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Palo Alto Networks (NYSE:PANW)

Q1 2014 Earnings Call

November 25, 2013 4:30 pm ET

Executives

Kelsey Turcotte

Mark D. McLaughlin - Chairman, Chief Executive Officer and President

Steffan C. Tomlinson - Chief Financial Officer and Principal Accounting Officer

Analysts

Gregory Dunham - Goldman Sachs Group Inc., Research Division

Keith Weiss - Morgan Stanley, Research Division

Rob D. Owens - Pacific Crest Securities, Inc., Research Division

Jonathan Ho - William Blair & Company L.L.C., Research Division

Philip Winslow - Crédit Suisse AG, Research Division

Catharine Anne Trebnick - Northland Capital Markets, Research Division

Brent Thill - UBS Investment Bank, Research Division

Michael Turits - Raymond James & Associates, Inc., Research Division

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Gray Powell - Wells Fargo Securities, LLC, Research Division

Robert Scott Zeller - Needham & Company, LLC, Research Division

Hendi Susanto - Gabelli & Company, Inc.

Shebly Seyrafi - FBN Securities, Inc., Research Division

Eric A. Ghernati - BofA Merrill Lynch, Research Division

Erik Suppiger - JMP Securities LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the First Quarter 2014 Palo Alto Networks Earnings Conference Call. My name is Britney, and I'll be the operator for today's conference. [Operator Instructions] At this time, I would now like to turn the presentation over to your host for today, Ms. Kelsey Turcotte. Please proceed, ma'am.

Kelsey Turcotte

Good afternoon, and thank you for joining us on today's conference call to discuss Palo Alto Networks' fiscal first quarter 2014 financial results. This call is being broadcast live over the web and can be accessed on the Investors section of the Palo Alto Networks website at investors.paloaltonetworks.com.

With me on today's call are Mark McLaughlin, Palo Alto Networks' Chairman, President and Chief Executive Officer; and Steffan Tomlinson, Chief Financial Officer.

After the market closed today, Palo Alto Networks issued a press release announcing the results for its 2014 fiscal first quarter ended October 31, 2013. If you would like a copy of the release, you can access it online at the company's website or you can call The Blueshirt Group at (415) 217-7722, and they will e-mail you a copy.

We would like to remind you that during the course of this conference call, Palo Alto Networks management will make forward-looking statements, including statements regarding continued revenue growth, increases in market share and overall momentum in Palo Alto Networks' business, trends in its business and operating results, including customer growth, its services revenue, gross margin, services margins and DSOs. Expectations regarding investments in research and development and the introduction of new products and Palo Alto Networks' revenue and non-GAAP estimated earnings per share for the second fiscal quarter of 2014 ending January 31, 2014.

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

These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future, and we undertake no obligation to update these statements after this call. For a more detailed description of these risks and uncertainties, please refer to our annual report on Form 10-K filed with the SEC on September 25, 2013, and our earnings release posted a few minutes ago on our website.

Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the Investors section of our website located at investors.paloaltonetworks.com.

Before I turn the call over to the team, I would like to inform you that Palo Alto Networks will be participating in the CSFB Annual Technology Conference on Wednesday, December 4, in Scottsdale, Arizona.

And with that, I'd like to introduce Mark, Chairman, President and Chief Executive Officer of Palo Alto Networks. Mark?

Mark D. McLaughlin

Thank you, Kelsey, and welcome to the team. And thanks, everyone, for joining us today. Q1 was a strong start for our fiscal 2014. Our results continue to prove that our next-generation enterprise security platform is quickly becoming the mainstream market choice for enterprises around the world. And that it uniquely positions us as a leader in the fast-growing cybersecurity market segment. The combination of these market drivers, our land and expand strategy and the power of our fast-growing subscription services model drove record revenue and strong bottom line results in the first quarter.

Revenue in Q1 grew by 49% year-over-year to over $128 million. And we delivered high gross margins, significant operating leverage and non-GAAP EPS of $0.08 per share. We are very pleased with what we have accomplished this quarter and believe that the reasons for such high growth positions us well for continued growth.

Today, global enterprises are facing an extremely difficult environment in which protecting their networks against ever-increasing threats is paramount. The risks are very high and include lost revenue, loss of customer data, loss of intellectual property and loss of customer trust. At the same time, it's more and more evident that the legacy security technologies that enterprises have relied on for a long time are incapable of addressing their security needs. This has led to a major market disruption in favor of Palo Alto Networks.

Our platform is at the forefront of next-generation enterprise security and is now being rapidly adopted by the Global 2000 as their mainstream solution at the expense of the legacy vendors.

In addition, we're uniquely positioned as a firewall, the main protection point for network security with the next-generation platform, which provides a highly integrated and automated level of visibility and intelligence around detection and prevention. This allows us to benefit from the drive for advanced cybersecurity solutions. The mainstream adoption of our platform as the firewall of choice, as well as our unique ability to provide the most integrated and automated cyber threat detection and prevention capabilities in the market is fueling our growth. And we can see this playing out in the numbers.

Our adoption as the primary network security platform by global enterprises continues to grow. In the first quarter, we saw continued penetration of the largest companies in the world, with over 65% of the Fortune 100 and 35% of Global 2000 customers, and we saw larger initial orders and deployments from our bigger customers. Also in the quarter, our wins against legacy competitors included: One of the largest oil and gas companies in the world, where we're replacing Check Point and Cisco; a major Canadian bank; a large health care organization that we'll be deploying our full solution, including WildFire and other subscriptions; one of Russia's largest oil transporters; and a leading international credit card company, where we are deploying the largest virtual firewall in Europe.

In addition, we demonstrated last quarter that we are well positioned to rapidly expand within our customer base. For example, we expanded within a Fortune 50 manufacturer based in the United States with a 7-figure deal to be their primary firewall. And we also expanded within a U.S. federal agency, where our platform is displacing large amounts of legacy technology.

These results show that we continue to rapidly move into the mainstream with the largest companies in the world. This trend is further evidenced by the climb in our lifetime customer value. For example, in Q1, our top 25 customer had to spend a minimum of $4.1 million with us in lifetime value to make the top 25 list. And our lifetime value, measured by the increase from their initial purchase, rose to 19.6x. This compares to $3.6 million and 15.4x in the immediately preceding quarter and $2.1 million and 9.5x at the beginning of fiscal 2013.

If I expand this list to our top 100 customers, they have all spent a minimum of $1.5 million on our solutions, which is double from what it was a year ago. We believe our continued increase in wallet share will enable high growth over the long term. Our position as the firewall and our innovative approach to increasingly sophisticated attacks also sets us up well for high growth in the market for cybersecurity solutions. This has been a big factor on our platform adoption that I mentioned earlier, and we can also see it in the rapid growth in WildFire, the market's most highly automated and integrated detection and prevention solution.

In Q1, WildFire customer adoption grew to approximately 2,400 customers, up from about 2,000 in the prior quarter, with approximately 1,000 paying customers using the platform, up from around 600 customers in Q4. The WildFire attach rate was over 20% in the quarter, and WildFire continues to act as a driver and differentiator for our core network security platform.

WildFire is an example of our high growth, hybrid revenue model, where we leverage our unique hardware platform to sell SaaS subscription services to meet our customers' evolving enterprise security requirements. The hybrid SaaS business model means that we're able to benefit over time with recurring revenues as we build our installed base. In a constantly evolving and complex threat landscape, we continue to deliver solutions that solve our customers' toughest security problems. This is an approach that makes sense, as our core platform sits in the single-most-important spot for network security is the firewall. And of course, we continue to invest in innovation and aggressively grow our go-to-market capabilities.

On the innovation front, in early calendar 2014, we expect to introduce our high-end 120-gig chassis for the data center and service provider market, deliver significant enhancements to our WildFire service, release our next major OS revision and bring our joint virtualization solution to market with VMware. Expect more innovation throughout the year as the technology gap between Palo Alto Networks and our competitors continues to widen as it has every year since we began providing solutions to our customers.

In terms of our go-to-market focus, the growth of our sales force, continued growth in investment in channel partners, penetration in emerging markets and building out our alliance ecosystem are accelerating the delivery of our solutions to the market and growth in the business. We'll continue to pursue all these focus areas to grow into our large addressable market.

Before concluding, I want to mention that we completed the summary judgment and claims construction hearings in our litigation with Juniper on November 15. We remain confident in our position in that case.

To wrap up, our first quarter results continue to demonstrate that we're on the right track. We've reached over $0.5 billion in annualized run rate revenues and continue to grow at almost 50% as we rapidly gain share in a very large addressable market. We will stay focused and do what we do best, delivering highly differentiated enterprise security solutions that solve our customers' most difficult challenges.

I'd now like to turn the call over to Steffan for a detailed look at our financial results. Steffan?

Steffan C. Tomlinson

Thank you, Mark. I'm pleased to report that first quarter results for fiscal 2014 exceeded our guidance. We continue to demonstrate rapid revenue and billings growth, solid bottom line performance and healthy free cash flow generation.

Before I get into the details, I'd like to note that except for revenue figures that are GAAP, all financial figures are non-GAAP unless stated otherwise and exclude IP litigation expenses for both the first quarter and historical comparisons.

New wins from customers in the quarter, our expansion within our existing customer base and our hybrid SaaS revenue model were the catalyst for revenue, billings and deferred revenue growth. In Q1, total revenue was a record $128.2 million, growing 49% over the prior year and 14% sequentially. The geographic mix of revenue was 67% Americas, 19% EMEA and 14% APAC. All theaters posted solid growth year-over-year, led by the Americas, which grew 58%.

From a vertical and customer standpoint, we saw broad strength across a wide range of verticals, including federal, and we had no end customer concentration. All 3 components of our hybrid SaaS model grew well in the quarter. Product revenue of $75.5 million increased 36% over the prior year and 15% sequentially. Growth was driven in part by demand for our midrange 3000 and high-end 5000 PA series of appliances.

Our recurring services revenue of $52.7 million increased 73% over the prior year and 12% sequentially, and accounted for a 41% share of total revenue. Looking at its 2 components, support and maintenance revenue of $27.9 million increased 75% over the prior year and 10% sequentially. Our SaaS-based subscription revenue of $24.8 million increased 71% over the prior year and approximately 15% sequentially. As a result of our land and expand strategy and the recurring nature of our support and subscription businesses, we expect the services revenue will continue to grow at a faster pace than product revenue as we continue to monetize our incumbent position in the network.

Every time we sell a new subscription or renew an existing subscription, it's equivalent to selling a product, except that we've chosen the SaaS model to deliver and monetize it. Increases in services revenue as a percentage of total revenue will improve our gross margins, as well as increase visibility into future revenue streams.

The strength of our business model was evident in the growth rate in billings, deferred revenue and free cash flow. Compared to the prior year, billings in Q1 grew 43% to $157.9 million. Total deferred revenue increased 74% to $279 million and short-term deferred revenue increased 69% to $171.6 million.

Turning to gross margin, total gross margin of 75% increased 50 basis points sequentially. Product gross margin was 76.6%, increasing 140 basis points sequentially, due in part to favorable product mix and continued focus on material and manufacturing cost reductions.

As a reminder, there will be fluctuations in our product gross margin, primarily due to product mix and the timing of new appliance shipments.

Services gross margin of 72.8% declined 70 basis points sequentially, due in part to investments in our customer support organization as we continue to add systems and personnel to accommodate the rapid growth of our customer base.

Moving on to operating expenses. As Mark discussed, we believe there is considerable opportunity for us to drive growth and capture market share, and we continue to invest in both product development and our sales and go-to-market organization.

Research and development expense was 12.9% of revenue, increasing approximately $2.1 million sequentially to $16.5 million. Headcount additions and project-related expenses supporting our development activities contributed to the increase.

Sales and marketing expense was 47% of revenue, essentially flat with the prior quarter as a percentage of sales and increasing approximately $7.3 million sequentially to $60.3 million.

New headcount additions at the beginning of the fiscal year, partner conferences, and our worldwide sales event that we held to kick off the new fiscal year contributed to the increase.

General and administrative expense was 7.6% of revenue, increasing approximately $2.5 million sequentially to $9.8 million. The sequential increase is attributed to higher personnel and infrastructure-related costs as we continue to support the growth of the business.

On a GAAP basis, IP litigation expense in our G&A line was $1.9 million in Q1 '14, $0.6 million in Q1 '13 and $1.4 million in Q4 '13. We've provided a supplemental schedule on our IR website that shows the historical impact of the IP litigation costs.

In total, operating expenses were $86.6 million or 67.5% of revenue. Operating margin increased 70 basis points year-over-year to 7.5% and declined 50 basis points sequentially. Our effective tax rate for Q1 was 38%. Net income for the quarter was approximately $6.2 million or $0.08 per diluted share, using 77.2 million shares, compared with net income of $3.3 million or $0.05 per diluted share in Q1 '13.

On a GAAP basis for the first quarter, net loss was $7.9 million or $0.11 per basic and diluted share compared to a Q1 '13 GAAP net loss of $3.5 million or $0.05 per basic and diluted share.

Turning to the balance sheet, we finished October with cash, cash equivalents and investments of $470.4 million. Cash flow from operations, free cash flow and free cash flow margin were $38.9 million, $23.2 million and 18.1%, respectively. Capital expenditures in the quarter totaled $15.7 million and were related to facilities purchases and acquiring intellectual property.

The accounts receivable balance was $91.4 million, up from the prior quarter balance of $87.5 million. Linearity in the quarter improved, which helped improve average days sales outstanding to 63 days, down from 72 days last quarter. This is below our DSO target range of 65 to 75 days.

Let me now move to our guidance. As a reminder, guidance excludes IP litigation expenses. In Q2 '14, we expect revenue to be in the range of $132 million to $136 million, which represents 37% to 41% growth year-over-year. And we expect non-GAAP EPS to be approximately $0.08 to $0.09 per share using 77 million to 79 million shares.

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

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Greg Dunham representing Goldman Sachs.

Gregory Dunham - Goldman Sachs Group Inc., Research Division

I guess Q4 was a good quarter for you guys. You improved your execution, but this quarter actually jumps out as better than that with accelerating product revenue growth. How -- can you decipher between how much of that is just increased tenure of the reps that you hired last year versus just a generally improving macro? Any way to distinguish that?

Mark D. McLaughlin

Greg, it's Mark. Yes, the answer is more likely or not all of the above, which is, I think the security market continues to be very robust. You can see that not just from ourselves, but other folks that reported. The needs out there are very strong. Customers are buying to solve those needs. And then on top of that, we have a unique platform. So we're benefiting disproportionately from that. As you know, we put a hell of a lot of focus into the major global accounts and the sales organization over last year, and I think that, that's paying off very well as you can see from the numbers, too. So I think a lot of these things are moving in our direction. Some are macro and some are about the solution. And some are about the things we're doing on an execution base at the company.

Gregory Dunham - Goldman Sachs Group Inc., Research Division

And then one quick follow-up, if I may. Where are we in terms of customers migrating to 5.0 on an OS basis?

Mark D. McLaughlin

Yes, a bit over 60%.

Operator

And your next question comes from the line of Keith Weiss representing Morgan Stanley.

Keith Weiss - Morgan Stanley, Research Division

I was wondering if we could talk a little bit about -- going into any Q1, there's some level of sales changes that take place. Maybe you can mark-to-market for us the level of changes that were enacted this year compared to prior years. And how comfortable do you feel with everybody kind of marching to order for the rest of the year from where we're standing today?

Mark D. McLaughlin

Yes, sure, Keith. Well, as you know over the last year, we made a number of changes in the sales organization, about 18 months ago, with Mark Anderson joining us under an assumption that he would do a certain number of things that he's done very well from a team perspective, starting with leadership. And then also getting the reps who know how to service and close large accounts. That's really worked itself out through the better course of the last year and all those changes have been made, and we think people are really humming now. And we mentioned at the last call that this will be the first year, by the end of the year, where we'll have more ramp than ramping salespeople in the organization, which we think is a good thing for us as we continue to march down the field.

Keith Weiss - Morgan Stanley, Research Division

Excellent. Excellent. And then maybe on the -- from a potential overhang perspective. If you could get to your comments on 2 aspects. One, just in terms of litigation, we are sort of into the thick of it past the Markman hearing. Anymore foot [ph] in the market in terms of tying up sales cycles? Any impact from the actual fundamentals from that litigation?

Mark D. McLaughlin

It doesn't appear to be the case. We said before that we haven't seen any impact in the market that we can discern from a selling perspective. We continue to grow at extremely healthy rates. So we continue to beat all the competition handily whenever we face them. So I don't see it really playing out in the market.

Keith Weiss - Morgan Stanley, Research Division

Excellent. Then one last one, just in terms of the competitive environment. Cisco, obviously, made a pretty big acquisition of Sourcefire. What's the initial indications on sort of how that's impacting you guys in terms of the competitive environment? Are people taking Cisco more seriously or is it just disruption in the near term?

Mark D. McLaughlin

I think to the extent there's any impact at all, it's been positive for us. And that's primarily because we handily beat Cisco when we face them. We've beat Sourcefire in head-to-head competitions as well. And taking an IPS technology and bolting it on a stateful inspection firewall is not a fundamental disruptive technology change. So I don't think it changes anything from a technical solution perspective. We've also seen confusion in the market from the Sourcefire customers about what that means. What's going to happen to them over time. And we've been able to develop hundreds and hundreds of leads from dissatisfied or confused Sourcefire customers. So at least from our perspective, it's been a positive.

Operator

And your next question comes from the line of Rob Owens representing Pacific Crest Securities.

Rob D. Owens - Pacific Crest Securities, Inc., Research Division

Mark, you mentioned how the spending in security markets were robust. And I think if you go back a couple of quarters, it was a little more choppy. So maybe just talk about general demand. How the space is firming. And are we in front of that perceived firewall replacement cycle that I think a lot of folks have been talking about for the last year?

Mark D. McLaughlin

Yes, Rob. It's a little hard to come by hard data around the refresh cycle, as far as anybody who would know for sure. But I've heard a number of anecdotal points that a big refresh cycle is upon us in the next 12 to 15 months. And we think we can see that from what we're seeing from a pipeline perspective, close rates. I mean, it all points in that direction. That there is a big refresh cycle in front of us. On the big picture about security, I know that there was a 1 quarter bump in the road before, not just security, but all of networking. There are various reasons for that. But it appears as though at least from a security perspective that, that's rebounded very nicely, and that security is a top-of-mind issue and is likely to remain that way for some time.

Rob D. Owens - Pacific Crest Securities, Inc., Research Division

Great. And then as we look at some of your incremental services and those SaaS capabilities in WildFire or the URL filtering or threat prevention, any sense of where renewal rates are running on those services?

Mark D. McLaughlin

Yes, we had said earlier that the renewal rates were better than 85%, and more likely than not higher that. One of the reasons that we were less exact on the higher number was, is that when a customer upgrades from an equipment perspective, for us, it looks like a new sale, not a renewal. So we're highly confident it's higher than that, but that's what we reported last time.

Operator

And your next question comes from the line of Jonathan Ho.

Jonathan Ho - William Blair & Company L.L.C., Research Division

Just wanted to start out with the EMEA and APAC regions. What typical opportunity do you see to sort of accelerate growth there? Are there any sort of things that restrict the growth from maybe being a little bit faster than what you're seeing, especially relative to your North American results?

Mark D. McLaughlin

Yes, so if we look at the results in EMEA and APAC. On the EMEA side, we saw good year-to-year -- year-over-year growth and a slight sequential decline of about 2%. We like EMEA as a market. We think that's a big growth opportunity for us. There continues to be some concern in Southern Europe. I think that's going to last for a while from a macro standpoint. But we're investing there, and we think that, that's a good growth market for us. Also, just as a general matter coming from a Q4 to Q1, it's not surprising to see a sequential decline there. And in APAC, we had a 2% sequential decline as well, but we had very strong year-over-year growth in APAC. And we're coming off a extremely high comp last sequential growth quarter-over-quarter in APAC. So it's across the board, generally pleased with all the performance in the regions.

Jonathan Ho - William Blair & Company L.L.C., Research Division

Got it. And just in terms of the latest products that you're seeing released, what type of opportunity do you think that's going to drive in terms of accelerating growth? Particularly relative to the high end of the market and the midrange, and what could that mean in terms of your growth expectations?

Mark D. McLaughlin

Yes, so the ones that we've talked about from a roadmap perspective coming up in relatively short order fall in the category of a new version of WildFire coming out, which is going to help us to continue to even faster accelerate the need for cybersecurity solutions. We've talked about our 120-gig chassis, which is coming out, which will help us expand even faster than we are today in the data center environment and it will open up a new part of the addressable market for us, which is the service provider market. And we've also talked about a joint technology offering coming to market shortly with VMware, which is going to allow us to even penetrate faster into the virtualization space. So those are a couple of 3 we've discussed a lot. There's more, obviously, and we're not going to get into laying out the entire roadmap. But we think those allow us to get bigger opportunities in different deployment models like virtualization and also get more than our fair share of the real fast-growing cybersecurity subsegment of the enterprise security market.

Operator

And your next question comes from the line of Phil Winslow representing Crédit Suisse.

Philip Winslow - Crédit Suisse AG, Research Division

Just wanted to focus in on your comments about improving attach rates and renewal rates of your subscription offerings, and particularly WildFire. Just what are you hearing from customers as far as the sort of the ability to adopt more subscriptions from you all? And in particular, WildFire, what are you hearing from customers about why they're choosing WildFire versus some of the other offerings that are on the market?

Mark D. McLaughlin

Sure. So from an attach rate on subscription services, they continue to go up for us, which is great, as we've expected they would. And as a reminder, the reason for that is that these subscription services are generally taking the place of what a customer used to have to buy from a standalone product. So this is best-of-breed functionality in a highly integrated, highly automated fashion at a much lower cost than what they would have to get by buying a standalone product. On the WildFire side, that's a very fast grower for us. And the reason for that is, it's just solving a real important problem for customers right now in this whole advanced persistent threat space. And the reason they're going with WildFire is primarily 3 things. The first is, is that because we are the firewall in most customers' cases already, not only can we do advanced detection capabilities, but we can also do prevention. Because ultimately, you have to be the firewall in order to do that. The second thing is from a deployment standpoint, we're doing this primarily in the cloud. So there is -- it's got infinite compute capacities. And it's wicked fast as a result of that. As an aside, we also have a private cloud solution with our WF 500 series. And the third reason is, you get the network impact because we do it in the cloud. And we have thousands of customers in all verticals in every geography, we're able to share in a highly leveraged basis what we're seeing across the customer base. So you don't have to be attacked yourself in order to see something from an attack perspective. You're getting the benefit of what we're seeing across the entire customer base that's using WildFire today. So those are really driving the adoption.

Operator

And your next question comes from the line of Catharine Trebnick representing Northland Securities.

Catharine Anne Trebnick - Northland Capital Markets, Research Division

Quick question is on WildFire. You have 2 solutions, the cloud-based solution and then the appliance. Is there any pushback from your clients at all regarding security in the cloud and not wanting security in the cloud? And could you pretty much give us more color around that, if that's the case or not the case?

Mark D. McLaughlin

Catharine, yes, so primarily, what we have been providing to customers, which they like, is cloud-based. And the reason for that is, it's easy. It's very fast. You get the leverage of the network and the sharing that goes on with that. However, there's a subset of customers that can't or won't, for various reasons, send files to the cloud. And because of that subset of the customer base, we developed the WF 500, which in essence, allows you to create a private cloud solution. So if you have those concerns, you can still have all the power of this technology without worrying about the public cloud aspect of it.

Catharine Anne Trebnick - Northland Capital Markets, Research Division

Are you -- also, in some of your customers, you also share, FireEye's also a customer, can you talk a little bit about how the difference is between your solution and maybe perhaps their pure play?

Mark D. McLaughlin

Yes, what I was just mentioning a little while ago, which was, first of all, you've got to start with the ability to do highly integrated and automated detection and prevention. And as the firewall, we can do both of those, not just the detection capabilities. We have the cloud aspect, which allows for a very fast ability to process files and get answers back. And then we're highly leveraged because we use the network. So that all the customers can get the benefit of what other customers are seeing. So generally, those are the high-level architectural differences that allow us to put these kind of growth rates up.

Operator

And your next question comes from the line of Brent Thill representing UBS.

Brent Thill - UBS Investment Bank, Research Division

Steffan, on your comment on linearity improvement, I'm curious if you could just give us a little more color, typically Q1, you wouldn't think you would see that. What do you think caused that linearity improvement in Q1?

Steffan C. Tomlinson

There are a couple of factors, Brent. When you think about the sales mechanisms we put in place around large account selling, we saw some nice traction from some of our larger customers in the first half of the quarter. So that was one thing. And then we have the other part of our sales engine, which is keep-the-lights-on business. And we have a very robust, high-touch and direct fulfillment model with our channel partners helping. So we had a very nice quarter from a linearity standpoint. It helped drive DSOs down nicely quarter-over-quarter. So we felt really good about the quarter.

Brent Thill - UBS Investment Bank, Research Division

Okay, and can you just comment on the impact of the federal market?

Mark D. McLaughlin

Yes, so we were pleased with the fed business in the first quarter. We saw the end of the year fed spend -- I mean, their end of the year. As we expected we would, despite all the sequestration anxiety. And just I think that's primarily the continued validation of our solution for a very discerning customer base. We like that vertical a lot. And given what their needs are, and what we do for a living, we think that, that will continue to grow nicely for us.

Brent Thill - UBS Investment Bank, Research Division

Okay. So that, in your perspective, exceeded your expectation or met or was below? How would you characterize that business?

Mark D. McLaughlin

In the first quarter, our expectations were met as we expected with the end of the year flush.

Operator

And your next question comes from the line of Michael Turits representing Raymond James.

Michael Turits - Raymond James & Associates, Inc., Research Division

I'm Michael Turits. One question on APAC, which was up strong year-over-year. Any impact from the NSA/political issues in China? And how much China exposure do you have? So could this be an issue going forward?

Mark D. McLaughlin

Yes, Michael. Not that we can tell. So I understood from Cisco's reports that they were seeing -- had some anxiety around that. At a big picture for us, our emerging market opportunities grew very, very well in the quarter, on a sequential and year-over-year basis. So we haven't seen any of that kind of impact. We have a smaller base of business than those guys do, but it performed very well for us.

Michael Turits - Raymond James & Associates, Inc., Research Division

Okay. And then kind of a high-level question about the security market. Obviously, you did well overall, and you did well with WildFire. Some people question what the impact is of APTs on budgets, on security budgets? In other words, is there any -- and taking oxygen out the room relative to next-gen firewall with APT or do you view this -- especially, since it's not a pre-budgeted line item, or is this something which is therefore, expanding what you think the IT security budgets are like in the next 12 months?

Mark D. McLaughlin

I think it's a good thing for us. The way we think about this is, is that we have -- we have a platform, right? And that years ago was considered just primarily a next-gen firewall, but it's really a platform that has multiple solutions that are highly integrated from the firewall and IPS and filtering and others. And when additional security needs need to be met, we have a unique ability to add services into that platform. So that platform, I think, is really in a mainstream adoption phase of getting taken in by Global 2000, Fortune 100 and companies across the globe. And that's just starting, of displacing all that legacy firewall plus the disparate other pieces of technology. In addition to that, we've got something that's popped up in a relatively recent term on the APT or cybersecurity threats. And that for us is a feature set of our platform. So we get to wrap that in there as well. And the next thing that's coming after that, whatever that may be, we have the ability with our platform architecture to bring that to bear as well. So we've got the mainstream adoption of our core platform plus another accelerator called APT, which is a feature of us on that platform, so we think it's an additive opportunity.

Operator

And your next question comes from the line of Jayson Noland representing Robert W. Baird.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

First for Steffan, we didn't really see seasonality in F Q1, Steffan, should we think about the rest of the year as F Q3 soft relative to a more positive F Q2 and F Q4?

Steffan C. Tomlinson

That's a good question. We've highlighted this in the past where our growth rates are -- have been so robust, it's hard to call the ball in seasonality. So what we originally thought was, our fiscal Q2 and Q4 may be strongest in terms of year-over-year and sequential growth rates. Q1, obviously, we saw no seasonality, which was a good thing. So what does that portend for the rest of the fiscal year? I would still say that, we would think that Q2 and Q4 would be very good quarters for us. We think Q3 would be, too. But if there's any historical pattern that's shaping up last fiscal Q3 more from a macro standpoint had hurt us. In that quarter, we were still able to grow 50% year-over-year. So we -- it's still too soon to call the ball on seasonality, but we feel good about the prospects of growth for the rest of the fiscal year.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then just a follow-up from me on U.S. fed gov, was the growth there a specific deal or broad-based? And Mark, can you continue to grow in this vertical given the challenges that likely remain?

Mark D. McLaughlin

Yes, Jayson. No, it's broad-based. The fed's a unique vertical in that it takes a long time to get yourself established in there, but when you do, it really starts to pay off for you. So I think this is a specific example of the focus we put into the major account program that we've been running for a while. This is a very, like I said, discerning customer, but once they start to adopt your technology, they can start -- they do that in a broad basis, and we're seeing that happen. So it's across-the-board. It's good growth in that vertical. And we think that could continue in time. Of course, we're keeping our eye on the ball, like everybody else, about sequestration and all the budget swirl that's going in Washington, D.C. That's not a helpful thing for anybody, ourselves included. And obviously, as we go into Q2, you don't have the end of the year fed flush that you have in our Q1. But that's all baked into our guidance.

Operator

And your next question comes from the line of Gray Powell representing Wells Fargo.

Gray Powell - Wells Fargo Securities, LLC, Research Division

So I think you touched on this earlier. But I guess I'll ask it again. So I mean, network security spending has been somewhat constrained in the last couple of years. How do you feel about the potential for improved refresh cycle for the industry as a whole? And then do you think that provides you a better opportunity to displace incumbents and take share?

Mark D. McLaughlin

Yes, Gray. Yes, a couple of thoughts on it. The first is that the addressable market opportunity we're playing in is $13 billion going to $16 billion, $17 billion in the next 3 or 4 years. Lots of studies out there suggest that, that grows anywhere on a 5% to 7% CAGR. So just from a greenfield opportunity or new opportunity, 5% to 7%, not a huge growth rate, but it's on a really big number, right? So that's hundreds and hundreds of millions of dollars that gets created every year. And we think we do very well there. More importantly than that though is the installed base that you just mentioned and the refresh opportunities that come with that, that are measured in billions of dollars of addressable market opportunity. And we can see just in the displacement of the competitors across-the-board, it doesn't matter who it is, we displace them at very high rates, that we continue to win these refresh opportunities. You've heard from -- like I said a little earlier, it's hard to be mathematically exact in this, but a number of sources of the refresh that comes up every 3 or 4 years, really big ones. And then we think we're at the beginning of one of those.

Gray Powell - Wells Fargo Securities, LLC, Research Division

Got it. Okay, that's helpful. And then just one more, if I may. Can you help us think about the opportunity with WildFire longer term, do you see that subscription being as meaningful as some of the other early ones like IPS? And then just -- I don't know, like sort of in life to date, how would you benchmark it versus some of the other subscriptions?

Mark D. McLaughlin

Yes, so the one that is probably closest akin to just from the way it might be thought of in the market is the threat prevention. So I'd expect over time that we could achieve rates in that zip code, which is pretty high. And then from just a growth perspective, it's been growing at the rates that we saw some of the earlier subscription services grow at over time. It takes time to get them going. The customers have to adopt 5.0. That's why I think it was Greg who asked before, what the percentage of the customer base is on 5.0? Right now, that's a bit over 60% and growing every quarter. So that's good just for our installed base. Yes, so there's a number of moving parts around that, that would lead that to grow over time, but we have very high hopes for that.

Operator

And your next question comes from the line of Scott Zeller representing Needham & Company.

Robert Scott Zeller - Needham & Company, LLC, Research Division

I wanted to ask over the -- just as a trend anecdotally over the last few quarters, how have the deals in the pipeline shaped up as far as breadth of service, point solution versus broad deployment of firewall? Can you give us some anecdotal color please?

Mark D. McLaughlin

Yes, a couple angles on that, Scott. First is, recently, we had said that over 75% of the deals that are coming through the pipeline for us that we're winning, we're the primary firewall in those deals, a bit over 60%. This is the number that we gave a couple of quarters ago. But over 60% of the installed base is we're the primary firewall. So those continue to rise. I said, we take that as one angle on the question. And then the second thing is, our attach rates continue to rise as well, meaning every time they get a product in there, we continue over time to attach more and more services to it. So the combination of those 2 things bodes well for us.

Steffan C. Tomlinson

One follow-on point to that. It really goes to the versatility of our platform. We can sell into any enterprise network in a security need that exists. It could be for firewall. It could be for IDS/IPS, filtering, you go down the list. And the platform approach that we have really gives us a unique position against all the other vendors that are out there.

Robert Scott Zeller - Needham & Company, LLC, Research Division

Just a follow-up, is that 75% -- we've heard that previously, has that been a consistent number?

Mark D. McLaughlin

Yes, we said we're going to update that. It's on a semiannual basis. That was the last time we gave that number. That's what it was. And that's up from the last time we talked about that.

Operator

And your next question comes from the line of Hendi Susanto representing Gabelli & Company.

Hendi Susanto - Gabelli & Company, Inc.

I have one question for Steffan. Management is targeting exiting the fourth quarter with operating margin in the low double-digit. Considering the current investment, how should we expect the timing of margin expansion and operating leverage in the current fiscal year?

Steffan C. Tomlinson

Well, we think that exiting Q4, we'll be in the low double-digit operating margin on an exit rate basis. And given the size of the market that we're going after, our -- if you look at our revenue growth, our customer additions, if you look at the power of our hybrid SaaS model, we've always said that we want to have more of a slow and steady approach to operating margin expansion throughout the fiscal year and towards our overall long term target model. So we feel like there's going to be room for incremental investment, but we're doing it in a disciplined way where we're generating positive operating margin right now. You look at positive cash flow and free cash flow generation. So the model is working. And when you combine all that together, exiting Q4, we feel pretty comfortable that we'll be in the low double-digit operating margin.

Operator

And your next question comes from the line of Shebly Seyrafi representing FBN Securities.

Shebly Seyrafi - FBN Securities, Inc., Research Division

So your product gross margin has increased for about 3 quarters in a row. And it's 76.6% non-GAAP. And your total gross margin is 75%, above your previous long-term target of 70% to 73%. So I'm just wondering with this 120-gig product coming out next year, should we think about the product gross margins staying at this level or potentially even increasing? Or do you think that it's above where you think it should be longer term?

Steffan C. Tomlinson

There are a couple of parts to that question. The first is, remember any time we introduce a new product, we typically see a little bit of pressure on the product gross margin line because we haven't achieved full scale and volume in that product line. So depending on the early level of traction, there's usually a little bit of a negative fluctuation for new platforms that we introduce. To your broader point, we have a target gross margin range of 70% to 73% total. We've been operating above that, which is great. It goes to the -- how we're operating our business in terms of the disciplined approach. Once we get to our target model of 22% to 25% non-GAAP operating margin, we're going to look at all the elements of that target model, including the gross margin. And we'll revisit at that point. But in the interim, we think there's going to be some fluctuation. We're still making investments in our services organization as an example, so you're going to see fluctuations there. But directionally over time, we feel good about the targets, and we'll revisit once we get to the target operating margin.

Shebly Seyrafi - FBN Securities, Inc., Research Division

Okay. And your IP litigation expense ticked up again, the $1.9 million as you're past the Markman hearing, et cetera. Where do you see that going over the next few quarters?

Steffan C. Tomlinson

Unfortunately, we see it going up as we get closer to the trial. We will definitely see increases in IP litigation expenses. We're not calling the ball specifically on the specific dollar amount. But in order to provide full transparency, we are -- we'll break it out every quarter, both on the call and in the supplemental documents that we post on our IR website.

Operator

And your next question comes from the line of Tal Liani representing Bank of America Merrill Lynch.

Eric A. Ghernati - BofA Merrill Lynch, Research Division

This is Eric Ghernati for Tal. Just on the refresh cycle opportunity that you have ahead of you in the next 12 to 15 months. Is the service provider included in that? And if so, can you just give us a sense of what you're seeing there from a customer interest in your upcoming platform? And how soon you can convert that into this meaningful revenue from the time you introduce the product?

Mark D. McLaughlin

Yes, so on the refresh that's specifically just, call it, the standard enterprise, meaning this is a firewall that's used in a standard enterprise environment. That's where the majority of the money sits today. And that's what I meant from a refresh cycle perspective. In the service provider market, as we mentioned before, other than working with the service providers and systems integrators and also the distribution channel, we've had decent penetration with them from a technology perspective in selling our technology to them, meaning they're an enterprise using our technology to protect their own environment. And also an increasing opportunity where they're using our technology to provide a service to their customers, specifically enterprise customers. So we think the 120-gig chassis that we're coming out with is really going to go to that last one I mentioned, which is, the ability to use our technology to provide services to their customers as a service. And that's a new portion of the TAM for us, as far as serviceability. And we expect good things from that over the future.

Eric A. Ghernati - BofA Merrill Lynch, Research Division

And then just on your EMEA business. Basically if the math is correct, have been kind of within a tight range the last 3 quarters. Certainly, up this quarter, albeit off of a easier comp? Just give a sense on what you think is needed there aside from a good macro, of course, to drive the growth rate a little faster in that region?

Mark D. McLaughlin

What's needed is a good macro environment. Unfortunately, that's the answer. I mean, we're doing very well on a relative basis competitively in the market. But in the absence of, I'll call it, a more normalized selling situation, the macro environment, it's tough sledding for everybody.

Operator

We are taking our final question from Erik Suppiger representing JMP Securities.

Erik Suppiger - JMP Securities LLC, Research Division

First off, the 20% attach rate you said for WildFire. I think you said that it was consistent with that last quarter. Where do you think that attach rate could go? And can you also comment as to how much of that is going into your existing customers versus how much is going into new deployments?

Mark D. McLaughlin

Erik, yes, a couple of things, it's over 20% in the first quarter is what I just mentioned. And as I mentioned a little while back in a different question, we think that the attach rates can approach the ones that we have today for like threat prevention, particularly in filtering. So much higher than they are today. So we have a lot of hope for that as a driver for us and a tailwind for us in the future.

Erik Suppiger - JMP Securities LLC, Research Division

In new customers versus existing?

Mark D. McLaughlin

Yes, on that, we don't break that out specifically, but we're doing well on both places. So we've got about 2,400 total customers on WildFire today. That's up from over 2,000 last quarter. So we're growing the total customers well. And the paid customers are close to 1,000 -- close to 1,000, which is up nicely from last quarter as well. So the more that we continue to grow the free customer base, the more opportunity we have to penetrate that base. And we are doing that. The other thing is just given all the concern about advanced persistent threat in cybersecurity today, we find that WildFire is also a great appointment getter for us just from a prospective on getting into accounts in the first place, and then being able to sell them the full solution, not just that feature set about APT.

Erik Suppiger - JMP Securities LLC, Research Division

Okay. And then last one, on the WildFire 500, do you think that can become a meaningful revenue stream? Or do you think that's still going to stay a minority kind of customer base that's just looking to not use the cloud?

Mark D. McLaughlin

It was designed and it's continued to be designed to solve the needs of customers who don't want to send or can't send files up to the public cloud. So I think that's a -- it is a minority segment of the customer base. So our main driver for WildFire is not going to be WildFire 500. But of course, we want to make sure we have total market coverage for anybody who wants a private cloud solution as well.

Operator

At this time, we have run out of time for Q&A. I will now hand the call back over to Mark McLaughlin for any closing remarks.

Mark D. McLaughlin

Great. Thanks again for being on the call today. I want to reiterate my appreciation for the hard work of the Palo Alto Networks team in support of all of our customers and partners as we continue to define the next-generation of enterprise security. And we look forward to updating you next quarter. Thanks, everybody.

Operator

Ladies and gentlemen, that concludes the presentation for today's conference. You may now all disconnect and have a wonderful day.

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