senior Notes of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for more information.
At January 31, 2016, our total cash, cash equivalents, and investments of $1.6 billion were held for general corporate purposes, of which approximately $130.9 million was held outside of the United States. We do not provide for federal income taxes on the undistributed earnings of our foreign subsidiaries, all of which we expect to reinvest outside of the United States indefinitely. However, if these funds were needed for our domestic operations, we would be required to accrue and pay U.S. taxes on undistributed earnings of foreign subsidiaries. There are no other restrictions on the use of these funds. If we were to repatriate these earnings to the United States, any associated income tax liability would be insignificant.
In June 2014, we issued $575.0 million aggregate principal amount of 0.0% Convertible Senior Notes due 2019 (the “Notes”), which mature on July 1, 2019. Prior to January 1, 2019, holders may surrender their Notes for early conversion under certain circumstances. Upon conversion, we will pay cash equal to the aggregate principal amount of the Notes to be converted, and, at our election, will pay or deliver cash and/or shares of our common stock for the amount of our conversion obligation in excess of the aggregate principal amount of the Notes being converted. Refer to Note 4. Convertible Senior Notes of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for information on the Notes.
The following table summarizes our cash flows for the six months ended January 31, 2016 and 2015:
 
Six Months Ended January 31,
2016
 
2015
 
(in millions)
Net cash provided by operating activities
$
300.5

 
$
151.8

Net cash used in investing activities
(284.7
)
 
(487.4
)
Net cash provided by financing activities
21.6

 
24.8

Net increase (decrease) in cash and cash equivalents
$
37.4

 
$
(310.8
)