Palo Alto Networks' (PANW) CEO Mark McLaughlin on Q3 2016 Results - Earnings Call Transcript

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Palo Alto Networks (NYSE:PANW)

Q3 2016 Results Earnings Conference Call

May 26, 2016, 04:30 PM ET


Kelsey Turcotte - VP, IR

Mark McLaughlin - Chairman, President and CEO

Steffan Tomlinson - EVP and CFO


Sterling Auty - JPMorgan

Saket Kalia - Barclays Capital

Ken Talanian - Evercore ISI

Matt Hedberg - RBC Capital Markets

Michael Turits - Raymond James

Keith Weiss - Morgan Stanley

Gregg Moskowitz - Cowen and Company

Rob Owens - Pacific Crest Securities

Walter Pritchard - Citigroup

Ryan Hutchinson - Guggenheim Securities LLC

Brent Thill - UBS

Michael Kim - Imperial Capital

Karl Keirstead - Deutsche Bank

Catharine Trebnick - Dougherty

Scott Zeller - Needham & Company


Good day, everyone, and welcome to the Palo Alto Networks Fiscal Third Quarter 2016 Earnings Conference Call. Today's conference is being recorded.

At this time, I'd like to turn the conference over to Kelsey Turcotte, Vice President of Investor Relations. Please go ahead ma'am.

Kelsey Turcotte

Thank you. Good afternoon, and thank you for joining us on today's conference call to discuss Palo Alto Networks fiscal third quarter 2016 financial results. This call is being broadcast live over the web and can be accessed on the Investors section of our website at

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

This afternoon, we issued a press release announcing our results for the fiscal third quarter ended April 30, 2016. If you'd like a copy of the release, you can access it online on our website.

We would also like to remind you that during the course of this conference call, Management will make forward-looking statements including statements regarding our financial outlook for the fiscal fourth quarter of 2016, the future of the security landscape, the spending environment and market opportunity for our products, subscriptions and services, investment in and increasing demand for our products, subscriptions and services by both new and existing customers, trends in certain financial results and operating metrics, our revenue, billings, deferred revenue and free cash flow growth rates, sales productivity, seasonality, operating leverage, ability to expand market share, gain leverage and deliver profitability, hiring expectations, expansion of our partner ecosystem, product and services development 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 factors that could cause actual results to differ, please refer to our Quarterly Report on Form 10-Q filed with the SEC on February 26, 2016, and our earnings release posted a few minutes ago on our website and on the SEC's website.

Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. For historical periods, we've provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the supplemental financial information that could be found in the Investors section of our website located in

For planning purposes, we expect our fiscal fourth quarter 2016 earnings conference call to be held after the market closes on Tuesday, August 30. We'd also like to inform you that we will be presenting at the DA Davidson Eight Annual Technology Forum on Wednesday, June 1, The Cowen and Company TMT Conference on Thursday, June 2, The RW Baird Consumer Technology & Services Conference on Thursday, June 9 and the William Blair Growth Stock Conference on Tuesday, June 14.

And finally, at the conclusion of today's conference call, we will be posting our prepared remarks to our Investor Relations website under Quarterly Results.

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 that in Q3 we once again delivered record results, significantly outpacing the growth of both the market and our competitors despite macro volatility. Q3 revenue was $346 million, up 48% year-over-year; billings were $486 million, up 61% year-over-year; free cash flow was $151 million, up 95% year-over-year and we reported non-GAAP earnings per share of $0.42.

Our results demonstrate not only that security is as important as ever and a priority spending item, but also that we are cementing our leadership position in the market at scale.

Customers agree that having the right foundational approach to security is critical. From inception we have been focused on a prevention oriented approach, which we believe is the only way to combat the imbalance between a highly automated adversary and increasingly manually dependent responses.

And, we are delivering that approach with a true, next-generation platform that integrates and automates prevention capabilities, is extensible and flexible to address the ever-changing security landscape, provides consistent security in both physical and cloud environments, and leverages the ecosystem effect of our expanding customer base so that our customers do not have to fight this battle alone.

This approach has enabled us to continually widen the gap in a highly competitive market. In the quarter, new customer additions were very strong and we are proud to now be serving over 31,000 customers across the globe.

Competitive wins in the quarter included, a Check Point and Juniper replacement at one of the largest life insurance companies in the U.S. with our full platform running on PA-7050’s and PA-7080’s, including WildFire, AutoFocus and Traps; a new win with a global semiconductor company where we replaced Symantec and FireEye to secure more than 10,000 workstations and servers with Traps and more than 20,000 users with Aperture; a multi legacy vendor replacement at a U.S. Federal agency to secure their internet access with PA-5060’s, PA-7050’s, and PA-7080’s; and a Cisco replacement at one of the world’s largest hosting companies to protect their infrastructure and ensure security compliance.

We also continued to expand the customer lifetime value of our top 25 customers, all of whom purchased in the quarter. To make the list in Q3, a customer had to have spent a minimum of $12.5 million in lifetime value compared to $8.2 million in the prior year period.

These wallet share gains underscore that customers understand the mathematical advantage of having an effective prevention capability at each part of the attack lifecycle built natively from the ground up with highly automated outcomes that increase security, reduce complexity, and result in significant total cost of ownership advantages.

Customers are securing their environments by adopting all aspects of our platform, especially our subscription services where revenue grew 69% year-over-year. Our overall recurring revenue now represents 53% of total revenue. This trend is very good for the business long-term as it creates revenue visibility and strong cash flow generation, as well as greater leverage over time.

Importantly, we are constantly improving and extending our platform capabilities through development efforts and partnerships. On the development side we recently released several updates to our Next-Generation Security Platform, including, augmentation of our universal protection across multi-cloud environments and SaaS applications, including the announcement of integration with Microsoft Azure and enhancements to our VM-Series.

Extension of Aperture’s SaaS security to safely enable Microsoft’s Office 365; advancements in certificate and two-factor authentication to help protect user credentials or neutralize them if they are stolen; and, the addition of Mac OS X coverage to WildFire, as well as the reduction in time from APT detection to prevention from 15 minutes to 5 minutes on average.

This is a major value proposition in the battle against advanced persistent threats. Our more than 10,000 WildFire customers appreciate the capability set we're delivering to them and how the large and fast growing ecosystem around WildFire is providing them with significant leverage.

And, it's not just customers who see the value in our approach, but also partners. Our NextWAVE partner community is thriving with both new and existing partners de-focusing on legacy vendors and shifting their investment to Palo Alto Networks as we become increasingly strategic to each other.

Hundreds of these partners attended our third annual Ignite user conference in early April, which brought together thousands of security practitioners to network and share best practices on their use of our platform in the battle for cyber security and breach prevention.

And, we are developing new routes to market with global systems integrators and service providers who are building out practices and managed services that will allow customers to benefit from our platform and our partners’ offerings and expertise.

For example, we're working with Honeywell Process Solutions to boost the cyber security capabilities of ICT and SCADA systems used in industrial facilities and critical infrastructures.

Telstra announced they will be offering Palo Alto Networks as a virtual NFV solution, launching later this year as part of their Cloud Gateway Protection offering on their SDN network platform and Palo Alto Networks and PwC’s Cybersecurity and Privacy practice have joined efforts to design a next-generation security framework that will serve as a guide for customer organizations to establish a breach prevention-oriented security architecture.

These efforts and partnerships will help ensure we have the capacity to grow with the market demand for our platform.

I am also pleased to announce that yesterday Gartner positioned us in the “leaders” quadrant of the “Magic Quadrant for Enterprise Network Firewalls” for the fifth year in a row. We're well positioned in the paradigm shifts from legacy to next generation, detection to prevention, physical to virtual, and on premise to cloud and I am incredibly proud of our team and their hard work and am grateful for the trust our customers and partners place in us.

And, with that, I’ll now turn the call over to Steffan to discuss the financials in more detail. Steffan?

Steffan Tomlinson

Thank you Mark, and thank you all for joining us.

Before I start, I’d like to note that except for revenue figures which are GAAP, all financial figures are non-GAAP unless stated otherwise. Demand was strong in Q3, which once again resulted in record revenue, billings, non-GAAP operating margin, free cash flow and free cash flow margin.

Core growth drivers in the business remain healthy, as we continue to see broad adoption of our Next-Generation Security platform, particularly our subscription services. New customer additions were robust and we continue to expand customer lifetime value across cohorts.

These drivers resulted in Q3 total revenue of $345.8 million, an increase of 48% over the prior year. The geographic mix of revenue for Q3 was 71% Americas, 18% EMEA, and 11% APAC.

Compared to the prior year, the Americas grew 56%, EMEA grew 34% and APAC grew 24%. We saw broad strength across a wide range of verticals and did not have any end customer concentration.

The three components of our hybrid-SAAS model; product, subscriptions and support all grew well in Q3. Q3 product revenue of $162.1 million increased 33% over the prior year. Growth was healthy across our product portfolio, with strong contribution from the PA-7050 and PA-7080 chassis.

Adoption of subscriptions and high renewal rates for both subscriptions and support continue to be catalysts for our recurring services business. Recurring services revenue of $183.7 million increased 63% over the prior year and accounted for a 53% share of total revenue.

Looking at the two components of recurring services revenue; the first component is our SaaS-based subscription revenue of $92.6 million, which increased 69% over the prior year. Support and maintenance revenue, the second component of recurring services, was $91.1 million, an increase of 57% over the prior year.

Billings in Q3 were $486.2 million, an increase of 61% year-over-year and annual contract duration ticked down slightly sequentially.

Total deferred revenue grew to $1.1 billion in Q3, an increase of 77% year-over-year and 15% sequentially, with strong growth in both short-term and long-term deferred revenue. The growth in deferred revenue underscores the power of our hybrid-SaaS model and provides increasing visibility into future revenue streams.

Total gross margin for Q3 was near the high end of our target range at 77.9%, an increase of 40 basis points compared to last year and 70 basis points sequentially.

Product gross margin was 76.3%, a decline of 10 basis points year-over-year and sequentially. Over time, we expect there will be fluctuations in product gross margin.

Services gross margin for Q3 was 79.4%, an increase of 80 basis points year-over-year and 130 basis points sequentially. Services gross margin continues to benefit, in part, from ongoing growth of our high margin subscription services.

Total headcount at the end of the quarter was 3,591 up from 3,343 at the end of the prior quarter. We continue to thoughtfully add talent across the business as we scale to support our growth.

For the quarter, research and development expense was 10.6% of revenue, decreasing approximately $800,000 sequentially to $36.7 million. Sales and marketing expense for Q3 was 45.3% of revenue, increasing approximately $10.5 million sequentially to $156.6 million. This was primarily due to headcount additions, as well as marketing expenses related to the RSA security conference and our annual Ignite user conference.

General and administrative expense for Q3 was 4.9% of revenue, decreasing approximately $1.2 million sequentially to $16.9 million. In total, Q3 operating expenses were $210.2 million, or 60.8% of revenue. Q3 non-GAAP operating margin was 17.1%, representing growth of 320 basis points year-over-year and 20 basis points sequentially.

Net income for the quarter was $38.5 million, or $0.42 per diluted share using 91.3 million shares, compared with net income of $20.5 million, or $0.23 per diluted share in Q3‘15. Our effective tax rate for Q3 was 38%.

On a GAAP basis for the third quarter, net loss was $70.2 million, or $0.80 per basic and diluted share. This compares with a Q3’15 GAAP net loss of $45.9 million, or $0.56 per basic and diluted share.

We finished April with cash, cash equivalents and investments of $1.8 billion. Cash flow from operations, free cash flow and free cash flow margin for Q3 were $170.1 million, $150.8 million and 43.6% respectively. Capital expenditures in the quarter totaled $19.3 million.

The accounts receivable balance was $267.6 million in Q3, up from $254.4 million in Q2. Reflecting a more back end loaded quarter, DSOs increased sequentially by seven days and year-over-year by 13 days to 68 days.

Now, turning to the fiscal fourth quarter guidance and modeling considerations. As we look at the fourth quarter, we continue to see robust pipeline coverage and strong demand and a volatile macro environment. Our guidance takes this into account.

We expect revenue to be in the range of $386 million to $390 million, which represents 36% to 37% growth year-over-year against an exceptionally strong comparable in Q4 fiscal '15. And, we expect non-GAAP EPS to be in the range of $0.48 to $0.50 per share using 91 million to 93 million shares.

Turning to modeling points; first, we have anticipated for some time that seasonality would evolve in the business and this is becoming increasingly evident in our Q1 and Q3 sequential results. Given the current size and scale of our business we would expect this seasonality to continue and to grow over time.

Consistent with previous comments, we expect fiscal Q2 and Q4 to show our strongest sequential total revenue growth. We continue to see a mix shift in our business towards ratable services billings as customers more broadly adopt our platform capabilities.

As we said previously, we expect to exit Q4 at approximately 18% to 19% non-GAAP operating margin, which represents an approximately 400 to 500 basis point increase year-over-year.

We expect CapEx to be in the range of $85 million to $90 million, which includes investments in infrastructure, cloud services and facilities to support the growth of our business. And, we expect free cash flow margin to be approximately 40% for Q4 of fiscal ‘16.

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

Question-and-Answer Session


[Operator Instructions] And we'll take our first question from Sterling Auty with JPMorgan.

Sterling Auty

Yes. Thanks. Wanted to start off with a point that was really a topic of conversation through most of the quarter, which was the duration, because it still looks like a healthy amount of long-term deferred revenue growth, but you mentioned that the duration ticked down. So wondering how we connect those dots? What contributed to the strong long-term deferred with the shortening duration?

Steffan Tomlinson

Well both short term and long term deferred grew very nicely and that is -- that's a phenomenal statement that our customers are making because they want to standardize on us long term.

The way that we calculate duration is units based duration, it's not a dollar weighted duration and we use that contract unit duration as a way to manage the business internally because it takes out the variability of any large deals that come in and out of a quarter.

So we feel very good about the quality of the deferred revenues. The fact that we have over a billion deferred revenues on the balance sheet, our standard process is to collect the cash up front and that is also a benefit to our model as well and we have very healthy renewal rates. So all those things put together, we've seen both a great increase in short term and long term deferred revenue.

Sterling Auty

Okay. And then one follow-up, Mark, for you. Looking at the example you gave of Aperture and Traps selling in to replace Symantec and FireEye, are you seeing, A, increasing traction with larger deals on Traps in terms of larger production deployments? And B, along with that, are you seeing a better tie ratio, meaning that you're seeing more customers that want Traps and Aperture going in at the same time?

Mark McLaughlin

So in the first point Sterling on Traps, yeah we're definitely seeing continued strong adoption of the Traps and we're also seeing larger deployments as well which is exactly what we would expect over time as we get reference ability and really work our install basis there as well.

From a Traps and Aperture, perspective we're seeing good growth in all of our services. So Aperture did well in the quarter too. There is not really so much of a time between Aperture and Traps. There really is a tie in on the concept of location about where your data is and where you have to protect it right.

So if data is increasingly moving endpoints, you definitely want to have protection there and we're for sure seeing strong move of folks using third party SaaS applications. So you want have your data protected there and that’s why Aperture is going to do for you. So it all points to the platform from a service respect we're seeing good strong adoption.


Thank you. And our next question is from Saket Kalia with Barclays Capital.

Saket Kalia

Hi guys. Thanks for taking my questions here. First, so obviously another strong subscription billings quarter. Can you just talk a little bit about how much of that strength is coming from getting the existing installed base to turn on more subscriptions, like WildFire, versus the higher attach for some of the new appliances sold versus renewals, if that makes sense?

Mark McLaughlin

Hey Saket, it’s Mark. So as you saw we had a good billings growth of 61% year-over-year. So we're very pleased with that. As Steffan mentioned, it's a great indication that customers are adopting more and more of the capabilities across the platform.

We're seeing that in the installed base really understanding the mathematical leverage they get every time they take one more service they are increasing the mathematical probability that prevention is going up for them.

We are definitely doing our best job to convince that to new customers when they come in the door we've a very good customer adoption, net new customers this quarter. And we're trying to make that point to those customers as well to take as much as much -- as much of the services as they can, and they want right up front, because it increases that mathematical prevention. So a lot of them are buying services in addition to buying a product.

And on the renewal side as you can see as our business grows like this over time, we have a very healthy renewals business. We have very high renewal rates and with a large customer base like this and adding 1,000 plus customers every quarter that's going to continue to feed us into the future.

Saket Kalia

Very helpful. And then for my follow-up, I think we've all heard the pushbacks on stock compensation and share dilution, of course understanding the demand for talent in the Bay Area. But can you just talk to us a little bit about how you can leverage that stock comp line item, and also how you think the Board really thinks about the use of capital when it comes to share buyback?

Mark McLaughlin

Yeah, sure Saket, I’ll take that one as well. So from a SBC perspective as you noted, we're here in the heart of Silicon Valley in a very, very competitive talent environment and we're very fast growing company.

So the combination of those two things has meant that to support the growth we're hiring a lot of people and we do that where you're granting them equity to put make them part of the team and that's ownership skin in the game as well along with the shareholders and that is driven stock-based compensation as you can see and I know it's high by the way and high along with some of our very fast growing peers along those lines.

As we think about that into the future, the SBC will come down. I certainly expect that to be the case and I would expect that to start next year as a matter of fact. And then as far as using cash for buybacks related to that concept of dilution when you're a fast growing technology company like ourselves, we watch cash all the time, how too much comes in the door and thinking about what the optimal uses of cash would be as a Board and we don't think it's this time the appropriate thing to do to be to be using it to buy back stock.


Okay. Thank you so much Saket for your question. Our next question comes from Ken Talanian from Evercore ISI.

Ken Talanian

Hi guys. Thank you for taking my question. If I did my math right and heard your headcount right, it looks like you hired fewer people in this quarter than you did in the last couple quarters. Was wondering if you could give us a sense for how we should think about that uptick going forward and how it might relate to operating expenses from a trend perspective?

Mark McLaughlin

Yeah Ken, so as far as on the headcount side, we've added a lot of people we've added almost a 1,000 people in the first nine months of the year. And we have to continue to add lots of team members into the organization to support the high growth you're seeing 48% year-over-year your revenue growth, 61% billing growth that takes a lot of talent to do that at scale.

So we'll continue to hire folks on the team, but we'll also be doing that thoughtfully and we would assume that over time in size that the absolute numbers of people that we hire would come down over time.

On the operating margin side the -- we obviously would get less expense for a less numbers of people you bring into the equation, but on the driver for that for us in the short term is really the strong growth you're seeing in subscription services when you're posting up numbers like this on the billing side where subscription is growing at really high rates like that and having that mismatch between the commissions and the ratable revenue on that, that puts some short term pressure on the operating margin.

Ken Talanian

Okay. Great. And if I may, one follow-up. You're somewhat early on with your endeavors on the service provider side. I was wondering if there's anything you could update us with there in terms of your traction?

Mark McLaughlin

Sure, happy to do that. On the service side, we called that out a number of times in the last two quarters. It's something we're very focused. We have been for a while looking at that market as an opportunity and then with every release that we put out the door and introduction of new, introduction of new capabilities particularly in the hardware side ensuring that we have capabilities that will address the very specific needs of the service provider market.

And then also organizationally made a change about nine months ago where we created a very specific service provider theater concept, build a theme around that, very aggressive right now, working with service providers and we have a number of design wins coming from that team already. So we would expect that we will get growth into the future on the service provider market which is something we really haven’t touched yet.

Ken Talanian

Great. Thanks very much.

Mark McLaughlin

Thanks Ken.


And our next question comes from Matt Hedberg with RBC Capital Markets.

Matt Hedberg

Hey guys. Thanks for taking my questions. So recurring revenue, obviously strong. I think you mentioned 53% as ratable, SaaS growing 69%. Is there a rule of thumb longer term to think about what the right mix is on ratable revenue? And then I have follow-up question to that.

Mark McLaughlin

Well, it's certainly going to grow over time as our platform is more fully adopted by all of our customers and when you think about what we’ve done over the past several years, we've gone from a couple of subscriptions services now to eight and the adoption rates and penetration rates continue to be very high and the renewal rates for both subscriptions and support are extremely high as well.

So you have this compounding effect of the services business which will play out over time. So, we haven't given a long term model around kind of revenue split between services and product, but it should be growing over time and with the call it a $1.1 billion on the balance sheet we have more visibility in future revenue.

So, think of it as up into the right. It will be a little bit -- it could be little bit lumpy relative to the traction that we are -- the strong traction that we’re still getting out of our product business.

Matt Hedberg

That's helpful. And then, Steffan, as a follow-up to that, you mentioned seasonality, increased seasonality as we go, and Q3 is a seasonally weaker quarter for you guys. Strong services, but product was a little bit light.

And I realize you don't guide to the license component, but I think it grew about 33%. What's the right way to think about that, given that a lot of these subscription services are additive versus cannibalistic to the product side?

Steffan Tomlinson

Well, as you mentioned the 33% year-over-year growth is very strong considering that we’re operating at scale and when you think about seasonality in our business what we’ve always said and now its playing out is that Q2 and Q4 will be our strongest sequential quarters and Q1 and Q3 both on a relative basis just be less strong . In our fiscal Q3 is proxy for like a calendar Q1 but just still being said that’s sort of thing.

The other part of your question as it relates to call it subscriptions business we have four subscription services that actually don’t attach to the device. So, there is a separation between the product revenue that we’re bringing in, half of the subscriptions that we offer attached to the device, but half of them do not and the half that don’t, are newly -- relatively newly introduced subscriptions that have a high growth rate trajectory that we’re looking to monetize over time.

So, less and less tying of subscriptions revenue to product revenue though it still will be tied, but it's less of the concrete tied then it has been in the past.

Matt Hedberg

Got it. Thanks.


Our next question comes from Michael Turits with Raymond James

Michael Turits

Hey guys. Two drill downs. One, in terms of, Steffan, in terms of, or Mark, in terms of those non-attached subscriptions, which were the ones that really drove things in the quarter? And also, I wanted to see if we could look at the duration question again and explain to us what that unit versus dollar issue was?

Mark McLaughlin

So I will take the first one. I'll let Steffan take the second one, like on the non-attached subscriptions we -- if there is a reminder for our folks who are keeping track, we have Traps, we have Aperture, we have AutoFocus and then we have our VM series.

And of those four, the two that are larger than the other two right now mostly because of when they're introduced the VM series and Traps, but all four of them did well in the quarter.

Steffan Tomlinson

So on the duration, as I said on the call the way that we calculated is a unit based duration and it ticked down slightly and I'll try to viewpoint on that is if you look at a dollar weighted based duration, that's something that we track internally, but we haven’t chosen to share that with the street because the way that we manage our business is off of the units based metrics and it takes up a volatility.

Now I’ll tell you that if you look at the profile of both the short term and long term deferred growth, they both had extremely high growth rates. Short term actually grew on a dollar basis, greater than long term year-over-year and then the other kind of lens that we look at is if you were to look at a proxy for call it current billings and which is you take our revenue plus change in short term deferred, you're looking at growth rate north of 50%.

So all of those things together kind of point a very healthy, both billings and deferred revenue business and the contact duration as measured on a units basis ticked down slightly.

Michael Turits

And then just a housekeeping, did you give the WildFire paid customers this quarter?

Mark McLaughlin

We said Michael it's over 10,000 for the quarter.

Michael Turits

Thanks. Missed that. Sorry. Thank you.

Mark McLaughlin



Next we have Keith Weiss from Morgan Stanley

Keith Weiss

Excellent. Thank you guys for taking the question and nice quarter. I think the questions that I'm getting after hours is really on the deceleration in the product revenue from Q2 to Q3 and guys just really asking me the question, has anything changed in terms of the competitive environment or the macro environment out there to cause that slower pace of growth?

You talked about seasonality. I see in the results that Asia Pac seemed to have slowed down a lot. So maybe to ask the two questions, one, from a competitive standpoint, anything change to slow down that rate of product revenue growth, or from a geographic or macro standpoint, anything change in the macro environment that caused Asia Pac to slow down like that?

Mark McLaughlin

Hey, Keith, it's Mark. So let me take the competitive question first. On the competitive front, we haven’t seen anything different from the competition and the way we always think about that is will fall on the two buckets. Technology and marketing we care more about the technology buckets and the marketing bucket, both are important.

But on the technology side we haven’t seen the competition do anything technically interesting there that will cause us any concern. I think you can see that also reflected just kind of as a proof point on very strong new customer ads, very strong lifetime value increases, strong attach rates, strong penetration rates.

Everything was working well there from that side. So on the marketing side we continue to see people be very aggressive from a pricing perspective, but that’s an environment we've lived in for quite some time.

On the macro side, we did mention that we’ve seen from the beginning of the year, the calendar year a lot of macro volatility and what I mean by that is there is same covering around out there whether there is a price of oil or what’s going to happen with interest rates,

China, the stock market being up and day down and I think from a sentiment perspective of our customers it has them more cautious then they had been in the past and they’re doing more inspection on deals, it's taking longer from a deals sales cycle as they look at -- as they look at different things, different number of times.

And also in some cases trying to did you with less today that they can in the future. So, a bit obviously in a better environment or macro environment those things can't go away. So -- but that’s we saw on our guide implied a sequential decline as we thought about that from beginning from January and as you can see from guide going forward, it's against a very, very strong comp of course but we took that macro into account when we provide Q4 guide.

Keith Weiss

Got it. And then maybe just one quick follow-up, in terms of the linearity in the quarter. Anything unusual in terms of linearity through the quarter and as strongly as it began?

Mark McLaughlin

We see on a -- yes, so as you can see we had a back ended loaded quarter there Keith on what we saw in more getting done in April then we usually see historically and I think that’s very tied to where we are saying on the macro sentiment of people just taking longer to get deals done. Team did a great job bringing the business in April. So we're very proud of that, but we did see -- we did see a different looking April than we had in the past.

Keith Weiss

Excellent. Thank you very much, guys.

Mark McLaughlin

Thanks Keith.


Our next question comes from Gregg Moskowitz with Cowen & Co.

Gregg Moskowitz

Okay. Thank you very much and good afternoon, guys. I just wanted to touch on the number of customers, and you mentioned over 31,000. But unless there's significant rounding involved, that would seem to imply some degree of slowdown in net adds versus what you've been showing over the past several quarters, and just wondering if there's any additional color you can provide on the rate of new customer acquisition this quarter as compared with historical periods?

Mark McLaughlin

Yeah Greg, there is a rounding going on there, just using round numbers when we report these, but no slowdown at all that the number was well over 1,500 in the quarter so closer to 2,000.

Gregg Moskowitz

Okay. That's helpful, Mark. And then just as a follow-up on Keith's question, because I noticed also Asia Pac growth, at 24%, was lower than we've seen in some time and just wondering if there was anything particularly pronounced from a macro standpoint or anything else that you would call out there?

Mark McLaughlin

Yeah we did see some in different places in the world we saw some of this what I would call the macro sentiment impact and one of them was in Australia for Asia is about 24% year-over-year growth as you saw, what we saw in Australia that was concern I think from customers in that environment they're very tied into China.

China's got a cold where they get the flu. So there's from a specific area Australia we saw some weakness there in the quarter. We also saw the Middle East having some concerns around the price of oil and budgets being reset by governments and companies over there as a result of that.

So that was an area as well, but generally you can see strong growth in the topline numbers, the billing numbers in our most mature market the Americas at 56% year-over-year growth so very strong there.

Gregg Moskowitz

Okay. That's helpful. Thanks very much.


Our next question comes from Rob Owens with Pacific Crest Securities.

Rob Owens

With regard to the July quarter and what's coloring your guidance, can you talk a little bit about velocity of business versus large deals and what you're seeing in the pipe? I know you said there's some modest extension, as people are looking at deals more closely right now.

But just curious, as we look at the fourth quarter here versus what you've seen traditionally, how does it look from a velocity perspective versus a big deal perspective?

Mark McLaughlin

Rob, I think just as a general matter where we've seen very strong velocity in the business and at the same time associated with that, we are continuing to work with larger and larger companies on bigger and bigger deals when you look at our penetration and well over a 1,000 and above 2,000 now in the high 80 percentage range on the Fortune 100. And as we get to work with bigger companies like that, we're going to get to work with them on larger deals as well.

So from a fourth quarter perspective it's always a seasonally strong quarter for us and we would expect that to be the case here. We are working against all the monster comp, if you recall, we had a fantastic color on fourth quarter last year, but we're also taking that macro into account when we set that guidance.

Rob Owens

And secondly, you mentioned success with a federal agency. And as we look at some of the newer opportunities that Palo Alto's getting into, whether it be government or critical infrastructure and SCADA systems, which you've mentioned, or service provider, what do you think can provide the most upside over the next six months to 12 months, just in terms of the overall business and monetization of some of these newer opportunities? Thanks.

Mark McLaughlin

Yes sure, as you've seen it from our business when we've shown you every year at our Analyst Day the vertical penetration we have we're a very horizontal business and I would like to see that personally and running the businesses because it shows one we don't have used exposure anywhere and two, we have a useful capability to all verticals.

So that continue to be the case by the way. We’ve seen increasing interest in business in the federal space. You can definitely see everybody great team together there. About two years ago they were really performing well and it takes a very long time to crack into that market, but when you're in you start to perform better and better if you're doing something useful for the customers.

So we see that service provider which I just mentioned a few minutes ago is an area we're putting a lot of attention of focus and we think that that will go well up for us and just as a general matter in the enterprise space with large companies, the attention to focus that Mark has put into the major accounts and global counts, that organizationally has really been paying off dividends for us and we would expect that to continue as well.


All right. Thank you. And our next question comes from Walter Pritchard with Citi.

Walter Pritchard

Hi thanks. Thanks. Mark, I'm wondering if you can talk about specifically the VM series, and there was, I think, some notion that depending on if customers deploy VM versus an appliance, the rev impact is different. Did you see any unexpected volatility in the mix between the VM series and the appliances in the quarter?

Mark McLaughlin

Just for background from what Walter is talking about is with our VM Series depending on how the customer takes it either perpetual license or non-perpetual is going to fall in category of product versus subscription services, that's basically the background for the question.

The VM Series has continued to perform very well for us including in the third quarter. But the breakdown between the perpetual and non-perpetual has been consistent and we didn't see any big swing there.

Walter Pritchard

Okay. Great. Thank you very much.

Mark McLaughlin

Thanks Walter.


Next we have Ryan Hutchinson with Guggenheim.

Ryan Hutchinson

Thanks. So I appreciate the color on duration and deferred. My question is back to billings, as a percentage of revenue, it's the highest it's been in any given quarter, with billings accelerating year-over-year to 61%, but revenue guidance is in line. I'm trying to get a better understanding of the relationship between billings and revenue, especially as the adoption of software and subscription services increases as a percentage of the overall mix.

So the question is, as we look forward over the next, call it, 12 months, will billings as percentage of revenues stay or improve off these higher levels? Any color on how to think about the change in the model and the relationship between the two would be appreciated. Thanks.

Mark McLaughlin

When you think about the relationship between the two, it all starts with the concept of mix and over the last couple quarters at our Analyst Day we devoted a fair amount of time giving insight into how that mix has been shifting.

In the first half of the fiscal '16 that mix was 63% services, relative to where it was the first half of '15, which is 58%. So you're starting to see that that shift over time.

So billings is increasingly benefiting from higher adoption rates of all of our subscription services and higher renewal rates of both subscriptions and support and that as a percentage of the business is growing and you're seeing that with the percentages that I just mentioned. And by the way in Q3 that mix shift continued in the direction of favoring subscriptions.

So the relation between billings and revenue should continue to have a separation, that should continue to grow over time, because those -- the services billing that go on to the deferred revenue side of the house will come off ratably whereas the product revenue that's associated with those billings is shrinking as a percentage of the total.

It's still growing in terms of absolute dollars, but on a percentage mix standpoint it's decreasing. So on a relative basis, billings and specifically services billings should be outpacing the rate of product billings over time and that same or similar proportion relates to revenue as well.


Thank you. Our next question comes from Brent Thill with UBS.

Brent Thill

Thank you. Mark, there's a lot of metrics that we probably aren't really accustomed seeing from you guys. You saw a spike in the AR, DSOs shot up. I think you mentioned sales cycles are extending. We know there's some seasonality, but what do you think happening?

You mentioned it's not really competitive, so are you just pinning this all to macro, or is there some type of overall customer behavior maybe you haven't seen for a while? I'm just trying to understand if they're saying, hey, we're going to with you, but we're just taking a little more time or having trouble getting funding.

What was the common denominator or the customer conversations during the quarter that caused those dynamics which you haven't really seen in the past several quarters?

Mark McLaughlin

Yes just to be specific from a dynamic perspective Brent, what I was saying was that the one metric you can look at there with DSOs being higher, you can see we had a more backend loaded quarter in April than before and the reason for that we believe we believe is we're very engaged with the customers is them taking longer to get approvals for deals.

I think I might use this term volatility before as a lot of things that play out there, but it ultimately boils down to sentiment right about how the customers feel about things and I think that sentiment in that environment has been cautious from January and it continues to be that case.

And they're putting more attention and focus on what they're going to spend and how they prioritize that. I think in a very good way as you can see from a lot of other companies reporting in the IT sector and what they’ve reported and how they felt about the future security I think obviously remains at the top it's a priority spend item.

How do we see customers taking longer to get the deals approved as are getting checked two or three times in a row just to make sure that they want to spend their money.

Brent Thill

Just to be clear, were deals, did you slip deals to the fourth quarter, given how back-end loaded it was, that you were anticipating those to come in Q3?

Mark McLaughlin

Brent, we're doing 1,000,1,000, 1,000 of deals this size right now as a company. So in any given quarter we're going to get cautious across quarters in the last month. So we saw that but that’s no different than what we've seen for some time now.

Brent Thill

Okay. Thank you.

Mark McLaughlin



Our next question comes from Michael Kim with Imperial Capital.

Michael Kim

Hi. Good afternoon, guys. Just going back to international, can you talk about the progress on your go-to-market initiative, especially around channel enablement? And then just aside from the macro volatility, is that changing your pace of hiring or where you're shifting your resources by GO?

Mark McLaughlin

That’s a good question Michael. So from a channel enablement perspective one of the things for sure we're seeing across the Board is in the channels whether it's distributors or whether its reseller or even distance integrators, we’ve achieved the size in the market and continue to have very, very high growth rate where everybody is paying attention to that and they want definitely want to have call it the networks as a place where they're going to investing and take in that high growth.

So we’re delighted with that of course as we have to continue to add capacity to do that. We’re doing that on a global basis as well and we’ll stay very focused on that as well

So from a headcount perspective, we're always watching resources lies where we're going to put resources. We've obviously started the year with the plan off of what the assumptions would be. As we progress through the year depending on the ROI we're getting out of this places headcount wise we may shift heads around into places with higher productivity.

So that's a dynamic thing for us. We don’t try to just set a statistic thing beginning the year and play with it, no matter what’s happening, but there is headcount rates. As I said earlier they're high and they remain high from a sales perspective just because the demand is obviously there and we want to make sure that we have the people and the place where we can satisfy the demand.

Michael Kim

And are you seeing a significant difference in the purchasing patterns of some of the international customers versus what you typically would be seeing in the Americas?

Mark McLaughlin

No, it just stands on a couple countries and this is every quarter we're going to see something in different places like that world is never filing on all cylinders at all times.

As I said I think a little earlier in this quarter, areas where we saw a more weakness than usual was the Middle East that was pronounced and I think as the price of oil has been so volatile and lower than I think many of the governments and then companies have set their budgets against as they have to reset those things and look for cost savings that we saw in the Middle East, we saw that in couple of the oil producing regions of Canada and then we saw not associated with oil, but just political stability issues in Brazil and we saw some weakness down there as well.

Michael Kim

Okay. Great. Thank you very much.


Our next question comes from Karl Keirstead with Deutsche Bank.

Karl Keirstead

Hi. A question for Steffan. I know you don't guide to product revenues, but given your macro commentary and the fact that you've got a 10% tougher compare, I suspect many on the line will end up modeling that product revenue for 4Q in the perhaps low to mid 20%. As we model that line item, besides macro and the tougher compare, anything else that you'd encourage us to keep in mind?

Steffan Tomlinson

I’d encourage you to really kind of look at the mix shift in our business. Well we don’t guide as you said specifically on product revs. The implied guide would call for a sequential increase in product for sure, but I think where some of the modeling has been off base has been the contribution from the subscriptions and services side of the house.

So, when you look at the guide that we gave off of a extremely tough comparable last year, there is going to be healthy growth in both product and services, but the mix I think you should really take a look at. So I would say look at the mix patterns and take into consideration what we've said as a company around how that the power of the platform is playing out.

Karl Keirstead

Yes. Makes sense. Thanks, Steffan.

Steffan Tomlinson

Thank you.


Our next question comes from Catharine Trebnick with Dougherty.

Catharine Trebnick

Thank you very much for taking my question. Nice quarter. Mine is on endpoints. Could you give us a little commentary on within the security budget what you're seeing is a concentration towards endpoints, and then do you think you believe you have the right product at this time to tackle that piece of the market? Thank you.

Mark McLaughlin

Sure, hey Catharine, it's Mark. Yeah so from an attention perspective, end points of very high attention, it’s pretty obvious to customers that legacy technologies are really not working that well for them and I think as a result of that, there has also been a shift of influence on those budgets as well up the chain into the CSO office of the CI office as well.

We like that a lot by the way because we are really trying to operate at those levels with a two platform approach that when we can get into this CIO, CSO, CTO level conversations, those folks are thinking about how do I protect no might higher enterprise, and that higher enterprise consistent of all the data and that data is all over the place right. So our story and our reality of being able to deliver in the story of the platform as we can protect the data everywhere including at the endpoints.

Now from how you do that to your second part of your question, we think that a prevention oriented approach is a right one, just as we done at the network level very successfully in the past and we think that’s the right approach to the end points as well.

And that’s what Traps does. It's a very prevention oriented approach because its tied into WildFire, it also provides the advantages of having your network and endpoint understand each other from a fed perspective and then also very significantly because its hid into WildFire, you also get the ecosystem of everything that we're finding from our customer ecosystem as being updated not only at the network level but at the end point level of course as well.

So we think we’ve got the right technology to solve a very important problem and that problem is growing in awareness and attention for customers.

Catharine Trebnick

Well, a follow-on to that, Mark, who do you guys typically see in a bake-off for some of these endpoints and do you think you're winning more of the bake offs and less of bake offs. Thanks.

Mark McLaughlin

We’re doing well in the bake offs Catharine. It’s a very, very busy market right now here in the endpoints space. So almost in every case that you're involved in you have the legacy provider in there and then you have a very, very long list of “next gen endpoint companies“ who are showing up trying to compete there.

I think we're doing very well in that competitive environments for the reasons I said, which is in addition to say we do something very important which is actually prevention of the end point, nobody think can match the follow on statements we're saying and it works with your network and you get these advantage of having 30,000 some plus customer and ecosystem working for you from a threat intelligence perspective at the endpoint level as well.


Thank you so much and our final question is from Scott Zeller with Needham & Company.

Scott Zeller

Thanks. Just looking for a little more color regarding the 4Q guidance, given the comments earlier about the seasonality, saying F2Q and F4Q are the strongest, it appears that the guide is conservative for the fiscal fourth quarter.

Mark McLaughlin

Well what we said Scott is that from a seasonality perspective we expect Q2 and Q4 to be stronger sequentially as you've noted and that would continue to be the case from the guide perspective. I know as I said a little earlier, we’ve taken into account that guide, not only they're really, really strong comp that we're working up against, but also the macro environment working in as well.

Scott Zeller

Thank you.


That does conclude our question-and-answer session. I would now like to turn the call over to Mark McLaughlin for closing comments.

Mark McLaughlin

Thanks operator. Appreciate that. Thanks everyone for joining us this afternoon. We’re all very excited here at Palo Alto Networks about the future and I want to thank our customers, partners and entire Palo Alto Networks team for their hard work and support in the third quarter and we look forward to updating you for the fourth quarter results in about 90 days. Thanks a lot.

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