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Palo Alto Networks, Inc. (NYSE:PANW)

Q3 2014 Earnings Conference Call

May 28, 2014 4:30 PM ET

Executives

Kelsey Turcotte - VP, IR

Mark McLaughlin - Chairman, President and CEO

Steffan Tomlinson - CFO

Analysts

Keith Weiss - Morgan Stanley

Karl Keirstead - Deutsche Bank

Phil Winslow - Credit Suisse

Gregg Moskowitz - Cowen & Company

Rob Owens - Pacific Crest

Jonathan Ho - William Blair

Erik Suppiger - JMP

Gray Powell - Wells Fargo

Walter Pritchard - Citigroup

Daniel Ives - FBR Capital Markets

Scott Zeller - Needham & Company

Brent Thill - UBS

Shaul Eyal - Oppenheimer

Fred Grieb - Nomura

Operator

Good day ladies and gentlemen and welcome to the Third Quarter 2014 Palo Alto Networks Incorporated Earnings Conference Call. My name is Denise and I will be the operator for today. At this time, all participants are in a listen-on mode. Later, we will conduct a question-and-answer session (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now turn the conference over to your host for today, Kelsey Turcotte. Please proceed.

Kelsey Turcotte

Good afternoon and thank you for joining us on today's conference call to discuss Palo Alto Networks’ fiscal third 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’ Web site 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 afternoon, Palo Alto Networks issued a press release announcing the results for its fiscal third quarter ended April 30, 2014, and its settlement of litigation with Juniper Networks. If you would like a copy of the release, you can access it online at the Company’s Web site. 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 fourth quarter, target operating model gross margins range, accelerating growth for all of our subscription services, expectations, plans and strategies relating to our acquisition and integration of Cyvera, demand and adoption of our products and services including demand for both our higher end appliances and WildFire products as well as our subscription services and our competitive position.

These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially from these anticipated by these statements. These forward-looking statements apply as of today and you should not rely on them as representing our views in the future and we undertake no obligation to update these statements after this call.

For a more detailed description of these risks and uncertainties, please refer to our quarterly report on Form 10-Q filed with the SEC on February 24, 2014 and our earnings release posted a few minutes ago on our Web site. 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 Web site located at investors.paloaltonetworks.com.

Before I turn the call over to Mark, we would like to inform you that we expect our fourth quarter and full year fiscal 2014 earnings conference call will be held after the market closes on Tuesday, September 9th.

And with that, I will turn the call over to Mark.

Mark McLaughlin

Thank you, Kelsey and thank you everyone for joining us this afternoon. I am pleased to report another strong quarter of growth. In Q3, revenue grew by 49% year-over-year to approximately $151 million. Billings grew 46% year-over-year to approximately $194 million and we delivered non-GAAP EPS of $0.11. These results were driven by continued strong product demand, robust services growth and a rapid market share gains in the large and growing strategic enterprise security markets. We also announced this afternoon that we have settled all existing litigation with Juniper. I’ll provide some more details about that later in my remarks.

The enterprise security market has been changing rapidly in the last few years due to a number of factors; the increasing number and sophistication of attacks has shown enterprises everywhere that cyber-attacks are a global, growing and lasting phenomenon. This realization has led enterprises to focus on the negative consequences of relying on legacy thinking, legacy technology and point products to try to secure their networks, and it is driving the demand for disrupted platform solutions that do not just detect and remediate but those that can protect and prevent. We believe that the solution for this challenge is a highly integrated and automated platform that enables enterprises to safely use all applications on their networks and to quickly turn unknown threats into known threats thereby protecting the enterprise from today’s most sophisticated attacks.

We built this platform, starting with our next generation Firewall then continued with our next generation threat intelligence cloud that allows us to quickly add high value services to the platform and now with the addition of Cyvera we will provide complete protection for the enterprise by extending prevention technology to the endpoint. This next generation enterprise security platform approach is driving our success as each of the technically disruptive capabilities we bring to the market are superior to conventional point solutions and when combined provide a truly unique solution to address modern security requirements. And we saw multiple proof points to the value of our platform in the third quarter.

We reported record financial results; we achieved the highest rate of new customer acquisition in the Company’s history; we held a highly successful Ignite User Conference with close to 2,000 attendees, a 100 plus percent increase from last year; we closed the acquisition of Cyvera, for the third year in a row Gartner positioned us in the Leaders quadrant of the Magic Quadrant for Enterprise Network Firewalls; we added more than 600 paid WildFire subscribers and now have over 2,000 paid subscribers; we were named technology partner of the year by VMware for integration with their NSX platform and we saw very high interest in our new PA-7050 chassis as well a large number of inbound request for demonstrations of our Cyvera endpoint protection technology. It was a very busy quarter and I am really proud of all that the team accomplished.

More important our continued success momentum in the third quarter positions us well for the future as we rapidly take market share in the global enterprise security market. At the end of the day we’re winning in this market because our enterprise security platform is disruptive and solves very complex and important problems that customers face today. A few examples of what we did in the third quarter around this are a seven figure deal to secure the entire network of one of America’s largest airports where WildFire was a key differentiator, a win at a premiere sports network production company to secure video traffic where we sold PA-7050s into the data center and PA-5000s into every stadium. And strategic wins for distributed Firewall projects at a large electric utility in Japan as well as Asia’s largest casino. These are just a few examples of how we’re serving our customers’ needs.

Our customer base grew to well over 17,000 in the third quarter including continued growing penetration rates into the Global 2000. This high rate of new customer acquisition plus demonstrated repeat selling in the installed base is the basis for a land and expand growth model. On the expense side of the equation in Q3 our top-25 customer had to have spent a minimum of $5 million with us in lifetime value to make our top-25 list, and our life time value is measured by the increase from their first purchase grew to 24.5 times. This compares to $4.6 million and 21.3 times last quarter.

One of the fastest growing areas for us both in landing new customers as well as expanding in the installed base is with WildFire, our subscription service for detection and prevention of sophisticated cyber-attacks. On any given day we typically analyze more than 280,000 unique files with WildFire and often find over 10,000 new instances in malware, over 70% of which is not detected by traditional security technologies. Importantly we then quickly deliver preventive signatures to protect against newly discovered malware through content updates every 30 minutes to paid WildFire subscribers.

This not only provides very fast prevention from future attacks to the customer where the new attack originated but it also provides proactive protection and prevention from future attacks to the entire paying customer base. No other company in the security market can provide this level of detection and prevention and we will soon provide additional and unique prevention capabilities at the endpoint with the integration of the Cyvera endpoint protection technology.

Endpoints are currently the most exposed part of an enterprise to threats and often times the entry point on to the network for the most damaging and sophisticated attacks. Legacy endpoints security technology is very far behind the curve on solving this problem and newer endpoint technologies focus primarily on detection and forensics. However customers want to be proactive rather than just reactive in this battle and we see time and again they are hungry for prevention capabilities, that’s why we spent more than a year looking at the endpoint security market and ultimately chose to acquire Cyvera due to its unique ability to prevent endpoint attacks at the critical exploit phase. We are moving quickly to integrate the Cyvera product into our platform by calendar year-end and we believe this endpoint capability will be as disruptive to the endpoint security market as our next generation Firewall and cloud-based subscription services are today in the network security market.

In addition to customers wanting our prevention platform approach at the endpoint, we’re also seeing increasing demand in the data center which is our fastest growing market segment, that’s why we recently introduced the PA-7050 our high-end chassis which is designed to serve the data center and service provider markets. Early demand for the chassis is high and we anticipate this being a strong contributor for our future growth.

On the go-to-market front we have been able to attract and develop career paths for some of the best sales talent in the industry, and we continue to optimize our distribution channels globally. Our customer satisfaction scores are well above industry average and we know that satisfied customers buy more, which you can see from our lifetime value numbers. We will continue to refine territories and add to our major account team to constantly improve the focus that enterprise customers receive from their sales teams and our value-added partners.

Before I turn the call to Steffan I want to provide some details around the settlement we reached with Juniper. Under the terms of the agreement the parties have dismissed all existing litigation against each other, have licensed the patents and dispute to each other for the life of the patents and have entered into a covenant not to sue each other for patent infringement for eight years. In addition we will pay Juniper a one-time settlement amount of $175 million of which $75 million is in cash and $100 million is in shares of our common stock. There is no royalty being paid as part of the settlement.

As we said from the beginning of this case, we do not believe that we infringe on any Juniper patents and we still believe this to be the case. However over the course of last 2.5 years, we’ve spent a large amount of time, money and other resources on this litigation. While we’re confident of our position in the case, we believe that this outcome will allow us to continue to focus our efforts in what we do best. Innovating and developing new products, servicing our customers and the growth that results from that.

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 Q3 results and Q4 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 Web site.

Q3 results once again underscored the power of our land, expand and retain strategy and our hybrid SaaS model. We added a record number of new customers in Q3 and continue to expand within our existing customer base where we drive repeat purchasing through sales of our products and recurring services. Every time we sell or renew a subscription service its equivalent to selling a new product, except that we have chosen a SaaS model to deliver and monetize it. In addition to better visibility into future revenue streams, growth in our subscription services has contributed to ongoing gross margin improvements. All of these factors were catalyst for record billings, revenue and deferred revenue in Q3.

Q3 total revenue grew 49% over the prior year and 7% sequentially to another record of $150.7 million. The geographic mix of revenue was 66% Americas, 21% EMEA and 13% APAC. Compared to the prior year, the Americas grew 56%, EMEA grew 40% and APAC grew 32%. We saw broad strength across a wide range of verticals and we did 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 $84.1 million increased 38% over the prior year and 4% sequentially. We saw a nice adoption across a number of our different appliance families in the quarter with particular strength in the contribution from our higher end appliances including our newly introduced PA-7050 which is providing greater expansion opportunity in the high-end datacenter market.

Our recurring services revenue of 66.6 million increased 64% over the prior year and 11% sequentially and accounted for 44% share of total revenue. Looking at the two components, our SaaS-based subscription revenue of $32 million increased 71% over the prior year and 11% sequentially. 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 34.6 million increased 58% over the prior year and 10% sequentially. Compared to the prior year, billings in Q3 grew 46% to 193.9 million. Total deferred revenue increased 68% to 367.9 million. Short-term deferred revenue increased 73% to 231.2 million.

Total gross margin was 76.1%, an increase of 200 basis points compared to last year and 80 basis points sequentially. Our target operating model gross margin range is 73% to 76% as we exit Q4 FY16. Product gross margin was 76.3%, an increase of 200 basis points year-over-year and 80 basis points sequentially. The sequential increase was due in part to contribution from our higher-end appliances and cost reduction efforts. As a reminder, we expect there will be fluctuations in our product gross margin primarily due to mix and the timing of new appliance shipments. Services gross margin was 75.9%, an increase of 220 basis points year-over-year and 70 basis points sequentially due in part to increased contribution from subscription services.

Our results continue to demonstrate the power and leverage of our hybrid SaaS model as we scale our business. For the quarter, research and development expense was 12.4% of revenue, increasing approximately $0.8 million sequentially to $18.6 million. Sales and marketing expense was 47.2% of revenue, increasing approximately $5.3 million sequentially to $71.1 million. New headcount additions, commissions and expenses associated with both RSA and our Annual Ignite User Conference contributed to the increase.

General and administrative expense was 7.4% of revenue, increasing approximately 1.4 million sequentially to 11.3 million. As a reminder, this does not include our IP litigation expense with Juniper which was 4.7 million in Q3 ’14. Total headcount at the end of the quarter was 1,556, up from 1,375 at the end of Q2 ’14. This includes the addition of 47 members of the Cyvera team. In total, operating expenses were 101 million or 67% of revenue. Operating margin increased approximately 60 basis points year-over-year to 9.1% and increased sequentially 10 basis points. Our effective tax rate for Q3 was 38%. Net income for the quarter was approximately 8.7 million or $0.11 per diluted share using 80.2 million shares, compared with net income of 5.3 million or $0.07 per diluted share in Q3 2013.

Turning to our GAAP results and the Juniper settlement, as Mark mentioned we will pay Juniper a one-time settlement amount that is valued at approximately $175 million. This consists of a cash payment of 75 million, stock issuance of $70 million or approximately 1.1 million shares of common stock and a warrant to purchase $30 million or approximately 450,000 shares of common stock at a nominal exercise price. The warrant will be subject to mark-to-market accounting beginning in Q4 FY14 and continuing to renew later than Q2 FY15, and we will exclude this non-cash expense from our future non-GAAP results.

The accounting for the 175 million value of the settlement is as follows. A 113.7 million is a one-time expense reflected in our Q3 ’14 GAAP results. In Q4 ’14 the remaining 61.3 million is an intangible asset on the balance sheet which will be amortized ratably over a five-year period into product cost of goods sold because this is a non-cash charge, we will exclude the amortization expense from our future non-GAAP financial results. On a GAAP basis, net loss was 139.1 million or $1.86 per basic and diluted share for the quarter, which includes the 113.7 million expenses associated with the settlement with Juniper. This compares with a Q3 ’13 GAAP net loss of 7.3 million or $0.10 per basic and diluted share.

Turning to the balance sheet, we finished April with cash, cash equivalents and investments of 471.9 million. This takes into account the 82.6 million of cash consideration we spent to acquire Cyvera which closed during the fiscal third quarter. Cash flow from operations, free cash flow and free cash flow margin were 34.3 million, 28.4 million and 18.8% respectively. Capital expenditures in the quarter totaled 5.9 million. Q3 attracted typical linearity was more backend loaded than Q2. Our accounts receivable balance was 114.8 million this quarter, up from 86.1 million in Q2 which resulted in DSO increasing to 60 days, up from 57 days in Q2.

Let me now move to modeling assumptions and our guidance. I’d like to highlight several assumptions. First, our strong performance has yielded expected seasonality in the business, going forward we would expect Q1 and Q3 to reflect a more typical seasonality pattern. Second, as we stated previously we are making the necessary investments in Cyvera and we anticipate spending 3.5 million in Q4, ’14 and 25 million in FY15. Third, from a cash planning standpoint, we expect full year capital expenditures to be in the range of 42 million to 47 million in FY14. And as a reminder the cash payment of 75 million to Juniper in Q4, ’14 will impact both cash flow from operations and free cash flow. Finally, our guidance excludes expenses related to the Juniper IP litigation. Given our settlement with Juniper, after Q4, ’14 we no longer expect to incur IP litigation expenses related to this matter.

Turning to guidance in Q4, ’14 we expect revenue to be in the range of 158 million to 162 million, which represents 41% to 44% growth year-over-year. We expect non-GAAP EPS to be approximately $0.10 to $0.11 per share using 81 million to 83 million shares. This includes shares issued in the acquisition of Cyvera as well as the equity component of our settlement with Juniper.

With that I will turn the call back over to the operator for Q&A.

Kelsey Turcotte

Operator?

Question-and-Answer Session

Operator

Yes. (Operator Instructions) Our first question comes from Raimo Lenschow, Barclays. Please proceed.

Unidentified Analyst

Hi, this is Saket here for Raimo. Thanks for taking my questions and congrats on getting the settlement behind you. Question for Mark, now that the settlement is behind you, do you see any changes to your product roadmap may be over the next one to two years?

Mark McLaughlin

Hi Saket thanks for being on the call. No, our roadmap is fairly well set right now for the next 12 to 18 months. We are really focused on the 7050 which we just launched the next edition of WildFire getting NSX out the door which is already GA but there will be improvements out later on with the VMware with the NSX Palo Alto edition and also probably some more device changes we will make in the next 12 to 18 months as far as introducing some new parts to the family and devices. And then the big picture obviously is getting the Cyvera integration done, so that we have the Cyvera as part of the platform that will be done by calendar year-end and so we like the roadmap we have right now for about next 12 to 18 months.

Unidentified Analyst

Great, that’s helpful. And then for my follow-up, apologies if I missed it but Mark, can you just talk about the subscription attach rate on WildFire in the quarter? And is there any reason to think that that subscription rate couldn’t approach may be the rates that you see on your other three offerings?

Mark McLaughlin

Sure. The subscription attach rate in the quarter was well over 35%, so good growth in attach rate. We added over 600 paid WildFire subscribers, so the paid base is over 2,000 subscribers now and I think about that in a number of ways. The paid subscribers against the total base of our customers which is well over 17,000 is more than 10%, right of the customer base using the paid for portion of this technology today. And we think that will continue to grow overtime or different way to think about it is, there is no reason to think that WildFire can’t grow to the size of your web filtering business or threat prevention business overtime and it looks like it’s heading in that direction.

Kelsey Turcotte

Next question please.

Operator

Our next question comes from Keith Weiss with Morgan Stanley. Please proceed.

Keith Weiss - Morgan Stanley

I just want to thank you guys for taking the question and very nice quarter. I want to check a little bit about WildFire and you guys mentioned WildFire being a key differentiator and getting into some large deals. Can you talk to us a little bit about the competitive environment around WildFire? It seems like a lot of vendors coming into this space with a master is the right or a sandboxing solution, how do you see that competitive environment putting out and where you are doing best in terms of against competitors?

Mark McLaughlin

Sure, Keith. Thanks for being on the call. Yes, WildFire is very important to us as a differentiator and I think it’s moving through phases. The first phase for us was as a door opener in order to be able to speak around cyber security, advanced persistent threats at the highest levels in companies and we’ve got a lot of traction from that. It’s into the selling phase now meaning that it’s selling very-very nicely. Attach rates are high. The reps really like to talk about it. The customers are very interested in it and I think is where it’s settling out now is its part of our platform. And just like the other components of the platform, it’s the entire platform working together that’s really unique and disruptive in the market and that is what differentiates us from all of the competition not just WildFire. It’s all those components working very-very well together in one automotive platform approach and soon to have Cyvera in that as well, but the highest level the difference between us and everybody also in the market who’s got a solution like this is the difference between detection and prevention. Everybody either has or say there is advanced detection capabilities for advanced persistent threats. We’re unique in having the most advanced detection capabilities but because we are the Firewall the ability to do prevention is well and that’s absolutely critical for companies as they think above protection and prevention.

Keith Weiss - Morgan Stanley

Got it. And then just a follow-up on that in terms of sort of partnerships around WildFire you do have sort of talk about detection and prevention, but remediation is different part of the equation, can you talk something about somehow your partnerships are evolving around sort of fill out that type of equation?

Mark McLaughlin

Yes, sure. We are very open for partnerships across the Board because the way we think about the business not just WildFire is what’s right for the customers, right. And customers definitely want the ability to do detection, which we do. They definitely want the ability to do prevention, which we’re unique and some stuff will get through, right. So the idea that you’d want to have some forensic capabilities and remediation capabilities, its true there is nothing, there is nothing wrong with that. Overtime that should abate as prevention capability gets better, but that’s definitely a need in the market today, and we’re very open to partnerships across the board with folks who can do those sorts of things for customer even if some competitive examples we have Cyvera where we’re partnered with some of the endpoint technology providers and other folks in the markets because that’s customers are asking for and we’re going to deliver the solution they’re looking for it.

Kelsey Turcotte

Great, next question please?

Operator

Our next question comes from Karl Keirstead with Deutsche Bank. Please proceed.

Karl Keirstead - Deutsche Bank

Hi, thank. One for Mark and maybe one for Steffan and Mark, first of all congratulations on getting that IP litigation risk off the Company and the stock and actually that’s where I wanted to ask you you’ve disclosed in the press release the financial settlement but I just wanted to ask you what it means more broadly for Palo Alto Networks in terms of potentially getting management focused 100% on the business now to the extent that you had workaround team in place. I presume those resources are freed up maybe it takes away an issue that your competitors are throwing at customers in bid situations, can you give a perspective on may what some of the indirect benefits might be for getting this out of the way?

Mark McLaughlin

Yes, sure, Karl. I think there is the very tangible benefits of we’re not spending millions of dollars of quarter in legal expenses on a go forward basis and from a management perspective the burden of all this is primarily fall on myself, Steffan, and our General Counsel Jeff True who did job in all this by the way and not much beyond that. So we have had a lot of focus on litigation that frankly has been primarily from the investors and I understand why, you know, it’s an important thing, but that’s where a lot of our time and attention was put from management perspective and then from our legal teams perspective obviously they have been spending a lot of time in this as well.

You know, below that or around that in the sales side, we have very-very few questions about the litigation from the minute it was filed up until today even less so in overtime it doesn’t appear to or have impacted our selling whatsoever. If that happened, it’s behind us now but it doesn’t look like it’s the case. From an engineering perspective, the team has been very just hedged on the product roadmap really not worrying about the litigation aspect of trying to do engineering work around that because the outcome was always uncertain and we don’t think we infringe in the first place. So the team, the engineering team hasn’t been really focused since then.

Karl Keirstead - Deutsche Bank

Okay, great color. And if could follow up with Steffan. The maintenance support growth 58% still tracking at a very healthy cliff and well above what the product revenue growth is growing or is so I am just curious what are the factors propping up that support maintenance line, is your renewal rate increasing perhaps a little color there? Thank you.

Steffan Tomlinson

So maintenance has been performed at a very high cliff. It grew 10% sequentially, 58% year-over-year. It’s a differentiated product that we have and you can’t really buy a platform and an appliance without buying maintenance services and the value added engineering that we’re putting into releases and fixes et cetera, customers have to have maintenance. So the attach rate on maintenance has historically been very high as we sell larger appliances down the road, we will have an incremental dollar benefits, all our contribute benefit from maintenance revenue as well. So we have a great customer support team. Our customer satisfaction scores continue to be best in class and we knew that that line has a competitive differentiator.

Kelsey Turcotte

Next question please.

Operator

Our next question comes from Phil Winslow with Credit Suisse, please proceed.

Phil Winslow - Credit Suisse

All right thanks guys, congrats on a great quarter and the settlement as well. Just two quick questions, first on just on the price environment out there, you guys had another gross margin quarter coming ahead of our numbers in the street. Just wondering if you could comment on just the price environment that you’re seeing out there and then just one follow-up after that.

Mark McLaughlin

Yes, sure Phil. The competition has been pretty aggressive on pricing for quite some time in response to our success. So it’s not any news that they continue to price very, very aggressively. We’ve been able to hold the line on that for a long time now. As we’ve reported every quarter as you can see from the gross margin discounting, this is the premium security technology in the market today with a platform approach and people understand that and they’re willing to pay for that. On the gross margin side, on the product side, we had a real nice lift from our higher end appliances and the 7050 and the 5000 and even the 3000 series, which carry nice gross margins. So that’s what we saw in this quarter.

Steffan Tomlinson

And just an add on point to that, we really look our product portfolio as a platform and when you have a hybrid SaaS model with high attach rates on subscription services and you look at the benefits of a total gross margin, we are seeing a tailwind around the benefit that we’re getting from subscriptions. So we’re holding the discounting line on product. We’re selling more higher end appliances and the power of the subscription model is coming into play here.

Phil Winslow - Credit Suisse

And just a quick follow up, with Cyvera, just hoping to get some early feedback from customers, as you’ve been talking to them, about the product.

Mark McLaughlin

It’s really great. We have a lot of in-bound requests from our existing customer base, particularly the large customers, wanting to understand how the technology works. I think they got a good sense of what our description was, in it being very different. Now they want to touch it, they want to test it. There is a lot of interest in doing POCs with them, and we’re going to manage that very carefully so that we can get those done within a very quality manner from getting the technology to where it needs to be and also the ability to support and sell it in the field. So we have a plan around all that. You’ll see a lot of activity in the fall around this product coming to market.

Kelsey Turcotte

Great, next question please.

Operator

And also to limit yourself to one question and one follow up. Our next question comes from Gregg Moskowitz with Cowen & Company. Please proceed.

Gregg Moskowitz - Cowen & Company

Mark for me, demand driver standpoint, just wondering if you have an updated view that you can share with us regarding magnitude or timing of a possible network refresh cycle.

Mark McLaughlin

Gregg, it’s hard to tell right now. Those are inexact things. Our best way to gauge that kind of thing as it turns out I think is coming from our major accounts team. So we’ve put a tremendous amount of effort as you’ve heard into major accounts in the last 18 months or so and our uptick in the G 2000 accounts, we’re adding a couple of dozen or more every quarter right. So we got over 800 and some G 2000 accounts now. We keep adding more every quarter and we get visibility into those accounts on a long term roadmap perspective and these are really big companies, long term roadmaps. So we’re getting our own sense of what they’re thinking about doing and the level of interest in moving to next generation technology I would say is very high generally.

Specifically the things we’re doing on the virtualization side, almost a 100% hit rate into our openers and conversations around that and then obviously cyber security’s top of the mind for everybody as well. It’s again back to the platform approach. We do all those things in the platform. So instead of thinking about things as firewall refresh cycles, I think people are thinking about moving to the next generation of technology in the face of the really complex things they have to face today and I think we’re a big beneficiary of that and are going to do that in the future.

Gregg Moskowitz - Cowen & Company

Okay, that’s helpful and then a follow up for Stephen. You mentioned that you have now over 2000 paid users of Wildfire. Just wondering how many total Wildfire customers exist today encompassing both free and paid.

Mark McLaughlin

Hey Greg, it’s Mark. We have close to 4000 total customers today and like I said we added over 600 paying customers in the quarter.

Kelsey Turcotte

Great, next question please.

Operator

Our next question comes from Rob Owens with Pacific Crest. Please proceed.

Rob Owens - Pacific Crest

A couple of questions. You mentioned this was the higher, highest rate of customer acquisition in the Company’s history. Just maybe a little bit more color there, security’s obviously being a spotlight, there’s been speculation around what this refresh could look like and coming off the quarter with the highest customer acquisition in history and maybe just some color on what the full pipe looks like.

Mark McLaughlin

Yes, sure. So, well, well over a 1000 customers. This is like the 9th to 10th quarter in a row, I am losing track here, over a 1000, but well over a 1000 in this quarter and like you said the highest one we’ve had. Very importantly around that Rob as well as it’s great to feed the funnel off the top under the LAN part of this but the expand side is equally as interesting for us. So you know the number we share with the quarter on the LTV of the top 25 just continues to go up into the rate. This is the second quarter or third quarter, I have to go back and look at the data, but every top 25 customer purchased again in the quarter. Right so, with the way we think about that is over 17,500 total customers today, all of which continue to do repeat purchasing patterns that following the trends of those top 25. So just a lot of existing additional sales to be made to the existing base and then throwing in 1,000 plus new customers every quarter is just a great model.

Rob Owens - Pacific Crest

And then as we approach Q4 here and I know you’re guiding for Q4, any high level thoughts around 2015 and maybe just where we should see product revenue at a minimum?

Steffan Tomlinson

We’re going to be updating folks on modeling assumptions for FY15 at the end of the Q4 call. But I can tell you that our goal is to continue to outpace the market in terms of growth rate in the competitive landscape. We’re definitely committed to continuing to prudently and consciously invest in parts of the business that have a good ROI and you can see the results that we’ve been posting. So our plan is to continue to grow at a very brisk pace in FY15.

Mark McLaughlin

Including on the product side.

Kelsey Turcotte

Great. Next question please.

Operator

Our next question comes from Jonathan Ho with William Blair. Please proceed.

Jonathan Ho - William Blair

Just wanted to get a sense from you, as you’ve released this new VMware product, can you give us a sense of maybe what that opportunity looks like and what type of contribution you’re looking for, maybe not for this fiscal year but just it is sort of in the short run and how that would potentially scale over time?

Mark McLaughlin

Yeah, hey Jonathan. Definitely a tailwind for us to think, just from own my experience of talking to prospects about this and existing customers and what I hear from the field. It is, like I said close to 100% hit rate on when you’re having this conversation with folks that you are definitely invited back for the next meeting if they are VMware customers today. VMware has put a lot of time and effort into the NSX platform itself, which certainly helps us since the -- we’re integrated into that platform. They have trained up a specialized sales folks who are training their entire sales team on this as well. The product is now GAA [ph] and as far as all of the field work that needs begun with their folks, comp plans, all that kind of stuff, my understanding is that’s all completed and they will be bringing that to market in an organized way in June.

So I would expect just from the pipeline we’re seeing, an interest level that this is going to be a good thing for us as it plays itself out through the end of this calendar year and into our -- into calendar ’15. It’s a fairly complex sale, right. This is virtualized datacenter stuff. So these are not 30 days sales. These are longer sales. And we definitely have the benefit of having VMware really organize and rallied around this as well in addition to our own sales team. So I think good things should come from this.

Jonathan Ho - William Blair

Great. And just as a follow up. In terms of your international distribution opportunity; clearly, the Americas region is showing some strength here. How do you guys think about sort of seeing similar growth materialize in terms of the international components over time?

Mark McLaughlin

The international markets are great markets for us. As you can see from our numbers, I would say at pretty good scale. When you look at the Americas, which is the largest contributor there from a revenue perspective and its growth rate is fantastic. And then you look at the international side, which is less mature in a sense of when we team to market with that, the development of the teams and territories and all the things you do to grow markets, all growing at very nice rates as well. But I think on an absolute dollar basis, if you get outside the United States here and look at just how many dollars we bring in the quarter say in APAC for example versus what all the companies in that region spend on security technology, it’s just the tip of the iceberg. So we’re committed to the international markets. They are performing well for us and we think they’re going to be great contributors over the long haul for us.

Kelsey Turcotte

Next question please.

Operator

Our next question comes from Erik Suppiger with JMP. Please proceed.

Erik Suppiger - JMP

First off, just how much of a factor has the litigation been with Juniper in terms of your sales execution and how much do you think that getting that settlement behind you will change your sales prospects going forward?

Mark McLaughlin

Yes, Erik, as was saying a little earlier, it doesn’t appear that we really had any impact from a selling perspective from those litigation. The number of times that I got asked about it, by somebody in the field who talked to customers, Steffan or maybe [indiscernible] in 2.5 years. So the bottoms up feedback from the field is this has not been a significant issue from going to market. The numbers wouldn’t suggest it is either. So -- but if there were, in a way that it was not visible to us, that’s now removed and that’s a good thing for us.

Erik Suppiger - JMP

Okay. And then Steffan can you give us a little sense for what we can expect from a cash -- cash from operations outlook for next quarter what we should think about for CapEx?

Steffan Tomlinson

Yes, so what we ended up giving was some guidance on CapEx, which for the full year we’re looking at $42 million to $47 million in CapEx. And to-date we spent around, call it, $31 million - $32 million of CapEx. So there will be some additional CapEx in Q4. As far as cash flow from operations or free cash flow, we would expect to deliver healthy free cash flow, cash flow from operations but you’re going to have to exclude the $75 million payment to Juniper, kind of looking at pro forma cash flow for that. So we expect to continue to drive healthy free cash flows in it. Part of that hybrid SaaS model that we have has been a differentiator for us from a business model standpoint. Our free cash flow margins tend to be -- call it anywhere between 8% to 12% higher than our operating margins, and that’s because how we license and how we go to market. So we think that free cash flow and cash flow from our office will continue to grow hopefully.

Kelsey Turcotte

Great, next question please.

Operator

Our next question comes from Gray Powell with Wells Fargo. Please proceed.

Gray Powell - Wells Fargo

Can you talk about the integration of your Morta acquisition with WildFire? I believe Morta’s capabilities were going to be introduced into the next version of WildFire. And can you just update us there on the timing and the additional functionality that Morta brings?

Mark McLaughlin

So the Morta acquisition for us was about getting two things; one was an extremely talented group of guys who have a lot of expertise and a built technology. The second thing, which is really the subtle -- some of these have lateral movement of APTs and malware through networks, and which is becoming more and more important in the data center where things kind of find their way in there. So they’re moving quietly through the network into the data center.

So when we use the terms like detection and prevention, this would fall really into the detection side of if something was in your network, being able to see it was there, so that you can then protect against it. And that technology is well along in its path in integration into the whole platform, including WildFire. And by the end of this calendar year -- we should see that in next release of WildFire early next year. But we’re excited about the technology we got there and it does a lot of great things around very sophisticated detection.

Kelsey Turcotte

Next question please.

Operator

Our next question comes from Walter Pritchard with Citigroup. Please proceed.

Walter Pritchard - Citigroup

Steffan, wondering, you talked about strong sales of the 7050. Can you talk about if you had any supply constraints or any troubles fulfilling demand on that product during the quarter?

Steffan Tomlinson

No, thankfully we didn’t --we had very good product demand planning cycles that we go through. We have a stellar operations and product management team. They are we are able to forecast. And we have very close customer intimacy. So we had a good handle on what the demand was coming into the quarter. So we were well situated to fulfill that demand.

Walter Pritchard - Citigroup

Got it. And then just on the attach rate, you talked a bit about the WildFire attach rates. I’m wondering, looking at some of the more mature subscriptions like URL and IPS and GlobalProtect, are you at a point there where those have sort of steadied out and plateaued in terms of the attach you’re seeing coming in on new purchases, or are we still seeing those escalate as the quarters go on?

Steffan Tomlinson

Interestingly enough, each of the subscriptions that we had this quarter, all grew sequentially which was nice. As we have mentioned before, threat prevention are filtering are already at very high rates, kind of the sequential growth rate, will by definition be just a little bit less. But as you point out, it’s really the power of the platform and the subscriptions that are big differentiator and we’re selling integrated appliance which is a big differentiator for us.

Kelsey Turcotte

Great, next question please.

Operator

Our next question comes from Daniel Ives with FBR Capital Markets. Please proceed.

Daniel Ives - FBR Capital Markets

Obviously you guys are doing great job in larger deals. Maybe you could sort of talk about, are you seeing a difference strategically in terms of recent attacks on Target and eBay in terms just going up to a C level [ph] or Board level in terms of fast track on some of these cyber security initiatives?

Mark McLaughlin

I think it’s definitely the case because of these high profile very well publicized attacks that folks are seeing, that the ability to have a conversation around cyber security advance persistent threats and then very importantly, the high differentiation of a platform that can do protection or prevention doesn’t hurt us at all. So these things all play to our favor. Our sales guys, they definitely understand how to take advantage of that and they have been doing that very successfully in the field.

Kelsey Turcotte

Great, next question please.

Operator

Our next question comes from Scott Zeller with Needham & Company. Please proceed.

Scott Zeller - Needham & Company

Is there any color you can offer us on the number of opportunities where customers are standardizing on Palo Alto as a platform?

Mark McLaughlin

I would say lots and lots of cases of standardization. The reason for the pause there for a second was that when companies standardize on Palo Alto, particularly large companies, that is the beginning of a multi-year process of putting Palo Alto all throughout the enterprise, all throughout the network and that takes time. Interestingly, that’s one of the reasons you see on the LTV the top 25 our ability to come on the phone every quarter and say that number goes up, everybody is buying every quarter, that those companies began with an initial purchase for something and then ultimately, in a lot of cases say we’re going to make Palo Alto networks the backbone of our enterprise network security. And then that manifests itself through all these repeat purchases. Only the customer knows about the date picture, roadmap of how those things look like. We get the visibility into that in our strategic planning sessions with them, and then what we see on a quarterly basis, when they’re making -- putting in orders against what they have shared with us from those decisions, but I think when you just think about -- over 60% of our base today is using us as a firewall. Over 75% of our initial sales there is a firewall. That’s a great indicator of standardization when you become the firewall for an enterprise.

Kelsey Turcotte

Great, next question please.

Operator

Our next question comes from Brent Thill with UBS. Please proceed.

Brent Thill - UBS

Mark, you mentioned the data [ph] is the fastest growing segment in the business. I’m curious if you could just give us a mile marker, where you think you are and if you had some achievements you’d like to put on the board in that segment. How would you look at that over the next year?

Mark McLaughlin

I think its early innings around that Brent; for two reasons. The first is that for the datacenter itself, having the next generation capabilities we bring to that has been very interesting for customers for some time and then the ability in the North-South traffic to now do that at a 100 gig plus just opens of tons of possibility for existing customers, who are already using us and new customers, whether they’re looking for that throughput requirement and then the Greenfield opportunity in the datacenter is really in the virtualization space with our own VM-series, with the NSX technology for East-West protection. That’s a use case that is fairly new for companies, really starting to understand they have to provide that same level next-generation security to their own traffic in a datacenter. That’s not something that they had to do before ABTs became so [indiscernible] for example. So it’s a combination of those two things, which is very high throughput North-South, East-West Greenfield opportunity, but being the only Company that can do the next-generation platform capabilities in both of those instances is a tremendous opportunity for us. Like I said, I think its early innings in all that for us.

Brent Thill - UBS

And for Stefan on the subscription attach -- just more to Walter’s question on, if you look through into the big buckets, is there a simple attach rate you could give us on each of those to just give us a sense of where each of those are at or are you not going in that level?

Steffan Tomlinson

Historically what we have done is, semi-annually we give the total metric. And we don’t get into each specific subscription. So as of Q2 we had an attach rate of about 1.9 as an average across the four subscriptions. And that metric has increased over the last several periods. And the reason why it is increasing is customers are continually looking for an integrated solution so they don’t have to have a proliferation of devices behind the firewall. So the elegance of the platform with the subscriptions provide the big differentiator.

Kelsey Turcotte

Great, the next question.

Operator

Our next question comes from Shaul Eyal with Oppenheimer. Please proceed.

Shaul Eyal - Oppenheimer

Congrats on good quarter and the settlement. You had a very solid quarter in APAC. Have you been displacing anyone, as some of your peers have been seeing some softness in that region?

Mark McLaughlin

Yes Shaul, just it’s a general matter, you should assume that regardless where we are, that almost 100% of our sales are displacement sales. So generally somebody is losing for us to win, and we do that at very high rates and it doesn’t matter around the geography. I mentioned just a few things we did in APAC in the last quarter. The largest Casino in Asia, for example, like Kabukicho in Japan, both are displacements in those cases. But then almost everything we do is a displacement.

Shaul Eyal - Oppenheimer

Fair enough. Steffan, are you looking any different on capitalization in light of the settlement? Obviously you’ve got plenty of cash even when embedding the settlement. Currency is probably about to get stronger near-term. Any view that you can share with us on that point?

Steffan Tomlinson

We feel great with our cash position right now and I think as a differentiator to our business model, relative to some other folks out there, we’ve been able to generate over $8 million of free cash flow fiscal year-to-date. And yes, we look to keep our options open. But we feel comfortable with our cash position and our ability to continue to generate cash.

Kelsey Turcotte

Great. We have time for one last question, please.

Operator

Last question comes from Fred Grieb with Nomura.

Fred Grieb - Nomura

I hopped on a bit late. So I apologize if this has already been asked, but could you give us some update on the Cyvera acquisition? I’m curious whether this is having any impact on customer conversations of bringing more customers potentially to you.

Mark McLaughlin

Yes, Fred. Yes, it has been very positive for us. So as far as selling the product, we’ll be doing that in a very organized approach in the fall of this year; meaning, having it integrated into the platform, having the sales people know how to sell it and the support personnel who can support that.

Putting that aside for a second though, this is another instance of being able to really strategic conversations with folks in companies. So great door opener for us right now. We are definitely talking about that. We’re talking about how it fills up the third corner of our enterprise security platform. So we have the firewall, we have the cloud and now we have the endpoint as well and that’s resonating very well. As a result of that the interest level, like I said earlier in the call, is very high. The request for POCs are off the charts. So we have got more inbound interest than we can handle at the moment. We want to make sure we do that in a very organized way. So we bring this to market as Palo Alto Networks quality.

Operator

We have no further questions. I would now turn the call back over to management for closing remarks. Please proceed.

Mark McLaughlin

Thanks, operator. Thanks everyone for being on the call this afternoon and I want to say a special thank you to all the Palo Alto Networks team for all the hard work and support, our customers and partners as we continue to redefine the next generation of enterprise security. We appreciate your interest in the company. Thanks.

Operator

This concludes today’s conference. You may now disconnect. Have a great day.

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Source: Palo Alto Networks' (PANW) CEO Mark McLaughlin on Q3 2014 Results - Earnings Call Transcript

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