PANW-4.30.2013-10Q
Table of Contents

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_____________________ 
Form 10-Q
 _____________________
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended April 30, 2013
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from             to             
Commission File Number 001-35594
Palo Alto Networks, Inc.
(Exact name of registrant as specified in its charter)
 
 
Delaware
20-2530195
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
3300 Olcott Street
Santa Clara, California 95054
(Address of principal executive office, including zip code)
(408) 753-4000
(Registrant's telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
¨
Accelerated filer
¨
Non-accelerated filer
x (Do not check if a smaller reporting company)
Smaller reporting company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  ¨   No   x
The number of shares outstanding of the registrant's common stock as of May 15, 2013 was 71,136,115.
 




Table of Contents

TABLE OF CONTENTS

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

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PART I
    

ITEM 1.    FINANCIAL STATEMENTS
 
PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except per share data)
 
April 30, 2013
 
July 31, 2012
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
213,664

 
$
322,642

Short-term investments
148,033

 

Accounts receivable, net of allowance for doubtful accounts of $79 and $164 at April 30, 2013 and July 31, 2012, respectively
91,489

 
45,642

Prepaid expenses and other current assets
19,538

 
13,373

Total current assets
472,724

 
381,657

Property and equipment, net
29,500

 
20,979

Long-term investments
29,767

 

Other assets
6,786

 
5,168

Total assets
$
538,777

 
$
407,804

Liabilities and stockholders’ equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
12,810

 
$
9,214

Accrued and other liabilities
15,578

 
15,189

Accrued compensation
19,662

 
11,307

Deferred revenue
133,968

 
86,296

Total current liabilities
182,018

 
122,006

Deferred revenue—non-current
85,336

 
49,512

Other long-term liabilities
7,542

 
7,215

Commitments and contingencies (Note 5)


 


Stockholders’ equity:
 
 
 
Preferred stock; $0.0001 par value; 100,000 shares authorized; none issued and outstanding at April 30, 2013 and July 31, 2012

 

Common stock, $0.0001 par value; 1,000,000 shares authorized; 71,103 and 67,852 shares issued and outstanding at April 30, 2013 and July 31, 2012, respectively
7

 
7

Additional paid-in capital
357,289

 
309,092

Accumulated other comprehensive income
23

 

Accumulated deficit
(93,438
)
 
(80,028
)
Total stockholders’ equity
263,881

 
229,071

Total liabilities and stockholders’ equity
$
538,777

 
$
407,804

 
See notes to condensed consolidated financial statements.

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PALO ALTO NETWORKS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share data)
 
 
Three Months Ended
 
Nine Months Ended
 
April 30,
 
April 30,
 
2013
 
2012
 
2013
 
2012
Revenue:
 
 
 
 
 
 
 
Product
$
60,793

 
$
43,524

 
$
178,251

 
$
125,023

Services
40,496

 
22,176

 
105,471

 
54,473

Total revenue
101,289

 
65,700

 
283,722

 
179,496

Cost of revenue:
 
 
 
 
 
 
 
Product
15,855

 
11,524

 
46,907

 
32,082

Services
11,835

 
7,109

 
32,591

 
16,904

Total cost of revenue
27,690

 
18,633

 
79,498

 
48,986

Total gross profit
73,599

 
47,067

 
204,224

 
130,510

Operating expenses:
 
 
 
 
 
 
 
Research and development
16,048

 
10,462

 
44,855

 
26,824

Sales and marketing
51,733

 
30,216

 
140,136

 
78,196

General and administrative
12,268

 
6,430

 
30,971

 
17,355

Total operating expenses
80,049

 
47,108

 
215,962

 
122,375

Operating income (loss)
(6,450
)
 
(41
)
 
(11,738
)
 
8,135

Interest income
133

 
3

 
347

 
7

Other expense, net
(157
)
 
(3
)
 
(387
)
 
(1,033
)
Income (loss) before income taxes
(6,474
)
 
(41
)
 
(11,778
)
 
7,109

Provision (benefit) for income taxes
808

 
(837
)
 
1,632

 
1,773

Net income (loss)
$
(7,282
)
 
$
796

 
$
(13,410
)
 
$
5,336

Net income (loss) attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
(7,282
)
 
$
43

 
$
(13,410
)
 
$
40

Diluted
$
(7,282
)
 
$
53

 
$
(13,410
)
 
$
49

Net income (loss) per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
(0.10
)
 
$
0.00

 
$
(0.20
)
 
$
0.00

Diluted
$
(0.10
)
 
$
0.00

 
$
(0.20
)
 
$
0.00

Weighted-average shares used to compute net income (loss) per share attributable to common stockholders:

 
 
 
 
 
 
 
Basic
69,575

 
18,459

 
67,980

 
17,238

Diluted
69,575

 
24,888

 
67,980

 
23,020


See notes to condensed consolidated financial statements.


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

 
Three Months Ended
 
Nine Months Ended
 
April 30,
 
April 30,
 
2013
 
2012
 
2013
 
2012
Net income (loss)
$
(7,282
)
 
$
796

 
$
(13,410
)
 
$
5,336

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Unrealized gains on investments
34

 

 
23

 

Comprehensive income (loss)
$
(7,248
)
 
$
796

 
$
(13,387
)
 
$
5,336


See notes to condensed consolidated financial statements.

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PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
 
Nine Months Ended
 
April 30,
 
2013
 
2012
Cash flows from operating activities
 
 
 
Net income (loss)
$
(13,410
)
 
$
5,336

Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Depreciation and amortization
7,221

 
4,193

Amortization of investment premiums, net of accretion of purchase discounts
1,445

 

Share-based compensation for equity based awards
29,608

 
7,350

Excess tax benefit from share-based compensation
(177
)
 

Change in fair value of preferred stock warrants

 
958

Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
(45,847
)
 
(9,119
)
Prepaid expenses and other assets
(5,991
)
 
(9,251
)
Accounts payable
3,347

 
5,079

Accrued and other liabilities
13,097

 
3,834

Deferred revenue
83,496

 
49,397

Reimbursement of cost of leasehold improvements

 
701

Net cash provided by operating activities
72,789

 
58,478

Cash flows from investing activities
 
 
 
Purchase of property, equipment, and other assets
(16,595
)
 
(11,281
)
Purchase of investments
(310,683
)
 

Proceeds from sales of investments
13,491

 

Proceeds from maturities of investments
117,150

 

Net cash used in investing activities
(196,637
)
 
(11,281
)
Cash flows from financing activities
 
 
 
Excess tax benefit from share-based compensation
177

 

Change in restricted cash

 
1,221

Proceeds from exercise of stock options
11,195

 
1,477

Proceeds from employee stock purchase plan
6,267

 

Proceeds from settlement of note receivable

 
637

Payments of initial public offering costs
(2,698
)
 
(703
)
Repurchase of restricted common stock from employees
(71
)
 
(63
)
Net cash provided by financing activities
14,870

 
2,569

Net increase (decrease) in cash and cash equivalents
(108,978
)
 
49,766

Cash and cash equivalents—beginning of period
322,642

 
40,517

Cash and cash equivalents—end of period
$
213,664

 
$
90,283


See notes to condensed consolidated financial statements.

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 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 1. Description of Business and Summary of Significant Accounting Policies
 
Description of Business
 
Palo Alto Networks, Inc. (the “Company,” “we,” “us,” or “our”), located in Santa Clara, California, was incorporated in March 2005 under the laws of the State of Delaware and commenced operations in April 2005. We offer a next-generation network security platform that allows enterprises, service providers, and government entities to secure their networks and safely enable the increasingly complex and rapidly growing number of applications running on their networks. The core of our platform is our Next-Generation Firewall that delivers application, user, and content visibility and control integrated within the firewall through our proprietary operating system, hardware, and software architecture. We primarily sell our products and services to end-customers through distributors, resellers, and strategic partners (collectively partners) and infrequently directly to end-customers. Our partners are supported by our sales and marketing organization in the Americas, in Europe, the Middle East, and Africa (EMEA), and in Asia Pacific and Japan (APAC).
 
Initial Public Offering

In July 2012, we completed our initial public offering whereby 6,200,000 shares of common stock were sold to the public at a price of $42.00 per share. We sold 4,687,000 common shares and selling stockholders sold 1,513,000 common shares. In connection with the exercise of the underwriters’ over-allotment option, 930,000 additional shares of common stock were sold to the public at the initial offering price of $42.00 per share. We received aggregate proceeds of $219,400,000 from the initial public offering and the underwriters’ over-allotment option, net of underwriters’ discounts and commissions, but before deducting offering expenses of approximately $4,000,000. Upon the closing of the initial public offering, all shares of our outstanding redeemable convertible preferred stock automatically converted into 41,305,000 shares of common stock.

Secondary Offering

In October 2012, we completed our secondary offering whereby certain stockholders of our company sold 4,800,000 shares of common stock to the public at a price of $63.00 per share. The aggregate offering price for shares sold in the offering was approximately $290,304,000, net of underwriting discounts and commissions. We did not receive any proceeds from the sale of shares in this offering. Offering expenses were paid by the stockholders who sold shares of common stock in the offering.

Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles, consistent in all material respects with those applied in our Annual Report on Form 10-K for the fiscal year ended July 31, 2012. We have made estimates and judgments affecting the amounts reported in our condensed consolidated financial statements and the accompanying notes. The actual results that we experience may differ materially from our estimates.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of the Company, and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

 Summary of Significant Accounting Policies
 
There have been no material changes to our significant accounting policies as compared to those described in our Annual Report on Form 10-K for the fiscal year ended July 31, 2012 except as disclosed below.

Investments

We classify our investments as available-for-sale at the time of purchase since it is our intent that these investments are available for current operations, and include these investments on our balance sheet as either short-term or long-term investments depending on their maturity. Investments not considered cash equivalents and with maturities one year or less from the condensed consolidated balance sheet date are classified as short-term investments. Investments with maturities greater than one year from the condensed consolidated balance sheet date are classified as long-term investments.


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Investments are considered impaired when a decline in fair value is judged to be other-than-temporary. We consult with our investment managers and consider available quantitative and qualitative evidence in evaluating potential impairment of our investments on a quarterly basis. If the cost of an individual investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established.

Warranties
 
We generally provide a one-year warranty on hardware and a three-month warranty on software. We accrue for potential warranty claims as a component of cost of product revenues based on historical experience and other data. Accrued warranty is recorded in accrued liabilities on the condensed consolidated balance sheets and is reviewed periodically for adequacy. To date, we have not accrued any significant costs associated with our warranty.
 
Recent Accounting Pronouncements
 
In June 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2011-05, Presentation of Comprehensive Income. The standard requires entities to have more detailed reporting of comprehensive income. The guidance was effective for us in the first quarter of fiscal 2013 and applied retrospectively. Our adoption of this guidance did not impact our condensed consolidated financial position, results of operations, or cash flows.

In February 2013, the FASB issued Accounting Standards Update No. 2013-02, Comprehensive Income (Topic 220)-Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The standard requires entities to present (either on the face of the income statement or in the notes) the effects on the line items of the income statement for amounts reclassified out of accumulated other comprehensive income. The guidance is effective for us in the first quarter of fiscal 2014 and should be applied prospectively. Early adoption is permitted. We believe that adoption of this guidance will not have a material impact on our consolidated financial position, results of operations, or cash flows.

2. Fair Value Measurements
 
We categorize assets and liabilities recorded at fair value on our condensed consolidated balance sheets based upon the level of judgment associated with inputs used to measure their fair value. The categories are as follows:
 
Level 1—Inputs are unadjusted quoted prices in active markets for identical assets or liabilities.  
Level 2—Inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the assets or liabilities, either directly or indirectly through market corroboration, for substantially the full term of the financial instruments.
 
Level 3—Inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. The inputs require significant management judgment or estimation.

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The following table presents the fair value of our financial assets and liabilities using the above input categories (in thousands):
 
 
 
April 30, 2013
 
July 31, 2012
 
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Cash equivalents:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 
$
1,864

 
$

 
$

 
$
1,864

 
$

 
$

 
$

 
$

U.S. government and agency securities
 

 
51,543

 

 
51,543

 

 

 

 

Money market funds
 
75,185

 

 

 
75,185

 
250,005

 

 

 
250,005

Total cash equivalents
 
77,049


51,543



 
128,592

 
250,005






250,005

Short-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 

 
22,239

 

 
22,239

 

 

 

 

U.S. government and agency securities
 

 
125,794

 

 
125,794

 

 

 

 

Total short-term investments
 

 
148,033

 

 
148,033

 

 

 

 

Long-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 

 
25,766

 

 
25,766

 

 

 

 

U.S. government and agency securities
 

 
4,001

 

 
4,001

 

 

 

 

Total long-term investments
 

 
29,767

 

 
29,767

 

 

 

 

Other assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Restricted cash
 
1,221

 

 

 
1,221

 
1,221

 

 

 
1,221

Total other assets
 
1,221

 

 

 
1,221

 
1,221

 

 

 
1,221

Total assets measured at fair value
 
$
78,270

 
$
229,343

 
$

 
$
307,613

 
$
251,226

 
$

 
$

 
$
251,226


3. Investments

Investments consist of the following (in thousands):


 
April 30, 2013
 
Amortized Cost 
 
Unrealized Gains
 
Unrealized Losses
 
Estimated Fair Value
Certificates of deposit
$
1,864

 
$

 
$

 
$
1,864

Corporate debt securities
47,992

 
28

 
(15
)
 
48,005

U.S. government and agency securities
181,328

 
11

 
(1
)
 
181,338

Money market funds
75,185

 

 

 
75,185

Total
$
306,369

 
$
39

 
$
(16
)
 
$
306,392



Investments in an unrealized loss position at April 30, 2013 consist of the following (in thousands):

 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
Corporate debt securities
$
20,832

 
$
(15
)
 
$

 
$

 
$
20,832

 
$
(15
)
U.S. government and agency securities
26,056

 
(1
)
 

 

 
26,056

 
(1
)
Total
$
46,888

 
$
(16
)
 
$

 
$

 
$
46,888

 
$
(16
)

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Unrealized losses related to these investments are due to interest rate fluctuations as opposed to credit quality. In addition, we do not intend to sell and it is not more likely than not that we would be required to sell these investments before recovery of their amortized cost basis, which may be at maturity. As a result, there is no other-than-temporary impairment for these investments at April 30, 2013.

The amortized cost and fair value of our investments at April 30, 2013, by contractual years-to-maturity, are as follows (in thousands):

 
Amortized Cost
 
Fair Value
Due within one year
$
201,418

 
$
201,440

Due within one to two years
29,766

 
29,767

Instruments not due at a single maturity date
75,185

 
75,185

Total
$
306,369

 
$
306,392


4. Intangible Assets

Intangible assets included in other assets consisted of the following (in thousands):

 
April 30, 2013
 
July 31, 2012
Acquired intellectual property
$
1,546

 
$
546

Less: amortization
(131
)
 
(63
)
Total
$
1,415

 
$
483


Amortization expense was $42,000 and $68,000 for the three and nine month periods ended April 30, 2013, respectively, and $11,000 and $26,000 for the three and nine month periods ended April 30, 2012, respectively.

The following table summarizes estimated future amortization expense of intangible assets as of April 30, 2013 (in thousands):


Amount
Years ending July 31:
 
Remaining 2013
$
57

2014
227

2015
227

2016
227

2017
208

2018 and thereafter
469

Total
$
1,415


5. Commitments and Contingencies
 
Leases
 
In September 2012, we entered into two lease agreements for space in Santa Clara, California with lease inception dates of November 2012 and August 2013. Both leases expire in July 2023 and allow for two separate five-year options to extend the lease term. Payments under these leases will be approximately $94,400,000 over the lease term. Each lease has a rent holiday, which was included in the determination of rent expense.

The aggregate future non-cancelable minimum rental payments on our operating leases and the minimum purchase commitments of products and components with our independent contract manufacturer or suppliers at April 30, 2013 are as follows (in thousands):


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Payments Due by Period 
 
Total 
 
Less Than 1
Year
 
1 - 3 Years
 
3- 5 Years
 
More Than 5
Years
 
 
 
(in thousands)
 
 
Operating lease obligations
$
106,242

 
$
6,994

 
$
21,966

 
$
22,633

 
$
54,649

Purchase obligations
24,425

 
24,425

 

 

 

Total
$
130,667

 
$
31,419

 
$
21,966

 
$
22,633

 
$
54,649

 
Litigation
  
Beginning in January 2009, Fortinet, Inc. began filing a series of complaints against us in the U.S. District Court for the Northern District of California alleging, among other claims, patent infringement. In January 2011, we entered into a settlement agreement with Fortinet to the mutual satisfaction of both parties. The parties also agreed upon a three-year covenant not to sue for patent related claims. Under the terms of the settlement agreement, we agreed to pay Fortinet $6,000,000 over a period of three years. We recorded the cost related to the settlement as of July 31, 2010. As of April 30, 2013, $750,000 remained payable under this settlement and is included in accrued liabilities in our condensed consolidated statement of financial position.
 
In December 2011, Juniper Networks, Inc. filed a complaint against us in the United States District Court for the District of Delaware alleging patent infringement. The complaint seeks preliminary and permanent injunctions against infringement, treble damages, and attorney’s fees. On February 9, 2012, we filed a response to the complaint, which denied all claims and asserted that the claimant’s patents were invalid. On February 28, 2012, Juniper filed a motion to strike our defense of invalidity based on the legal doctrine of “assignor estoppel.” On March 23, 2012, we filed a brief in opposition to that motion. Juniper filed a brief in response on April 2, 2012. On August 2, 2012, the District Court issued an order granting Juniper’s motion as to one of the patents in suit (the ’634 patent) but denying Juniper’s motion as to the five other patents in suit. On September 4, 2012, Juniper filed a motion to amend its complaint to allege that our appliances infringe two additional U.S. patents but also to withdraw its allegations as to a previously-asserted patent. This amended complaint was officially filed on September 25, 2012, pursuant to a stipulation between the parties. Juniper now alleges that our appliances infringe seven of its patents. On September 13, 2012, we filed with the U.S. Patent and Trademark Office requests for inter partes reexamination of five of the six patents asserted by Juniper in its original complaint. We did not file a request for reexamination on the withdrawn patent. On October 12, 2012, we filed an answer to Juniper’s amended complaint, which denied that we infringed Juniper’s patents and asserted that Juniper’s patents were invalid. On October 19 and December 3, 2012, the U.S. Patent and Trademark Office granted our requests for reexamination for three patents, rejecting a number of the claims asserted in the litigation, and on November 15 and 26, 2012, the U.S. Patent and Trademark Office denied our requests for reexamination as to two other patents. We have the opportunity to seek review of these denials within the U.S. Patent and Trademark Office.

A trial date has been scheduled for February 24, 2014, and we are vigorously defending ourselves from such claims. At this stage in the litigation, we are unable to estimate a possible loss or range of possible loss.
 
In addition to the above matter, we are subject to legal proceedings, claims, and litigation arising in the ordinary course of business, including intellectual property litigation. Such matters are subject to many uncertainties and outcomes are not predictable with assurance. We accrue for contingencies when we believe that a loss is probable and that we can reasonably estimate the amount of any such loss. We have made an assessment of the probability of incurring any such losses and whether or not those losses are estimable.
 
To the extent there is a reasonable possibility that a loss exceeding amounts already recognized may be incurred and the amount of such additional loss would be material, we will either disclose the estimated additional loss or state that such an estimate cannot be made. We do not currently believe that it is reasonably possible that additional losses in connection with litigation arising in the ordinary course of business would be material.

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6. Equity Award Plans
 
A summary of the activity under our stock plans and changes during the reporting periods and a summary of information related to options exercisable and options and restricted stock units (RSUs) vested and expected to vest are presented below (in thousands, except per share amounts):
 
 
Options Outstanding  
 
Number
of
Shares
 
Weighted-
Average
Exercise
Price 
 
Weighted-
Average
Remaining
Contractual
Term (Years)
 
Aggregate
Intrinsic
Value
Balance—July 31, 2012
14,225

 
$
9.46

 
8.3
 
$
678,248

Options granted
90

 
55.36

 
 
 
 
Options forfeited
(563
)
 
10.51

 
 
 
 
Options exercised
(3,115
)
 
3.61

 
 
 
 
Balance—April 30, 2013
10,637

 
11.51

 
8.0
 
$
453,030

Options vested and expected to vest—April 30, 2013
10,081

 
$
11.29

 
8.0
 
$
431,568

Options exercisable—April 30, 2013
6,520

 
$
6.93

 
7.5
 
$
307,548

 
 
RSUs Outstanding  
 
Number
of
Shares
 
Weighted-
Average
Grant-Date Fair Value Per Share
 
Weighted-
Average
Remaining
Contractual
Term (Years)
 
Aggregate
Intrinsic
Value
Balance—July 31, 2012

 
$

 
0.0
 
$

RSUs granted
1,866

 
56.09

 
 
 
 
RSUs vested
(3
)
 
49.25

 
 
 
 
RSUs forfeited
(65
)
 
57.20

 
 
 
 
Balance—April 30, 2013
1,798

 
$
56.06

 
1.6
 
$
97,272

RSUs vested and expected to vest—April 30, 2013
1,600

 
$
56.08

 
1.6
 
$
86,560


The following table summarizes the assumptions relating to our stock options:
 
 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2013
 
2012
 
2013
 
2012
Risk-free interest rate
N/A
 
1.1%
 
1.0%
 
0.7% - 1.1%
Expected term
N/A
 
6 years
 
6 years
 
4 - 6 years
Volatility
N/A
 
49%
 
50%
 
49% - 50%
Dividend yield
N/A
 
—%
 
—%
 
—%
 
During the three and nine month periods ended April 30, 2013, compensation expense recognized in connection with the 2012 Employee Stock Purchase Plan (2012 ESPP) was $1,132,000 and $3,943,000, respectively. The following table summarizes the assumptions related to the 2012 ESPP:

 
Three Months Ended April 30, 2013
 
Nine Months Ended April 30, 2013
Risk-free interest rate
0.1%
 
0.1%
Expected term
< 1 year
 
< 1 year
Volatility
41%
 
41%
Dividend yield
—%
 
—%

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Share-based compensation expense is included in costs and expenses as follows (in thousands):
 
 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2013
 
2012
 
2013
 
2012
Cost of revenue
$
1,364

 
$
185

 
$
2,799

 
$
433

Research and development
3,024

 
1,452

 
6,687

 
2,217

Sales and marketing
5,686

 
942

 
13,919

 
2,049

General and administrative
2,560

 
1,295

 
6,325

 
2,674

Total
$
12,634

 
$
3,874

 
$
29,730

 
$
7,373


At April 30, 2013, total compensation cost related to unvested share-based awards granted to employees under our stock plans but not yet recognized was $127,075,000, net of estimated forfeitures. This cost is expected to be amortized on a straight-line basis over a weighted-average period of three years. Future grants will increase the amount of compensation expense to be recorded in these periods.

For the first quarter of fiscal 2013, we modified the terms of certain share-based awards and as a result, in the three and nine month periods ended April 30, 2013, we recorded compensation expense within sales and marketing expense of nil and $1,861,000, respectively.

For the third quarter of fiscal 2012, we modified the terms of certain share-based awards and as a result, in the three and nine month periods ended April 30, 2012, we recorded compensation expense within research and development expense of $854,000.

7. Income Taxes
 
Our provision for income taxes for the three and nine month periods ended April 30, 2013 reflects an effective tax rate of negative 12% and negative 14%, respectively, and consists of foreign income and withholding taxes.

Our benefit for income taxes for the three month period ended April 30, 2012 consisted of U.S. federal alternative minimum tax, state taxes, and foreign taxes on our consolidated income before income taxes. Our domestic income before income taxes is subject to limited U.S. federal tax at the U.S. federal alternative minimum income tax rate and limited state tax due to our net operating loss carryforwards and other tax attributes. We experienced better than expected income before income taxes for the three month period ended April 30, 2012. This resulted in an increase in forecasted annual profit before tax without a proportional increase in forecasted annual tax expense and therefore reduced the estimated annual effective tax rate. This reduced estimated annual tax rate applied to our results for the year to date period yielded an overall reduction in our year to date income tax expense. As such, an income tax benefit was recorded during the period.

Our provision for income taxes for the nine month period ended April 30, 2012 reflected an effective tax rate of 25% and consisted of U.S. federal alternative minimum tax, state taxes, and foreign taxes on our consolidated income before income taxes.

8. Net Income (Loss) Per Share
 
We compute net income (loss) per share of common stock using the two-class method required for participating securities. Immediately prior to the completion of our initial public offering on July 19, 2012, all shares of outstanding redeemable convertible preferred stock were automatically converted to common stock. Prior to their conversion, we considered all series of our redeemable convertible preferred stock to be participating securities as the holders were entitled to participate in common stock dividends with common stock on an as-converted basis. The holders of our redeemable convertible preferred stock were also entitled to non-cumulative dividends prior and in preference to common stock and did not have a contractual obligation to share in the losses of the Company. Additionally, we consider shares issued upon the early exercise of options subject to repurchase and unvested restricted shares to be participating securities because holders of such shares have non-forfeitable dividend rights in the event of our declaration of a dividend for common shares. In accordance with the two-class method, earnings allocated to these participating securities, which

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include participation rights in undistributed earnings with common stock, are subtracted from net income to determine net income (loss) attributable to common stockholders.
 
Basic net income (loss) per common share is computed by dividing net income (loss) attributable to common stockholders by basic weighted-average shares outstanding during the period. All participating securities are excluded from basic weighted-average shares outstanding. In computing diluted net income (loss) attributable to common stockholders, undistributed earnings are re-allocated to reflect the potential impact of dilutive securities. Diluted net income (loss) per share attributable to common stockholders is computed by dividing net income (loss) attributable to common stockholders by diluted weighted-average shares outstanding, including potentially dilutive securities.
 
The following table presents the computation of basic and diluted net income (loss) per share of common stock (in thousands, except per share data):
 
 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2013
 
2012
 
2013
 
2012
Net income (loss) used to compute net income (loss) per share:
 
 
 
 
 
 
 
Net income (loss)
$
(7,282
)
 
$
796

 
$
(13,410
)
 
$
5,336

Less: undistributed earnings allocated to participating securities

 
(753
)
 

 
(5,296
)
Net income (loss) attributable to common stockholders, basic
$
(7,282
)
 
$
43

 
$
(13,410
)
 
$
40

Reallocation of income attributable to participating securities


 
10

 

 
9

Net income (loss) attributable to common stockholders, diluted

$
(7,282
)
 
$
53

 
$
(13,410
)
 
$
49

Weighted-average shares used to compute net income (loss) per share:
 
 
 
 
 
 
 
Weighted-average shares used to compute net income (loss) per share, basic

69,575

 
18,459

 
67,980

 
17,238

Weighted-average effect of potentially dilutive securities:

 
 
 
 
 
 
 
Employee stock options

 
6,429

 

 
5,782

Weighted-average shares used to compute net income (loss) per share, diluted

69,575

 
24,888

 
67,980

 
23,020

Net income (loss) per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
(0.10
)
 
$
0.00

 
$
(0.20
)
 
$
0.00

Diluted
$
(0.10
)
 
$
0.00

 
$
(0.20
)
 
$
0.00

 
The following outstanding options and RSUs were excluded from the computation of diluted net income (loss) per common share applicable to common stockholders for the periods presented as their effect would have been antidilutive (in thousands):
 
 
April 30, 2013
 
April 30, 2012
Options to purchase common stock
10,637

 
3,021

RSUs
1,798

 

Redeemable convertible preferred stock

 
41,305



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Table of Contents

ITEM 2.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. The following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding:

our ability to extend our leadership position in next-generation network security;
trends in revenue, cost of revenue, gross margin, cash flows, operating expenses, interest and other income, income taxes, investments and liquidity;
the sufficiency of our existing cash and investments to meet our cash needs for at least the next 12 months;
our expectations regarding a reduction in our overall effective tax rate as a result of the reorganization of our corporate structure
as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements generally can be identified by words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,” “will be,” “will continue,” “will likely result,” and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q, and in particular, the risks discussed under the caption “Risk Factors” in Part II, Item 1A of this report and those discussed in other documents we file with the Securities and Exchange Commission. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.
 
Overview
 
We have pioneered the next generation of network security with our innovative platform that allows enterprises, service providers, and government entities to secure their networks and safely enable the increasingly complex and rapidly growing number of applications running on their networks. The core of our platform is our Next-Generation Firewall, which delivers application, user, and content visibility and control integrated within the firewall through our proprietary hardware and software architecture. Our products and services can address a broad range of our end-customers’ network security requirements, from the data center to the network perimeter, as well as the distributed enterprise, which includes branch offices and a growing number of mobile devices.
 
We were founded in 2005 to address the limitations that exist in legacy approaches to network security and to restore the firewall as the most strategic point of network control. From 2005 to 2007, our activities were focused on research and development, which resulted in the commercial release of our first product, the PA-4000 Series, as well as our first subscription service, Threat Prevention, in 2007. Since then, we have continued to innovate and consistently introduce new products and services, including the PA-5000 Series and GlobalProtect subscription service in March 2011, the PA-200 and free WildFire modern malware detection subscription service in November 2011, and most recently, the VM-Series, PA-3000 Series, M-100 management appliance, and paid WildFire modern malware prevention subscription service in November 2012.
     
We derive revenue from sales of our products and services, which together comprise our platform. Product revenue is primarily generated from sales of our Next-Generation Firewall. All of our products incorporate our proprietary PAN-OS operating system, which provides a consistent set of capabilities across our entire product line. Our products are designed for different performance requirements throughout an organization, from branch offices to large data centers. Our platform can be centrally managed across an organization with our Panorama product. Services revenue includes sales from subscriptions and support and maintenance. Our Threat Prevention, URL Filtering, GlobalProtect, and WildFire subscriptions provide our end-customers with real-time access to the latest antivirus, intrusion prevention, web filtering, and modern malware prevention capabilities across fixed and mobile devices. When end-customers purchase a product, they typically purchase one or more of our subscriptions for additional functionality, as well as support and maintenance in order to receive ongoing security updates, upgrades, bug fixes, and repairs. Sales of these services increase our deferred revenue balance and contribute significantly to our positive cash flow provided by operating activities.
 
We maintain a field sales force that works closely with our channel partners in developing sales opportunities. We use a two-tier, indirect fulfillment model whereby we sell our products and services to our global distributor channel partners, which, in turn, sell our products and services to our reseller network, which then sell to our end-customers. Our channel partners purchase our products and services at a discount to our list prices before reselling them to our end-customers. Our channel partners generally receive an order from an end-customer prior to placing an order with us and generally do not stock appliances.

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We had more than 12,500 end-customers in over 100 countries as of April 30, 2013. Our end-customers represent a broad range of industries including education, energy, financial services, healthcare, Internet and media, manufacturing, public sector, and telecommunications. During the third quarter of fiscal 2013, 62% of our revenue was generated from the Americas, 23% from Europe, the Middle East, and Africa (EMEA), and 15% from Asia Pacific and Japan (APAC). As of April 30, 2013, we had 1,034 employees.
 
We have experienced rapid growth and increased demand for our products in recent periods. For the third quarter of fiscal 2013 and 2012, revenues were $101.3 million and $65.7 million, respectively, representing year-over-year growth of 54%, despite continued uncertainty in the macroeconomic environment, in particular, weakness in EMEA and a slowdown in spending by the U.S. Government. These macroeconomic factors may continue to impact overall spending in information technology (IT) by our customers, which could adversely affect our revenues and operating results.

We believe that the growth of our business and our short and long term success are dependent upon many factors, including our ability to extend our technology leadership, grow our base of end-customers, expand deployment of our platform within existing end-customers, and focus on end-customer satisfaction. While these areas present significant opportunities for us, they also pose challenges and risks that we must successfully address in order to sustain the growth of our business and improve our operating results.
 
To manage any future growth effectively, we must continue to improve and expand our information technology and financial infrastructure, our operating and administrative systems and controls, and our ability to manage headcount, capital, and processes in an efficient manner. Additionally, we face intense competition in our market, and to succeed, we need to innovate and offer products that are differentiated from existing infrastructure products, as well as effectively hire, retain, train, and motivate qualified personnel and senior management. If we are unable to successfully address these challenges, our business, operating results, and prospects could be adversely affected.

On July 25, 2012, we completed our initial public offering (IPO), in which 7,130,000 shares of our common stock were sold to the public (inclusive of 5,617,000 shares of common stock sold by us). The public offering price of the shares sold in the IPO was $42.00 per share. After deducting underwriting discounts and commissions, offering expenses payable by us, and net proceeds received by the selling stockholders, the aggregate net proceeds received by us totaled approximately $215.4 million. 

On October 23, 2012, we completed our secondary offering, in which certain stockholders sold an aggregate of 4,800,000 shares of our common stock at a public offering price of $63.00 per share. The aggregate offering price for shares sold in the offering was approximately $290.3 million, net of underwriting discounts and commissions. We did not receive any proceeds from the sale of shares in this secondary offering. Offering expenses were paid by the stockholders who sold shares of common stock in the offering.
 
Key Financial Metrics
 
We monitor the key financial metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts, and assess operational efficiencies. We discuss revenue, gross margin, and the components of operating income (loss) and margin below under “—Financial Overview” and “—Results of Operations.” Deferred revenue, cash flow provided by operating activities, and free cash flow are discussed immediately below the following table.

 
April 30, 2013
 
July 31, 2012
 
(in thousands)
Total deferred revenue
$
219,304

 
$
135,808


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Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2013
 
2012
 
2013
 
2012
 
(dollars in thousands)
Total revenue
$
101,289

 
$
65,700

 
$
283,722

 
$
179,496

Year-over-year percentage increase
54.2
 %
 
110.9
 %
 
58.1
 %
 
129.0
%
Gross margin percentage
72.7
 %
 
71.6
 %
 
72.0
 %
 
72.7
%
Operating income (loss)
$
(6,450
)
 
$
(41
)
 
$
(11,738
)
 
$
8,135

Operating margin percentage
(6.4
)%
 
(0.1
)%
 
(4.1
)%
 
4.5
%
Cash flow provided by operating activities
 
 
 
 
$
72,789

 
$
58,478

Free cash flow (non-GAAP)
 
 
 
 
$
56,194

 
$
47,197

 
Deferred Revenue. Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue as of the period end. The majority of our deferred revenue balance consists of subscription and support and maintenance revenue that is recognized ratably over the contractual service period. We monitor our deferred revenue balance because it represents a significant portion of revenue to be recognized in future periods.
 
Cash Flow Provided by Operating Activities. We monitor cash flow provided by operating activities as a measure of our overall business performance. Our cash flow provided by operating activities is driven in large part by sales of our products and from up-front payments for both subscriptions and support and maintenance. Monitoring cash flow provided by operating activities enables us to analyze our financial performance without the non-cash effects of certain items such as depreciation, amortization, and share-based compensation costs, thereby allowing us to better understand and manage the cash needs of our business.
 
Free Cash Flow. We define free cash flow, a non-GAAP financial measure, as cash provided by operating activities less purchases of property, equipment, and other assets. We consider free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after the purchases of property, equipment, and other assets, can be used for strategic opportunities, including investing in our business, making strategic acquisitions, and strengthening the balance sheet.

 
Nine Months Ended April 30,
 
2013
 
2012
 
(in thousands)
Cash Flow:
 
 
 
Cash flow provided by operating activities
$
72,789

 
$
58,478

Less: purchase of property, equipment, and other assets
16,595

 
11,281

Free cash flow (non-GAAP)
$
56,194

 
$
47,197

Net cash used in investing activities
$
(196,637
)
 
$
(11,281
)
Net cash provided by financing activities
$
14,870

 
$
2,569

 
Financial Overview
 
Revenue
 
We derive revenue from sales of our products and services. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured.
 
Our total revenue is comprised of the following:
 
Product Revenue. The substantial majority of our product revenue is derived from sales of our appliances. Product revenue also includes revenue derived from software licenses of Panorama and Virtual Systems Upgrades. We recognize product revenue at the time of shipment, provided that all other revenue recognition criteria have been met. As a percentage of total revenue, we expect our product revenue to vary from quarter-to-quarter based on seasonal and cyclical factors.

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Services Revenue. Services revenue is derived primarily from Threat Prevention, URL Filtering, GlobalProtect, and WildFire subscriptions and support and maintenance. Our subscriptions are priced as a percentage of the appliance’s list price. Our contractual subscription and support and maintenance terms are typically one to three years. We recognize revenue from subscriptions and support and maintenance over the contractual service period. As a percentage of total revenue, we expect our services revenue to remain at consistent levels or increase over the long term as we introduce new subscriptions, renew existing services contracts, and expand our end-customer base.
 
Cost of Revenue
 
Our total cost of revenue consists of cost of product revenue and cost of services revenue. Our cost of revenue includes personnel costs, which consist of salaries, bonuses, and share-based compensation associated with our operations and global customer support organizations. Our cost of revenue also includes allocated costs, which consist of certain facilities, depreciation, benefits, recruiting, and information technology costs that we allocate based on headcount.
 
Cost of Product Revenue. Cost of product revenue primarily includes costs paid to our third-party contract manufacturer. Our cost of product revenue also includes product testing costs, allocated costs, warranty costs, shipping costs, and personnel costs associated with logistics and quality control. We expect our cost of product revenue to increase as our product revenue increases.
 
Cost of Services Revenue. Cost of services revenue includes personnel costs for our global customer support organization, allocated costs, and URL filtering database service fees. We expect our cost of services revenue to increase as our end-customer base grows.
 
Gross Margin
 
Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including the average sales price of our products, manufacturing costs, the mix of products sold, and the mix of revenue between products and services. For sales of our products, our higher throughput firewall products generally have higher gross margins than our lower throughput firewall products within each product series. For sales of our services, our subscriptions typically have higher gross margins than our support and maintenance. We expect our gross margins to fluctuate over time depending on the factors described above.
 
Operating Expenses
 
Our operating expenses consist of research and development, sales and marketing, and general and administrative expense. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, share-based compensation, and with regard to sales and marketing expense, sales commissions. We expect operating expenses to increase in absolute dollars, although they may fluctuate as a percentage of revenue from period to period, as we continue to grow in response to demand for our products and services. As of April 30, 2013, we expect to recognize approximately $127.1 million of share-based compensation expense over a weighted-average period of three years, excluding additional share-based compensation expense related to any future grants of share-based awards. Share-based compensation expense, net of forfeitures, is recognized on a straight-line basis over the requisite service periods of the awards.
 
Research and Development. Research and development expense consists primarily of personnel costs. Research and development expense also includes prototype related expenses and allocated costs. We expect research and development expense to increase in absolute dollars as we continue to invest in our future products and services, although our research and development expense may fluctuate as a percentage of total revenue.
 
Sales and Marketing. Sales and marketing expense consists primarily of personnel costs including commission costs. We expense commission costs as incurred. Sales and marketing expense also includes costs for market development programs, promotional and other marketing costs, travel costs, office equipment and software, depreciation of capital equipment, professional services, and allocated costs. In the last 12 months, we have significantly increased the size of our sales force and have also substantially grown our local sales presence internationally. We expect sales and marketing expense to continue to increase in absolute dollars as we increase the size of our sales and marketing organizations to increase touch points with end-customers and to expand our international presence, although our sales and marketing expense may fluctuate as a percentage of total revenue.
 
General and Administrative. General and administrative expense consists of personnel costs as well as professional services. General and administrative personnel include our executive, finance, human resources, and legal organizations. Professional services consist primarily of legal, auditing, accounting, and other consulting costs. We

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expect general and administrative expense to increase in absolute dollars due to additional legal costs, and additional costs associated with accounting, compliance, insurance, investor relations, and other costs associated with being a public company, although our general and administrative expense may fluctuate as a percentage of total revenue. Refer to the discussion under “Legal Proceedings” included in Part II, Item 1 of this Quarterly Report on Form 10-Q for information related to pending litigation.
 
Interest Income
 
Interest income consists of income earned on our cash and cash equivalents and investments. We expect interest income will increase as we grow our cash and investments portfolio depending on our average investment balances during the period, types and mix of investments, and market interest rates.
 
Other Income (Expense), Net
 
Other income (expense), net consists primarily of the change in the fair value of our convertible preferred stock warrant liability, foreign currency re-measurement gains and losses, and foreign currency transaction gains and losses. Convertible preferred stock warrants were classified as a liability on our condensed consolidated balance sheets and remeasured to fair value at each balance sheet date with the corresponding change recorded as other expense. These warrants were exercised during the second quarter of fiscal 2012, and therefore, we will no longer incur any charges related to these warrants. We expect other expense to fluctuate depending on foreign exchange rate movements.
 
Provision for Income Taxes
 
Provision for income taxes consists primarily of federal and state income taxes in the United States, income taxes in foreign jurisdictions in which we conduct business, and foreign withholding taxes. We maintain a full valuation allowance for domestic deferred tax assets, including net operating loss carryforwards and research and development and other tax credits. We expect the provision for income taxes to increase in absolute dollars in future years.
 
We have reorganized our corporate structure and intercompany relationships to more closely align with the international nature of our business activities. This corporate structure may cause volatility to our overall effective tax rate in the short term but is expected to reduce our overall effective tax rate over the long term through changes in international procurement and sales operations.

Results of Operations

The following tables summarize our results of operations for the periods presented and as a percentage of our total revenue for those periods. The period to period comparison of results is not necessarily indicative of results for future periods.

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Table of Contents

 
 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
Condensed Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
Revenue:
 
 
 
 
 
 
 
Product
$
60,793

 
$
43,524

 
$
178,251

 
$
125,023

Services
40,496

 
22,176

 
105,471

 
54,473

Total revenue
101,289

 
65,700

 
283,722

 
179,496

Cost of revenue:
 
 
 
 
 
 
 
Product
15,855

 
11,524

 
46,907

 
32,082

Services
11,835

 
7,109

 
32,591

 
16,904

Total cost of revenue
27,690

 
18,633

 
79,498

 
48,986

Total gross profit
73,599

 
47,067

 
204,224

 
130,510

Operating expenses:
 
 
 
 
 
 
 
Research and development
16,048

 
10,462

 
44,855

 
26,824

Sales and marketing
51,733

 
30,216

 
140,136

 
78,196

General and administrative
12,268

 
6,430

 
30,971

 
17,355

Total operating expenses
80,049

 
47,108

 
215,962

 
122,375

Operating income (loss)
(6,450
)
 
(41
)
 
(11,738
)
 
8,135

Interest income
133

 
3

 
347

 
7

Other income (expense), net
(157
)
 
(3
)
 
(387
)
 
(1,033
)
Income (loss) before income taxes
(6,474
)
 
(41
)
 
(11,778
)
 
7,109

Provision (benefit) for income taxes
808

 
(837
)
 
1,632

 
1,773

Net income (loss)
$
(7,282
)
 
$
796

 
$
(13,410
)
 
$
5,336

 

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Table of Contents


 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2013
 
2012
 
2013
 
2012
 
(as a percentage of revenue)
Condensed Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
Revenue:
 
 
 
 
 
 
 
Product
60.0
 %
 
66.2
 %
 
62.8
 %
 
69.7
 %
Services
40.0
 %
 
33.8
 %
 
37.2
 %
 
30.3
 %
Total revenue
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Cost of revenue:
 
 
 
 
 
 
 
Product
15.7
 %
 
17.5
 %
 
16.5
 %
 
17.9
 %
Services
11.6
 %
 
10.9
 %
 
11.5
 %
 
9.4
 %
Total cost of revenue
27.3
 %
 
28.4
 %
 
28.0
 %
 
27.3
 %
Total gross profit
72.7
 %
 
71.6
 %
 
72.0
 %
 
72.7
 %
Operating expenses:
 
 
 
 
 
 
 
Research and development
15.8
 %
 
15.9
 %
 
15.8
 %
 
14.9
 %
Sales and marketing
51.1
 %
 
46.0
 %
 
49.4
 %
 
43.6
 %
General and administrative
12.2
 %
 
9.8
 %
 
10.9
 %
 
9.7
 %
Total operating expenses
79.1
 %
 
71.7
 %
 
76.1
 %
 
68.2
 %
Operating income (loss)
(6.4
)%
 
(0.1
)%
 
(4.1
)%
 
4.5
 %
Interest income
0.1
 %
 
 %
 
0.1
 %
 
 %
Other income (expense), net
(0.2
)%
 
 %
 
(0.1
)%
 
(0.6
)%
Income (loss) before income taxes
(6.5
)%
 
(0.1
)%
 
(4.1
)%
 
3.9
 %
Provision for income taxes
0.8
 %
 
(1.3
)%
 
0.6
 %
 
1.0
 %
Net income (loss)
(7.3
)%
 
1.2
 %
 
(4.7
)%
 
2.9
 %
 
 
Comparison of the Three and Nine Month Periods Ended April 30, 2013 and 2012
 
Revenue
 
 
Three Months Ended April 30,
 
 
 
 
 
Nine Months Ended April 30,
 
 
 
 
 
2013
 
2012
 
Change
 
2013
 
2012
 
Change
 
Amount
 
Amount
 
Amount
 
%
 
Amount
 
Amount
 
Amount
 
%
 
(dollars in thousands)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
60,793

 
$
43,524

 
$
17,269

 
39.7
%
 
$
178,251

 
$
125,023

 
$
53,228

 
42.6
%
Services
40,496

 
22,176

 
18,320

 
82.6
%
 
105,471

 
54,473

 
50,998

 
93.6
%
Total revenue
$
101,289

 
$
65,700

 
$
35,589

 
54.2
%
 
$
283,722

 
$
179,496

 
$
104,226

 
58.1
%
Revenue by geographic theater:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Americas
$
63,233

 
$
41,331

 
$
21,902

 
53.0
%
 
$
178,169

 
$
111,883

 
$
66,286

 
59.2
%
EMEA
23,154

 
15,646

 
7,508

 
48.0
%
 
67,048

 
46,014

 
21,034

 
45.7
%
APAC
14,902

 
8,723

 
6,179

 
70.8
%
 
38,505

 
21,599

 
16,906

 
78.3
%
Total revenue
$
101,289

 
$
65,700

 
$
35,589

 
54.2
%
 
$
283,722

 
$
179,496

 
$
104,226

 
58.1
%
 

Product revenue increased $17.3 million, or 40%, for the three month period ended April 30, 2013 compared to the three month period ended April 30, 2012. The increase was driven by our newly introduced PA-3000 Series firewalls and M-100 management appliance.


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Product revenue increased $53.2 million, or 43%, for the nine month period ended April 30, 2013 compared to the nine month period ended April 30, 2012. Approximately half of the increase was driven by a greater than 50% increase in product unit volume attributable to sales of our PA-5000 Series and PA-200 firewalls. The remaining increase was driven by our newly introduced PA-3000 Series firewalls and M-100 management appliance.

Service revenue increased $18.3 million, or 83%, for the three month period ended April 30, 2013 compared to the three month period ended April 30, 2012. Approximately half of the increase was related to support and maintenance as a result of an increase in total end-customers to more than 12,500 at April 30, 2013 from more than 7,750 at April 30, 2012. The remaining increase was due to an increase in subscriptions. The relative increases in subscriptions and support and maintenance will fluctuate over time, depending on the mix of services revenue and the introduction of new services offerings.

Service revenue increased $51.0 million, or 94%, for the nine month period ended April 30, 2012 compared to the nine month period ended April 30, 2012. Approximately half of the increase was related to support and maintenance as a result of an increase in total end-customers. The remaining increase was due to an increase in subscriptions. 

With respect to geographic theaters, the Americas contributed the largest portion of the increase in revenue for the three and nine months periods ended April 30, 2013 due to its larger and more established sales force compared to our other theaters. Revenue from both EMEA and APAC increased during three and nine month periods ended April 30, 2013 due to our investment in increasing the size of our sales force and number of partners in these theaters.

Cost of Revenue and Gross Margin
 

 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2013
 
2012
 
2013
 
2012
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
(dollars in thousands)
Cost of revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
15,855

 
 
 
$
11,524

 
 
 
$
46,907

 
 
 
$
32,082

 
 
Services
11,835

 
 
 
7,109

 
 
 
32,591

 
 
 
16,904

 
 
Total cost of revenue
$
27,690

 
 
 
$
18,633

 
 
 
$
79,498

 
 
 
$
48,986

 
 
Gross profit:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
44,938

 
73.9
%
 
$
32,000

 
73.5
%
 
$
131,344

 
73.7
%
 
$
92,941

 
74.3
%
Services
28,661

 
70.8
%
 
15,067

 
67.9
%
 
72,880

 
69.1
%
 
37,569

 
69.0
%
Total gross profit
$
73,599

 
72.7
%
 
$
47,067

 
71.6
%
 
$
204,224

 
72.0
%
 
$
130,510

 
72.7
%

 Gross margin increased 110 basis points for the three month period ended April 30, 2013 compared to the three month period ended April 30, 2012. The increase of 40 basis points in product margin was due to decreases in manufacturing costs. The increase of 290 basis points in services margin was due to an increase in support and maintenance without a proportionate increase in our global customer service organization costs. The mix in services revenue was largely unchanged on a period-over-period basis.  Services gross margin will fluctuate depending on the timing of the investment ramp of our global customer service organization.

Gross margin decreased 70 basis points for the nine month period ended April 30, 2013 compared to the nine month period ended April 30, 2012. The decrease of 60 basis points in product margin was due to an 80 basis point decrease as a result of the introduction of our PA-3000 Series firewalls and our M-100, which will have lower product margins until volume and related cost savings increase partially offset by decreases in manufacturing costs. The increase of 10 basis points in services margin was due to an increase in support and maintenance without a proportionate increase in our global customer service organization costs. The mix in services revenue was largely unchanged on a period-over-period basis.

 

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Operating Expenses
 
 
Three Months Ended April 30,
 
 
 
 
 
Nine Months Ended April 30,
 
 
 
 
 
2013
 
2012
 
Change
 
2013
 
2012
 
Change
 
Amount
 
Amount
 
Amount
 
%
 
Amount
 
Amount
 
Amount
 
%
 
(dollars in thousands)
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
$
16,048

 
$
10,462

 
$
5,586

 
53.4
%
 
$
44,855

 
$
26,824

 
$
18,031

 
67.2
%
Sales and marketing
51,733

 
30,216

 
21,517

 
71.2
%
 
140,136

 
78,196

 
61,940

 
79.2
%
General and administrative
12,268

 
6,430

 
5,838

 
90.8
%
 
30,971

 
17,355

 
13,616

 
78.5
%
Total operating expenses
$
80,049

 
$
47,108

 
$
32,941

 
69.9
%
 
$
215,962

 
$
122,375

 
$
93,587

 
76.5
%
Includes share-based compensation of:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
$
3,024

 
$
1,452

 
$
1,572

 
108.3
%
 
$
6,687

 
$
2,217

 
$
4,470

 
201.6
%
Sales and marketing
5,686

 
942

 
4,744

 
503.6
%
 
13,919

 
2,049

 
11,870

 
579.3
%
General and administrative
2,560

 
1,295

 
1,265

 
97.7
%
 
6,325

 
2,674

 
3,651

 
136.5
%
Total
$
11,270

 
$
3,689

 
$
7,581

 
205.5
%
 
$
26,931

 
$
6,940

 
$
19,991

 
288.1
%

 
Research and development expense increased $5.6 million, or 53%, for the three month period ended April 30, 2013 compared to the three month period ended April 30, 2012, due to an increase in personnel costs of $3.5 million related to increasing our headcount and share-based compensation, an increase in development costs of $0.9 million to support continued investment in our future product and service offerings, and an increase in allocated costs of $0.9 million.

Research and development expense increased $18.0 million, or 67%, for the nine month period ended April 30, 2013 compared to the nine month period ended April 30, 2012, due to an increase in personnel costs of $12.6 million related to increasing our headcount and share-based compensation, an increase in allocated costs of $2.5 million, and an increase in development costs of $2.0 million to support continued investment in our future product and service offerings.
 
Sales and marketing expense increased $21.5 million, or 71%, for the three month period ended April 30, 2013 compared to the three month period ended April 30, 2012, due to an increase in personnel costs of $15.5 million largely due to an increase in headcount, share-based compensation, and commission costs, an increase in allocated costs of $2.5 million, and an increase in travel and entertainment cost of $1.7 million.

Sales and marketing expense increased $61.9 million, or 79%, for the nine month period ended April 30, 2013 compared to the nine month period ended April 30, 2012, due to an increase in personnel costs of $41.2 million largely due to an increase in headcount, share-based compensation, and commission costs, an increase in allocated costs of $7.6 million, and an increase in marketing activity of $5.7 million related to demand generation activities, trade shows, and other marketing activities. The remaining increase was due to an increase in travel and entertainment costs of $3.8 million and office equipment and software costs of $2.1 million in support of our sales efforts.
 
General and administrative expense increased $5.8 million, or 91%, for the three month period ended April 30, 2013 compared to the three month period ended April 30, 2012, due to an increase in professional services costs of $3.2 million and an increase in personnel costs of $1.9 million related to overall growth to support the business and building our infrastructure to satisfy the increased regulatory requirements of being a public company.

General and administrative expense increased $13.6 million, or 78%, for the nine month period ended April 30, 2013 compared to the nine month period ended April 30, 2012 due to an increase in personnel costs of $6.2 million, an increase in professional services costs of $5.0 million, and an increase in allocated costs of $1.8 million related to overall growth to support the business and building our infrastructure to satisfy the increased regulatory requirements of being a public company.

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Provision for Income Taxes
 
 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2013
 
2012
 
2013
 
2012
 
(dollars in thousands)
Provision (benefit) for income taxes
$
808

 
$
(837
)
 
$
1,632

 
$
1,773

Effective tax rate
(12.5
)%
 
2,041.5
%
 
(13.9
)%
 
24.9
%

 We recorded an income tax provision for the three month period ended April 30, 2013 due to foreign income taxes and withholding taxes. The provision for income taxes increased for the three month period ended April 30, 2013 compared to the three month period ended April 30, 2012 due to an increase in foreign income taxes as a result of an increase in foreign taxable income and an increase in withholding taxes for the period compared to the net benefit for income taxes in the U.S. in the third quarter of fiscal 2012. This tax benefit for income taxes was recognized as a result of a decrease in the projected annual effective tax rate for fiscal 2012 due to better than expected pretax income results in the quarter and an increase in foreign income taxes.

We recorded an income tax provision for the nine month period ended April 30, 2013 due to foreign income taxes and withholding taxes. The provision for income taxes decreased for the nine month period ended April 30, 2013 compared to the nine month period ended April 30, 2012 due to a decrease in income before income taxes, partially offset by an increase in foreign income taxes as a result of an increase in foreign taxable income and an increase in withholding taxes.
 
Liquidity and Capital Resources
 
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