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Palo Alto Networks, Inc. (NYSE:PANW)

F2Q 2014 Results Earnings Conference Call

February 24, 2014 08:00 AM ET

Executives

Kelsey Turcotte – VP, IR

Mark McLaughlin – Chairman, President & CEO

Steffan Tomlinson – CFO

Analysts

Phil Winslow – Credit Suisse

Gray Powell – Wells Fargo Securities

Rob Owens – Pacific Crest Securities

Keith Weiss - Morgan Stanley

Greg Dunham – Goldman Sachs

Jayson Noland – Robert W. Baird

Walter Pritchard – Citigroup

Brent Thill – UBS

Jonathan Ho – William Blair

Scott Zeller – Needham & Company

Karl Keirstead - Deutsche Bank

Operator

Welcome to the second quarter 2014 Palo Alto Networks' financial results earnings conference call. My name is Shiquana and I will be your coordinator for today. (Operator Instructions) I would now like to turn the presentation over to your host for today's call, Ms. Kelsey Turcotte. Please proceed, ma'am.

Kelsey Turcotte

Good morning and thank you for joining us on today's conference call to discuss Palo Alto Networks' fiscal second 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.

This morning, Palo Alto Networks issued a press release announcing the results for its fiscal second quarter ended January 31, 2014. If you would like a copy of the release, you can access it online at the Company's website. 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 our revenue and earnings per share guidance for our fiscal third quarter, accelerating growth for all of our subscription services, product demand and adoption, strength of our sales pipeline, our litigation with Juniper and our competitive position.

These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially from 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 quarterly report on Form 10-Q filed with the SEC on December 5, 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 invite institutional investors and sell-side analysts to join an investor track at Palo Alto Networks' Ignite user conference at the Cosmopolitan in Las Vegas. Our program will run from noon on Monday, March 31st through 1 P.M. on Tuesday, April 1st. To register, please go to investors.paloaltonetworks.com and click on the registration link. Any questions, please call us at 408-753-3872.

And with that, I'd like to introduce Mark.

Mark McLaughlin

Thank you, Kelsey. Thank you everyone for joining us this morning. Given that it's the start of the RSA Conference, we want to ensure that everyone has time to make the event, so we appreciate you joining us pre-market this morning. I'm pleased to report that we had a very good second quarter. Strong customer demand for our integrated and automated enterprise security platform drove Q2 results that exceeded our guidance.

Revenue grew by 46% year-over-year to a record $141 million and billings grew 50% year-over-year to approximately $187 million both driven by strong profit demand, continued acceleration of our fast growing subscription services and expansion of our global direct and indirect distribution capabilities. Along with this strong top line growth, we delivered expanding operating margins in non-GAAP EPS of $0.10, as we continue to demonstrate our ability to scale the business quickly and profitably.

Security spending remains a top and growing priority for customers across organizations of all sizes and across all geographies. There's a growing understanding among security professionals, C-Suite executives and Boards that traditional security approaches limit their business agility and are not keeping up with the new wave of cyber threats. As a result, these legacy approaches and point products create unacceptable business and security risks.

With this in mind, enterprise customers globally are adopting our enterprise security platform, resulting in continued market share gains against the competition. We see this demonstrated in customer acquisitions, where we now have over 16,000 customers; continued growth in customer lifetime value; and increasingly strong subscription service adoption, as our customers take advantage of the power of our integrated and automated platform.

Examples of wins for us in last quarter include one of the world's largest oil and gas companies, where we implemented our full platform to protect their data center and SCADA systems in the Middle East; a global consumer goods company, where we replaced Cisco and beat Check Point for a full data center security refresh; and one of the largest cruise lines in the world, where we replaced Cisco in the data center and have been selected as the sole provider for network security on their ships.

Our expanding product portfolio, innovative approach to delivering subscription services and focus on Global 2000 accounts continue to increase our lifetime customer value. In Q2, a top 25 customer had to spend a minimum of $4.6 million with us in lifetime value to make the top 25 list. Our lifetime value measured by the increase from their initial purchase rose to 21.3x. This compares to $4.1 million and 19.6x last quarter.

Mainstream enterprise customers are facilitating this growth by repeat purchases and larger deal sizes, as we’re being adopted as the go-to technology in the battle for enterprise security. Not only are customers buying more devices but they are also increasingly unlocking the power of our platform with subscription services that often take the place of a competitor's device.

Enterprises are doing this because of the highly integrated and automated capabilities inherent in our platform that deliver superior security while reducing their operational burden. That's the winning formula for the future of enterprise security and is an accelerating growth for all of our subscription services.

The power of this integrated and automated platform is evident in success we are seeing with WildFire, which is our powerful subscription service for unique detection and prevention capabilities for increasingly sophisticated cyber threats. Over 1,400 customers are now on the paid version of WildFire, up from approximately 1,000 customers in Q1. In Q2, we saw a significant lift in the WildFire attach rate for paid subscriptions to over 30% of devices shipped up from 20% in Q1.

WildFire continues to act as a driver and differentiator for our enterprise security platform, attracting both new and existing customers. WildFire is also an example of the continued disruptive innovation that causes widening of the gap between our platform and the competition. To extend that leadership and security, we acquired Morta Security in December, bringing us a highly experienced team of experts in cyber security, as well as technology that will enhance our platform.

This past quarter, we continued to deliver on disruptive innovation with the release of the 6.0 version of our Palo Alto Networks Operating System and enhanced WildFire functionality, including protection for many more file types, zero-day exploit detection and access to our global database of compromised domains and infrastructure. Also, two weeks ago, we announced the availability of the PA-7050 chassis and we continue the beta testing for our virtualized offering that tightly integrates with VMware's NSX platform.

We are very pleased with this partnership and honored that VMware presented us with their Technology Partner of the Year Award ago two weeks ago at their partner conference. Early demand for the PA-7050 and for VM series appears to be strong and we look forward to reporting on adoption throughout the rest of the year.

In addition to the innovation engine, we are also scaling the capacity and productivity of our sale teams around the world while expanding our partner footprint with large-scale service providers, global systems integrators and direct manufacturing reps, all of whom are interested in helping their customers displace point products that are ill-equipped to address the threat landscape today. The combination of our highly differentiated offerings, strong pipeline and increasing global distribution capabilities sets us up well for the second half of our fiscal year and beyond, as we continue to demonstrate our leadership position in enterprise security.

Lastly, I wanted to touch base on the Juniper litigation. As many of you know, the trial starts today. We remain confident in our position in this case and are pleased with the judge's pre-trial decisions. The Palo Alto Networks' team look forward to seeing many of you at our booth at the RSA Conference in San Francisco this week. And as Kelsey mentioned, we invite you to participate in the special investor track at our Ignite user conference in Las Vegas at the end of March, where you will see our technology firsthand and get a sense of the enthusiasm of our customers and partners.

And with that, I'll wrap it up and turn the call over to Steffan.

Steffan Tomlinson

Thank you, Mark. Before I get into the details of the Q2 results and Q3 guidance, I'd like to note that except for revenue figures that are GAAP, all financial figures are non-GAAP unless stated otherwise. A reconciliation between GAAP and non-GAAP results can be found in our press release and on our investor relations website.

Growth in the quarter was driven by new customer acquisition and continued expansion within our existing customer base, where we continue to sell our suite of products and recurring services, including our subscription services. Structurally, our business model continues to benefit from higher attach rates of our SaaS-based subscriptions. Every time we sell or renew a subscription, its equivalent to selling a product except that we have chosen a SaaS model to deliver and monetize it. Increases in subscription revenue as a percentage of total revenue will improve our gross margins, as well as increase visibility into future revenue streams.

All of these factors, new customer acquisitions, success in our land and expand strategy and continuing momentum in our subscription services were catalyst for record billings, revenue, deferred revenue and free cash flow. Q2 total revenue grew 46% over the prior year and 10% sequentially to another record of $141.1 million. The geographic mix of revenue was 64% Americas, 24% EMEA and 12% APAC. Compared to the prior year, the Americas grew 51%, EMEA grew 37% and APAC grew 42%. We saw broad strength across a wide range of verticals. We do not have any end customer concentration.

Product, subscription and support, the three components of our hybrid SaaS model all grew well in the quarter. Product revenue of $80.8 million increased 30% over the prior year and 7% sequentially. We saw nice adoption across a number of our different appliance families in the quarter. Our recurring services revenue of $60.2 million increased 74% over the prior year and 14% sequentially and accounted for a 43% share of total revenue. Looking at its two components, our SaaS-based subscription revenue of $28.8 million increased 76% over the prior year and approximately 16% sequentially.

Growth was driven by a higher attach rate for our subscription services, in particular WildFire. On a year-over-year basis, we expect that subscription revenue will continue to grow at a faster pace than product revenue. Support and maintenance revenue of $31.4 million increased 73% over the prior year and 13% sequentially. Compared to the prior year, billings in Q2 grew 50% to $186.7 million. Total deferred revenue increased 72% to $324.6 million. Short-term deferred revenue increased 72% to $202.3 million.

Total gross margin was 75.3%, an increase of 30 basis points sequentially. Product gross margin was 75.5%, an increase of 210 basis points year-over-year and a decrease of 110 basis points sequentially. The sequential decline was due in part to product mix. 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 was 75.2% increasing 240 basis points sequentially due in part to increased contribution from subscription services.

Moving on to operating expenses, research and development expense was 12.6% of revenue, increasing approximately $1.3 million sequentially to $17.8 million. Headcount additions and project-related expenses, supporting our development activities, contributed to the increase. Sales and marketing expense was 46.6% of revenue, increasing approximately $5.5 million sequentially to $65.8 million. New headcount additions, commissions and the expenses in marketing contributed to the increase.

General and administrative expense was 7.1% of revenue, increasing approximately $0.1 million to $9.9 million. As a reminder, this does not include our IP litigation expense, which was $2.7 million in Q2 2014. Total headcount at the end of the quarter was 1,375, up from 1,264 at the end of Q1 2014. In total, operating expenses were $93.6 million or 66.3% of revenue.

Operating margin increased approximately 180 basis points year-over-year to 9% and increased 150 basis points sequentially. Our effective tax rate for Q2 was 38%. Net income for the quarter was approximately $7.8 million or $0.10 per diluted share using 78.2 million shares, compared with net income of $4.1 million or $0.05 per diluted share in Q2 2013.

On a GAAP basis, net loss was $39.9 million for the quarter or $0.55 per basic and diluted share compared to a Q2 2013 GAAP net loss of $2.6 million or $0.04 per basic and diluted share. Our GAAP net loss as well as our cash flow from operations and free cash flow reflect a $20 million payment we made in the second quarter to extend an existing mutual covenant not to suit with Fortinet for six more years.

Turning to the balance sheet, we finished January with cash, cash equivalents and investments of $501.3 million, including the impact of our acquisition of Morta. Cash flow from operations, free cash flow and free cash flow margin were $41.4 million, $31.6 million and 22.4% respectively. Capital expenditures in the quarter totaled $9.8 million and were primarily related to facilities purchases. The accounts receivable balance was $86.1 million down from the prior quarter balance of $91.4 million. Linearity in the quarter improved which helped improve average day sales outstanding to 57 days down from 63 days last quarter.

Let me now move to our guidance and as a reminder, guidance excludes IP litigation expenses. In Q3 2014, we expect revenue to be in the range of $143 million to $147 million, which represents a 41% to 45% growth year-over-year and we expect non-GAAP EPS to be approximately $0.10 to $0.11 per share using 79 million to 81 million shares.

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

Questions-and-Answer Session

Operator

(Operator Instructions) As a reminder, please limit your question to one question and one follow up. Your first comes from the line of Phil Winslow representing Credit Suisse. Please proceed.

Phil Winslow – Credit Suisse.

Hi, guys. Congrats on a great quarter. One of the things that really jumped out at me was your comments on WildFire. I wonder if you could provide more detail there and then also, you know, maybe just an update of how you think it's positioned out there versus the competition. Thanks.

Mark McLaughlin

Thank, Phil. Good morning. Yes, so we had a very nice quarter again on the WildFire. As you can see, we've added over 400 paying customers so we've got about 1400 paying customers over 3,000 total customers using WildFire. And I think what's going on there is that customers are continuing – the existing customers and new logo customers are continuing to see the value of having a very, very sophisticated detection and prevention, which is critically important capability in a platform that they already own with their existing customer or the opportunity to have it very simply from the subscription service model, if they're a new customer. And when you look at not only just the capabilities of WildFire but then also the total cost of ownership, you know, of that very advanced platform versus what's out there competitively. It's a big difference, right? So I think people are voting with their pocket books and saying, “We'll go for very advanced, very sophisticated detection,” and prevention critically important and in addition to that we get it with the platform if you're an existing customer you already owned and with a TCO that's a big difference just like all of our subscription services are and so we're very happy with the adoption we're seeing.

Phil Winslow – Credit Suisse.

Got it and then just a follow on to that. Obviously, you're seeing a better attach of more subscriptions, you know, call it per appliance but wondering if you could give us some comments on renewal rates that you're saying across the subscriptions? Thanks.

Steffan Tomlinson

Renewal rates continue to remain very high. They're in line with what we disclosed in the past. On support in particular, it's close to 100%. For subscriptions, it's trending north of 85% so we feel very comfortable about the recurring nature of our business model.

Phil Winslow – Credit Suisse.

Great. Thanks, guys, and congrats again.

Steffan Tomlinson

Thank, Phil.

Operator

Your next question comes from the line of Gray Powell representing Wells Fargo. Please proceed.

Gray Powell – Wells Fargo Securities

Good morning. Thanks for taking the questions. So maybe just kind of following up on the WildFire theme. Over the last few months you've had a few developments on the APT side with the acquisition of Morta and the partnership with Bromium. How do you see your APT capabilities expanding and do you see the potential to more closely tie WildFire with an end point solution or offer incident response type services at some point?

Mark McLaughlin

Yes, sure, and Gray, it's Mark. Just generally on WildFire we continue to improve WildFire pretty much every quarter to make it market leading so we put out a big release with our PAN 6.0 Operating System recently at the same time some improvements in WildFire, which I mentioned in the script about covering more file types, giving some access into corrupted domains, things that customers really wanted to see with that so we think that, you know, doing that adds continued value and we're going to keep doing that.

We bought a small Company called Morta Security in December. This is a team of really sophisticated folks who are from the NSA US Air Force kind of background, who have been involved on playing offense, you know, at cyber security and because of that, we are developing some really interesting technologies that are looking at like subtle lateral movements sort of things from a malware perspective so you'll see that materialize in the next versions of WildFire and obvious [inaudible] continue to keep that service as market leading around that.

On your end point question, you know, we've talked with lots of customers for a while and about is there a value proposition of I'll call it connecting the network to endpoints from a security perspective under the belief or growing belief probably that endpoints are considered part of the network more and more just because of [inaudible] mobility and [inaudible] it’s pretty positive.

So they test that out in the market. We’ve done a number of integrations. You’ve mentioned Bromnium. We’ve done Bit9, Symantec, so with some folks in the market where we connect WildFire in the endpoints and then, you know, see if that's providing value - the customer feedback and that has been pretty positive so we expect to do more of that kind of work in the future.

And then your last question on incident responses, we're not going to be in the response business, I don't see us doing that and the reason for that is we just philosophically believe that incident response is kind of a necessity because of the technology is not stopping things in the first place. You have to have [business in response] [ph] to human – you know a very, very capital intensive human remediation effort and we think our job is the technology provider of detection and prevention is to reduce the need for that over time, we think that's exactly what's going to happen as we continue to advance the platform.

Gray Powell – Wells Fargo Securities

Understood. Okay. That's very helpful. Congratulations.

Mark McLaughlin

Thanks, Greg.

Operator

Your next question comes from the line of Rob Owens representing Pacific Crest Securities. Please proceed.

Rob Owens – Pacific Crest Securities

When you talk about the higher attach rate of subscription services just wondering if you could give us some color in terms of which services you're contributing the most revenue at this point and obviously you're seeing great growth with WildFire but just curious on the others.

Steffan Tomlinson

Well we have threat prevention and URL filtering, which both have been very nice sellers for us and our threat prevention is for IDS/IPS, URL filtering is for filtering obviously. Those two continue to be work horses for us. They’re big competitive differentiators in the market and then of course WildFire, which has really posted very significant growth sequentially and year-over-year. And then lastly we have GlobalProtect which with the advances that we're making, the innovations we're making in our global protect solutions we're seeing an uptake from customers.

So this quarter really marked a very strong quarter for us from a overall subscription attach rate. All four subscriptions increased in the quarter sequentially with WildFire albeit growing off a smaller base grew the fastest so we’re very pleased with that. And you know as we’ve talked about before, every time we sell a subscription service it's the equivalent of selling a product but we’ve decided to monetize in a SaaS way.

Rob Owens – Pacific Crest Securities

Okay, great and then you mentioned the new customer acquisition helping drive results. Just wondering any change in terms of who you're displacing or the rate at which you're displacing them?

Mark McLaughlin

Hey, Rob. We continue to do well against all [competitors] [ph] competitively at the highest level where our main competition will be enterprise firewall vendors such as Check Point, Juniper and Cisco and our win rates continue to be very healthy against anybody regardless who the competition is.

Operator

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

Keith Weiss – Morgan Stanley

Thank you guys and thank you for taking the question. I wanted to dig into the announcement you guys made with VMware and also getting the Partner of the Year Award with VMware, because we've been hearing a lot more about you guys going to market together and hearing a lot more evidence of garnering success in there, so maybe you could sort of mark-to-market for us what you guys have been doing thus far with VMware; where there's new integration where you think that’s going to be able to take you guys?

Mark McLaughlin

Yes, sure Keith. We're excited about this so as we've described in the past the highest level of what's going on is our data center [inaudible] changing fairly rapidly both from a throughput perspective and also virtualization.

So, if you think about just a data center use case for next-generation security you've got north/south traffic going in there and those throughput rates continue to grow. That's one of the primary reasons we introduced the 7050 and it’s been a big use case for that.

On east/west, which is a use case that's becoming more and more important to folks because as malware and malicious activity find its way into a network it's trying to get into the data center because that's where the crown jewels are and the idea of moving around inside the data center is more of a concern for folks than it used to be so you want to have the same kind of next-generation security capabilities in the data center there, because that's becoming a highly, highly virtualized environment – all that has to be virtualized. So working with VMware over the last year at their request, taking our virtualized technology, everything we have physically is also been available for virtual context.

What we've done is we've integrated that with their new platform NSX and what that's going to mean is that VMware customers adopt the NSX platform if they would like to have the best and most advanced next-generation security of highly virtual environment in the data center, they’re going to be able to purchase at the same time something called the Palo Alto Networks [addition] [ph] for NSX, which is our virtualized capabilities but really integrated at the orchestration layer so that when you're, say, provisioning or deprovisioning virtual machines inside that data center, security is just going to automatically follow up so this is not to throw the SDN word around but sort of SDN-ish nature about you don't have to do anything now that you used to have to do from a security perspective. Your policies are just going to automatically follow along with those virtual machines. That's important mostly for security and then also for ease-of-use and that reduces the selling objection for VMware when they're trying to get people to adopt, you know, NSX when they say, “Well, what about security? What about this new wave of threats inside data centers and virtualized environments? What are you going to doing about that?” This gives the answer to their customers to say, “We have the best next-generation technology very tightly integrated [across] [ph] networks.”

And last thing – and I know I'm going on for a minute – is from an availability perspective, this –and addition for NSX is available in just a few weeks time. From a go-to-market perspective with VMware, their salesforce and partner base will be able to and start to sell this in late spring or early summer so that's when we expect to see adoption begin is when VMware's – the power of their sales machine and partner community falls in behind us. So sorry for the long answer but that's it.

Keith Weiss – Morgan Stanley

I love the long answer. If I could perhaps sneak one last one in. Just on the new 7050 appliance that you guys rolled out. Could you give us some early indications, where are you seeing the early adopters, the early demand there and how broadly do you think this will open up data center opportunities for you? Does it get you into some incremental service provider business as well?

Mark McLaughlin

Yes, so we think that demand there is coming from what I just said which is the data center use case just because of increasing throughput requirements and we have evidence of that from our 5060 so our 5050 series is selling very well into that use case and the assumption there from customers telling us was, “Well, if you like the 5060 you'll love the 7050, right, just because of – you know it's a bigger in chassis.”

So we expect that that's going to be true in that the data center requirements grow over time you know that's a fantastic answer for customers to grow in with others through the requirement. And in addition to that it gets us the ability to have the conversation from a new customer set or a news case for customer set, which is in the service provider market where in the absence of having 100 gig-plus chassis, you know, using our technology for sell-through into the SMB base is – was a short conversation just from a throughput requirement so this gets us the ability to start to have that conversation with us the service providers.

Keith Weiss – Morgan Stanley

Excellent. Great quarter guys.

Operator

(Operator Instructions) Your next question comes from the line of Greg Dunham representing Goldman Sachs. Please proceed.

Greg Dunham – Goldman Sachs

Mark, I guess first one for you. You mentioned last quarter, at least when you looked at the pipeline and when you’re talking together customers you saw anecdotes of perhaps a little bit higher refresh in 2014 and ‘15 than in previous years. Can you just give us an update on that?

And then a second one for Steffan. How should we expect the 7000 series or 7050 series to impact product gross margins going forward?

Mark McLaughlin

Yes, I’ll start, Greg. Yes on the refresh cycle comment, we heard anecdotally that's a possibility that there might be a larger refresh cycle coming than, you know, say, in the last couple years and that's based on a few data points.

One is conversations with our partner community. The second is with our major account focus it's our own guys who are now more and more the Fortune 100 Global 2000 accounts, having longer term road map conversations and more visibility in architecture and so the commentary around that was that might be possible. I mean it happens every number of years and it might be possibly a time, where we might see a larger refresh cycle. It's anecdotal. I think it's hard to say for sure one way or the other.

The way we look at it is if that is the case and we have seen the industry generally reporting decent numbers, you know, in the last quarter for – even our competitors that looks like, you know, they're doing better than you had in the past, so maybe another data point around that. But if that is the case with their out sized market share gains that's only beneficial for us if this were in fact there.

Steffan Tomlinson

Greg, on the product gross margin question as it relates to the 7050, with our chassis and one line card that's for very much in line with our standard product gross margins, as we add line cards to a chassis, the gross margin profile actually improves and it gets above our standard product gross margin targets internally. So the more fully built out each chassis we sell is, it will be a positive tail wind for product gross margins down the road.

Greg Dunham – Goldman Sachs

Great, thanks guys.

Operator

Your next question comes from the line of Jayson Noland representing Robert Baird. Please proceed.

Jayson Noland – Robert W. Baird

Steffan, I wanted to ask about international plans for expansion in calendar ‘14.

Steffan Tomlinson

Certainly. Our international – it's growing off a smaller base but we're posting very solid year-over-year growth rates in EMEA, APAC and the emerging Markets. When we look at productivity and the opportunity that's there, the resources required we're still dividing territories there. We're adding major account folks. Mark Anderson has done a very nice job in terms of building out an international presence from where we were so we're continue to invest in APAC and EMEA on – because we're seeing very strong returns there.

Jayson Noland – Robert W. Baird

And would you continue to push into emerging markets? There had been some challenges there, you know, more broadly and I assume that's still an area of opportunity for you but is that still full speed ahead or do you pause there?

Mark McLaughlin

No – it's Mark, Jason. Now, we’re going to be full speed ahead there. We've seen in the emerging markets, even though it's a small base for us outsized returns even greater than what we're seeing in the – and as you would expect in the established markets so we're not pausing on that and we expect that we continue to do very well in.

Jayson Noland – Robert W. Baird

Thanks guys.

Mark McLaughlin.

Thanks.

Operator

Your next question comes from the line Walter Pritchard representing Citi. Please proceed.

Walter Pritchard – Citigroup

Hi, thanks. Back in July, you had product revenue decelerate back into the lower 30s and you indicated that you expect it at the time it would reaccelerate. I’m wondering, any sort of guidance around product revenue? But should we expect product revenue growth to pick back up or should we expect it to accelerate down into the 20s?

Mark McLaughlin

Walter, it's Mark. So on the product growth side, we've got a pretty good product growth here 7% sequentially, 30-plus [ph], you know, close to 31% year-over-year and we would expect to be able to continue product growth rates at these numbers – north of these numbers, so that expectation would be set before and that's the plans we had.

I think just at a big picture level on this too, the way we think about this is we're trying to grow the total revenue base of the Company. Actually, there's a number of things that Steffan went through that are in the mix of that and ones you can see on the subscription services side grows extremely well and that's because customers buy those generally in lieu of buying products, right?

So we're very happy with very strong product growth of at 30% – close to 31% at the size and scale we have there. And then we're extremely happy with the subscription services revenue. When you look at it – we're running close to $120 million run rate SaaS business in this Company growing it close to 75% year-over-year and that's because people are choosing those in lieu of other people’s products. So it's the combination of those things that's the powerhouse here from model perspective and we're not going any further than billings deferred – all the things, wonderful things happening, from the model to see how powerful that is. But specifically in your question yeah, we have strong product growth at a very high run rate right now and scale and we expect that to continue.

Walter Pritchard – Citigroup

And then just, Mark, one follow-up on the subscription side. Some of your competitors and [inaudible] has more aggressively bundled subscription in the product sales. I know you bundle support in. Have you guys played with potentially bundling in subscription and trying to – obviously, growth has been great but trying to drive the growth potentially faster to more attach group to those types of tactics?

Mark McLaughlin

The approach that we've taken which was really based on market feedback early on was the first thing was to try to sell the subscription services as services instead of just bundling it into the product. That was obviously a good idea a number of years ago from a model perspective. And related to that was simplicity.

So when you look at the competitors and feedback that we've heard years ago from the customer base is it was very complicated pricing models, you know, pricing sheets go on for pages and pages and pages and we just took a different approach called this 20% of the list price of the device and people reacted very well to that because it's – one, it’s simple and the TCO is very, very obvious around that. You know we have for the subscription services.

Now in the future if we were to add additional services and our intent would be that we would do that, yeah, we'll think about how we price all those – when you start to add up some numbers or subscription services at, you know, a 20% of list pricing that might get you to think about why we would change it later on but right now the market was reacting very well to the way we've packaged this. So…

Walter Pritchard – Citigroup

Great, thanks.

Mark McLaughlin

Thanks, Walter.

Operator

Your next question comes from the line of Brent Thill representing UBS. Please proceed.

Brent Thill – UBS

Good morning. Steffan, in Q1 I think you mentioned it became a little less back end loaded with the DSO. This quarter DSO dropped again. I think it's the lowest you've seen in last six quarters. Can you just walk through the linearity and what you're seeing in the business and it feels like there's a bigger tail wind from some of these high profile bridges that perhaps are offsetting maybe some of the historical seasonality. Can you just comment on that?

Steffan Tomlinson

Certainly. On linearity in the quarter, remember our fiscal Q2 encompasses December, which has a calendar year and budget flush component of it and we definitely participated in that. So we had a very good month one and month two of the quarter where a lot of the sales came in November and December and so that definitely helped with linearity in the quarter and we came in with a tail wind as well, so DSOs did come down sequentially. You are very pleased with that. And when you look at, you know, the construct of calendar year and budget flush we really saw it across-the-board in nearly every vertical, which we were very pleased with, given the nature of the advanced persistent threat landscape out there and also just the struggles that many companies are going through trying to do a fork lift upgrade of existing legacy technology to our platform, its created a lot of disruption, a lot of opportunity for us. So those call it macro dynamics have played to our strength and that shows up in our billings and revenue and business momentum.

Brent Thill – UBS

And just a quick follow-up for Mark. I know you mentioned the 7050 will give you a nicer tail wind with the service providers but can you just give us a sense of where the current state of business is with some of the service providers that you're engaging with, you know, Periva 7050?

Mark McLaughlin

Yes, so the way we look at certifiers, Brent, is three opportunities. One is the most simple, which is service providers are enterprises so they are likely customers for our own technology to protect their own networks and we’ve actually – that's been our first penetration point with all the major service providers is just having them buy our technology to protect their own networks and that's a good business for us and continues to grow.

The second area we looked at is many of the large service providers run pretty good sized systems integration business and their systems integrators for large enterprises and often do outsourcing for networks and in that case having them resell our technology as part of those offerings is an area we focus on and we've actually done very well there with them as well.

The third area is service providers using our technology on a sell-through basis like as a service. Sell-through basis – we offer a security – usually into the lower end markets. That's an area where we haven't penetrated service providers yet intentionally just because of the technology requirements and some of the support requirements around that. We're very focused on the enterprise market as we continue to be right now because we're in enormous growth in the enterprise.

But the 7050 is a throughput device that allows us to begin the conversation with the service provider to say, “If we wanted to attack that third opportunity with you, now that we have the chassis can we do that?” And the answer to that has been, “Yes.” There are different requirements for different service providers you have to get to other than just throughput and we'll engage with those guys as we've started to on what those would look like and road map around this. But that's how we think about service providers is it's not just a one trick pony. There's multiple ways to interact with them.

Brent Thill – UBS

Thank you.

Mark McLaughlin

Thanks, Brent.

Operator

And your next question comes from the line of Jonathan Ho representing William Blair. Please proceed.

Jonathan Ho – William Blair

Hey, guys. Just wanted to understand a little bit better about sort of the EMEA region starting out. Are you seeing sort of improvements there or any impact to the macro environment and sort of your thoughts around the ability to continue improving the growth in that region?

Mark McLaughlin

Yes, hi Jonathan. It's Mark. So EMEA has been challenging for us and for others for quite some time, given all of the macro environment over there but it seems to be improving, you know, on a quarter-by-quarter basis from a sentiment perspective and then I think sentiment leads to spending as well.

So this last quarter, we’re very happy with what we saw from a selling perspective and revenue perspective and a selling perspective in EMEA. And, you know, for the first time for us, I'm not sure about other folks but every sub region in EMEA that we organize around did very well for first time in a long time, which was fantastic. We've been seeing you know, some regions do much better and some regions do less better like Southern Europe but even Southern Europe performed very well for us in this last quarter so we like EMEA. It's only about as we said before 23%, 24% of our revenue base so we have a lot of head room to get over there.

Jonathan Ho – William Blair

Got it and can you talk a little bit about sort of where your revenue coming from today relative to refresh of your existing customers versus competitive displacement and potentially at what point we start to see more of the lift from refreshing existing customer which is theoretically should be a bit easier?

Mark McLaughlin

Yes, we would expect that from a refresh perspective, given what Steffan said about extremely low churn and higher renewal rates for the Company that we would do well in refresh cycles. I think for us in refreshing, if you think about the history of the Company and size or magnitude of the revenue base of the Company and a refresh cycle generally being three to five years, call that, you know, 2010, 2011 is when the Company actually of any size from a revenue perspective that a refresh would matter one way or the other for us, so anything prior to that I think has been refreshed but it's small numbers off a small base. It's after that where the numbers get bigger and we would expect that we would do extremely well from a refresh perspective with our existing customers because all our indications, customer satisfaction reports, things we hear from the channel, things we heard from the customers are very, very high satisfaction rates with our technology. That's also obviously an opportunity for us to have a further conversation with a lot of customers about additional services that they may not be using when we have the chance to talk about refreshes. But as a general matter, you know, our growth has been and continues to come from displacing competitors when they're up for refresh so refresh for us is a positive thing whenever that's going to come upon us.

Jonathan Ho – William Blair

Great, thank you.

Operator

And we now have time for one audio question. The question will come from the line of Scott Zeller, Needham & Company. Please proceed

Scott Zeller – Needham & Company

Thanks. Steffan, could you just give us some color around your expectations for seasonality of the deferred again please, just review that?

Stefan Tomlinson

Well, seasonality in the business in general has been a little bit hard to call. We historically said that our fiscal Q2 and fiscal Q4 will set out to be a bit the strongest from a seasonality standpoint. Q3 is effectively calendar Q1 for many companies because we have call it February, March, April, and we've seen some – you know, if you’ve seasonality in Q3 last year, although we grew total revenue by 53% year-over-year. We saw a sequential decline in product, so when you get to the seasonality of deferred revenues heading into fiscal Q3, I would say you can follow normal seasonality patterns that we've seen in the past. We are guiding 41% to 45% year-over-year total revenue growth and deferred revenues and billings will usually follow the same seasonality patterns that we've seen in the past so I would look to our prior historicals for that.

Scott Zeller – Needham & Company

Thank you.

Operator

We do have time for one more audio question. It comes from the line of Karl Keirstead representing Deutsche Bank. Please proceed.

Karl Keirstead - Deutsche Bank

Well, great. Thanks for setting me and my question is to Mark. Mark, clearly, this APT or anti malware focus – this inside the firewall focus is probably going to be the topic here at RSA. And I just wanted to ask you a big picture question about how this changes your – the model this – the Palo Alto Networks salesforce and M&A focus this year, does it tilt you towards doing additional M&A besides the Morta deal you just did? Do you need to pivot the sales force focus a little bit? Any kind of model shifts as the customer focus on APT that ramps as much as it has it seems in the last few months.

Mark McLaughlin

Yes, Karl. Well big picture the answer would be no, so from an APT perspective as a threat that – a kind of threat that has been highly discussed and vocalized in the last year or two and I also expect this would be a big topic at RSA – it's very well from us because what we're selling is a platform – and the platform is able to address from a detection prevention standpoint APT.

The reason for that and the interesting thing about the platform architecture and hence some of the business model that flows from that is of the aspects of our platform, the people have been using for quite some time to combat threat, we're all native, you know, to the platform. We've chosen to monetize it from a service perspective but it's when they're operating together is that’s the real – at the juice, that’s the power. So we like the fact, for example, that wildfire is selling very well from a subscription perspective but it's the – it’s wildfire is part of that overall platform with all of the other technology now that's really delivering the value from an APT detection and prevention standpoint for customers.

So the reason I mentioned that is that our salesforce is very conversant on how to talk to the platform itself and what that could do from a security perspective. And now if you want to talk about the newest thing called APT, here is how that fits into that security landscape and the platform all do for you. So from a selling perspective, where the team has been able to discuss any subscription service in the concept of the platform for quite some time and has been doing that pretty successfully.

You know from an M&A perspective, we've said for awhile that we've got a very large addressable market opportunity here in enterprise network security of, you know, big kind of these numbers you look at $13 billion growing to $15 billion in the next few years and that the product we have today and the road map we have today organically allows us to address the vast majority, if not the entire total addressable market there but if we saw opportunities where we could accelerate the product road map by, you know, buying a small Company along the way, we would be interested and we demonstrated that with Morta, which brings us an acceleration of the road map on things related to wildfire and then also if there was team expansion opportunities outside of that were interesting over time but they were very close in from what we do for a living and we’d be interested in that as well.

So I think you're right. I think you'll hear a lot of APT at RSA. We like that since we have a fantastic answer and solution for that. The place – and it’s a much bigger picture answer from a platform perspective and everybody else who were –we're hopeful that you're correct on that and it gives us a chance to get more potential customers.

Karl Keirstead - Deutsche Bank

Got it. Thanks for the color, Mark.

Mark McLaughlin

Thanks, Karl.

Operator

I would now like to turn the call back over to Mr. Mark McLaughlin for closing remarks.

Mark McLaughlin

Okay. Thanks, operator, and thanks, everybody, for being on the call this morning. I also want to thank the entire Palo Alto Networks' team for all their hard work and support, and as well as customers and partners to help us continue to find the next generation of enterprise security. We appreciate your time this morning. Take care.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.

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