Edgar Filing: Palo Alto Networks Inc

PANW-10.31.2014-10Q (Q115)

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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 October 31, 2014


¨	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.)
4401 Great America Parkway 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	x	Accelerated filer	¨
Non-accelerated filer	¨ (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 November 17, 2014 was 80,545,942.

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TABLE OF CONTENTS




		Page
	PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets	3
	Condensed Consolidated Statements of Operations	4
	Condensed Consolidated Statements of Comprehensive Loss	5
	Condensed Consolidated Statements of Cash Flows	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	27
Item 4.	Controls and Procedures	27

	PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	28
Item 1A.	Risk Factors	28
Item 6.	Exhibits	50

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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)



	October 31, 2014			July 31, 2014
Assets
Current assets:
Cash and cash equivalents	$	543,747		$	653,812
Short-term investments	227,752			118,690
Accounts receivable, net of allowance for doubtful accounts of $983 and $471 at October 31, 2014 and July 31, 2014, respectively	116,224			135,518
Prepaid expenses and other current assets	45,844			50,306
Total current assets	933,567			958,326
Property and equipment, net	49,823			48,744
Long-term investments	289,011			201,880
Goodwill	155,033			155,033
Intangible assets, net	47,451			47,955
Other assets	65,471			66,528
Total assets	$	1,540,356		$	1,478,466
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	10,497		$	14,526
Accrued compensation	35,935			48,727
Accrued and other liabilities	27,852			25,000
Deferred revenue	286,682			259,918
Total current liabilities	360,966			348,171
Convertible senior notes, net	471,856			466,875
Long-term deferred revenue	184,038			162,660
Other long-term liabilities	30,285			32,177
Commitments and contingencies (Note 6)
Stockholders’ equity:
Preferred stock; $0.0001 par value; 100,000 shares authorized; none issued and outstanding at October 31, 2014 and July 31, 2014	—			—
Common stock; $0.0001 par value; 1,000,000 shares authorized; 80,518 and 79,519 shares issued and outstanding at October 31, 2014 and July 31, 2014, respectively	8			8
Additional paid-in capital	859,010			804,406
Accumulated other comprehensive loss	(13		)	(105		)
Accumulated deficit	(365,794		)	(335,726		)
Total stockholders’ equity	493,211			468,583
Total liabilities and stockholders’ equity	$	1,540,356		$	1,478,466

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
	October 31,
	2014			2013
Revenue:
Product	$	101,476		$	75,485
Services	90,870			52,695
Total revenue	192,346			128,180
Cost of revenue:
Product	29,141			17,954
Services	24,320			15,853
Total cost of revenue	53,461			33,807
Total gross profit	138,885			94,373
Operating expenses:
Research and development	37,305			19,893
Sales and marketing	106,366			67,366
General and administrative	18,977			14,125
Total operating expenses	162,648			101,384
Operating loss	(23,763		)	(7,011		)
Interest expense	(5,489		)	(8		)
Other income, net	341			405
Loss before income taxes	(28,911		)	(6,614		)
Provision for income taxes	1,157			1,247
Net loss	$	(30,068	)	$	(7,861	)
Net loss per share, basic and diluted	$	(0.38	)	$	(0.11	)
Weighted-average shares used to compute net loss per share, basic and diluted	79,388			71,681

See notes to condensed consolidated financial statements.

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PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(Unaudited, in thousands)



	Three Months Ended
	October 31,
	2014			2013
Net loss	$	(30,068	)	$	(7,861	)
Other comprehensive gain, net of tax:
Change in unrealized gains (losses) on investments	92			21
Comprehensive loss	$	(29,976	)	$	(7,840	)

See notes to condensed consolidated financial statements.

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PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)



	Three Months Ended
	October 31,
	2014			2013
Cash flows from operating activities
Net loss	$	(30,068	)	$	(7,861	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Share-based compensation for equity based awards	38,443			14,383
Depreciation and amortization	6,115			3,146
Amortization of investment premiums, net of accretion of purchase discounts	667			386
Amortization of debt discount and debt issuance costs	5,478			—
Excess tax benefit from share-based compensation	(346		)	(56		)
Changes in operating assets and liabilities:
Accounts receivable, net	19,294			(3,978		)
Prepaid expenses and other assets	3,409			(1,707		)
Accounts payable	(4,460		)	(205		)
Accrued compensation	(12,792		)	1,614
Accrued and other liabilities	1,046			3,433
Deferred revenue	48,142			29,726
Net cash provided by operating activities	74,928			38,881
Cash flows from investing activities
Purchase of investments	(247,849		)	(122,238		)
Proceeds from sales of investments	1,999			—
Proceeds from maturities of investments	50,692			43,959
Purchase of property, equipment, and other assets	(5,935		)	(15,680		)
Net cash used in investing activities	(201,093		)	(93,959		)
Cash flows from financing activities
Proceeds from exercise of stock options	7,963			4,610
Proceeds from employee stock purchase plan	7,791			5,988
Excess tax benefit from share-based compensation	346			56
Repurchase of restricted common stock from terminated employees	—			(8		)
Net cash provided by financing activities	16,100			10,646
Net decrease in cash and cash equivalents	(110,065		)	(44,432		)
Cash and cash equivalents—beginning of period	653,812			310,614
Cash and cash equivalents—end of period	$	543,747		$	266,182

See notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(all dollar and share amounts rounded to the nearest thousand, except per share data)

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 enterprise security platform that allows enterprises, service providers, and government entities to simultaneously empower and secure their organizations by safely enabling the increasingly complex and rapidly growing number of applications running on their networks and by preventing breaches stemming from targeted cyber attacks.

Our enterprise security platform consists of three major elements: our Next-Generation Firewall, our Advanced Endpoint Protection, and our Threat Intelligence Cloud. Our Next-Generation Firewall delivers application, user, and content visibility and control as well as protection against network-based cyber threats integrated within the firewall through our proprietary hardware and software architecture. Our Advanced Endpoint Protection prevents cyber attacks that aim to exploit software vulnerabilities on a broad variety of fixed and virtual endpoints. Our Threat Intelligence Cloud provides central intelligence capabilities as well as automated delivery of preventative measures against cyber attacks. The cloud-based element of our platform is delivered in the form of a service that can be used either in the public cloud or in a private cloud using a dedicated appliance.

We primarily sell our products and services to end-customers through our channel 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).

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, 2014. The condensed consolidated financial statements include all adjustments necessary for a fair presentation of our quarterly results. All adjustments are of a normal recurring nature. 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. Certain prior period amounts have been reclassified to conform with current period presentation.

Principles of Consolidation

The condensed consolidated financial statements include our accounts and our 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 of and for the three months ended October 31, 2014, as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended July 31, 2014.

Recent Accounting Pronouncements

In August 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40)-Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. The standard provides guidance about management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures. The standard is effective for fiscal years ending after December 15, 2016, and for interim periods thereafter. Early adoption is permitted. We will adopt the new standard in our fiscal year ending 2017. The adoption of this standard is not expected to have a material impact on our condensed consolidated financial statements.

In May 2014, the FASB issued ASU No. 2014-09 regarding Accounting Standards Codification (ASC) Topic 606-Revenue from Contracts with Customers. The standard provides principles for recognizing revenue for the transfer of promised goods or services to customers with the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance is effective for us in the first quarter of fiscal 2018 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within the guidance; or (ii) retrospective with the cumulative effect of initially applying the guidance recognized at the date of initial application and providing certain additional disclosures as defined per

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the guidance. Early adoption is not permitted. We are currently evaluating adoption methods and whether this standard will have a material impact on our condensed consolidated financial statements.

In July 2013, the FASB issued ASU No. 2013-11, Income Taxes (Topic 740)-Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The standard requires us to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss (NOL) carryforward or other tax credit carryforward when settlement in this manner is available under applicable tax law. The guidance was effective for us in the first quarter of fiscal 2015. Our adoption of this guidance did not have any impact on our condensed consolidated financial statements.

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.

The following table presents the fair value of our financial assets and liabilities using the above input categories as of October 31, 2014 and July 31, 2014 (in thousands):



	October 31, 2014								July 31, 2014
	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Short-term investments:
Corporate debt securities	$	—	$	39,297	$	—	$	39,297	$	—	$	22,239	$	—	$	22,239
U.S. government and agency securities	—		188,455		—		188,455		—		96,451		—		96,451
Total short-term investments	—		227,752		—		227,752		—		118,690		—		118,690
Long-term investments:
Certificates of deposit	—		1,000		—		1,000		—		1,000		—		1,000
Corporate debt securities	—		63,433		—		63,433		—		39,018		—		39,018
U.S. government and agency securities	—		224,578		—		224,578		—		161,862		—		161,862
Total long-term investments	—		289,011		—		289,011		—		201,880		—		201,880
Other assets:
Restricted cash	1,220		—		—		1,220		1,220		—		—		1,220
Total other assets	1,220		—		—		1,220		1,220		—		—		1,220
Total assets measured at fair value	$	1,220	$	516,763	$	—	$	517,983	$	1,220	$	320,570	$	—	$	321,790

Refer to Note 5. Convertible Senior Notes for the carrying amount and estimated fair value of our convertible senior notes, which were not recorded at fair value as of October 31, 2014.

3. Investments

The following tables summarize the unrealized gains and losses and fair value of our investments as of October 31, 2014 and July 31, 2014 (in thousands):

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	October 31, 2014
	Amortized Cost		Unrealized Gains		Unrealized Losses			Estimated Fair Value
Certificates of deposit	$	1,000	$	—	$	—		$	1,000
Corporate debt securities	102,797		18		(85		)	102,730
U.S. government and agency securities	412,980		172		(119		)	413,033
Total	$	516,777	$	190	$	(204	)	$	516,763



	July 31, 2014
	Amortized Cost		Unrealized Gains		Unrealized Losses			Estimated Fair Value
Certificates of deposit	$	1,000	$	—	$	—		$	1,000
Corporate debt securities	61,299		16		(58		)	61,257
U.S. government and agency securities	258,376		45		(108		)	258,313
Total	$	320,675	$	61	$	(166	)	$	320,570

The following tables present our investments that were in an unrealized loss position as of October 31, 2014 and July 31, 2014 (in thousands):



	October 31, 2014
	Less Than 12 Months					12 Months or Greater				Total
	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
Corporate debt securities	$	72,352	$	(85	)	$	—	$	—	$	72,352	$	(85	)
U.S. government and agency securities	185,151		(119		)	—		—		185,151		(119		)
Total	$	257,503	$	(204	)	$	—	$	—	$	257,503	$	(204	)



	July 31, 2014
	Less Than 12 Months					12 Months or Greater				Total
	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
Corporate debt securities	$	43,868	$	(58	)	$	—	$	—	$	43,868	$	(58	)
U.S. government and agency securities	142,490		(108		)	—		—		142,490		(108		)
Total	$	186,358	$	(166	)	$	—	$	—	$	186,358	$	(166	)

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 October 31, 2014.

The following table summarizes the amortized cost and fair value of our investments as of October 31, 2014, by contractual years-to-maturity (in thousands):



	Amortized Cost		Fair Value
Due within one year	$	227,738	$	227,752
Due within one to two years	287,530		287,506
Due within two to three years	1,509		1,505
Total	$	516,777	$	516,763

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4. Intangible Assets

The following table presents details of our purchased intangible assets as of October 31, 2014 and July 31, 2014 (in thousands):



	October 31, 2014							July 31, 2014
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Intangible assets with finite lives:
Developed technology	$	42,100	$	(2,965	)	$	39,135	$	34,500	$	(1,643	)	$	32,857
Acquired intellectual property	7,796		(1,169		)	6,627		6,546		(958		)	5,588
In-process research and development held for defensive purposes	1,900		(528		)	1,372		1,900		(370		)	1,530
Other	500		(183		)	317		500		(120		)	380
Total intangible assets with finite lives	52,296		(4,845		)	47,451		43,446		(3,091		)	40,355
In-process research and development with indefinite lives	—		—			—		7,600		—			7,600
Total purchased intangible assets	$	52,296	$	(4,845	)	$	47,451	$	51,046	$	(3,091	)	$	47,955

We recognized amortization expense of $1,754,000 and $155,000 for the three months ended October 31, 2014 and 2013, respectively. Our in-process research and development acquired from Cyvera Ltd. in April 2014 was transferred to developed technology during the three months ended October 31, 2014 and is being amortized over its estimated useful life of seven years.

The following table summarizes our estimated future amortization expense of intangible assets with finite lives by type as of October 31, 2014 (in thousands):



	Fiscal Years Ending July 31,
	Remaining 2015		2016		2017		2018		2019		2020 and Thereafter
Developed technology	$	4,511	$	6,014	$	6,014	$	6,014	$	6,014	$	10,568
Acquired intellectual property	644		816		722		596		511		3,338
In-process research and development held for defensive purposes	475		633		264		—		—		—
Other	187		130		—		—		—		—
Total future amortization expense	$	5,817	$	7,593	$	7,000	$	6,610	$	6,525	$	13,906

5. Convertible Senior Notes

Convertible Senior Notes

On June 30, 2014, we issued $575,000,000 aggregate principal amount of 0.0% convertible senior notes due 2019 (the “Notes”). The Notes are governed by an indenture between us, as the issuer, and U.S. Bank National Association, as Trustee. The Notes are unsecured, unsubordinated obligations that do not contain any financial covenants or restrictions on the payments of dividends, the incurrence of indebtedness, or the issuance or repurchase of securities by us or any of our subsidiaries. The Notes mature on July 1, 2019 unless converted or repurchased in accordance with their terms prior to such date. We cannot redeem the Notes prior to maturity.

The Notes are convertible for up to 5,214,000 shares of our common stock at an initial conversion rate of approximately 9.068 shares of common stock per $1,000 principal amount, which is equal to an initial conversion price of approximately $110.28 per share of common stock, subject to adjustment. Holders of the Notes may surrender their Notes for conversion at their option at any time prior to the close of business on the business day immediately preceding January 1, 2019, only under the following circumstances, none of which have occurred to date:

•

during any fiscal quarter commencing after the fiscal quarter ending on October 31, 2014 (and only during such fiscal quarter), if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is greater than or equal to 130% of the conversion price for the Notes on each applicable trading day;

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•	during the five business day period after any five consecutive trading day period (the “measurement period”), in which the trading price per $1,000 principal amount of Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate for the Notes on each such trading day; or


•	upon the occurrence of specified corporate events.

On or after January 1, 2019, holders may convert all or any portion of their Notes at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date regardless of the foregoing conditions. Upon conversion, holders will receive cash equal to the aggregate principal amount of the Notes to be converted, and, at our election, cash and/or shares of our common stock for any amounts in excess of the aggregate principal amount of the Notes being converted.

The conversion price will be subject to adjustment in some events. Holders of the Notes who convert their Notes in connection with certain corporate events that constitute a “make-whole fundamental change” per the Indenture governing the Notes are, under certain circumstances, entitled to an increase in the conversion rate. Additionally, upon the occurrence of a corporate event that constitutes a “fundamental change” per the Indenture governing the Notes, holders of the Notes may require us to repurchase for cash all or a portion of the Notes at a purchase price equal to 100% of the principal amount of the Notes plus accrued and unpaid contingent interest.

In accounting for the issuance of the Notes, we separated the Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the par value of the Notes as a whole. The difference between the principal amount of the Notes and the liability component (the “debt discount”), is amortized to interest expense using the effective interest method over the term of the Notes. The equity component of the Notes is included in additional paid-in capital in the condensed consolidated balance sheets and is not remeasured as long as it continues to meet the conditions for equity classification.

In accounting for the transaction costs related to the issuance of the Notes, we allocated the total amount incurred to the liability and equity components using the same proportions as the proceeds from the Notes. Transaction costs attributable to the liability component were recorded in other assets in the condensed consolidated balance sheets and are being amortized to interest expense in the condensed consolidated statements of operations using the effective interest method over the term of the Notes. Transaction costs attributable to the equity component were netted with the equity component of the Notes in additional paid-in capital in the condensed consolidated balance sheets. We recorded liability issuance costs, or debt issuance costs, of $12,497,000 and equity issuance costs of $2,949,000.

The following table sets forth the components of the Notes as of October 31, 2014 and July 31, 2014 (in thousands):



	October 31, 2014			July 31, 2014
Liability:
Principal	$	575,000		$	575,000
Less: debt discount, net of amortization	103,144			108,125
Net carrying amount	$	471,856		$	466,875

Equity	$	(109,785	)	$	(109,785	)

The total estimated fair value of the Notes was $677,856,000 and $587,087,000 at October 31, 2014 and July 31, 2014, respectively. The fair value was determined based on the closing trading price per $100 of the Notes as of the last day of trading for the period. We consider the fair value of the Notes at October 31, 2014 and July 31, 2014 to be a Level 2 measurement. The fair value of the Notes is primarily affected by the trading price of our common stock and market interest rates. Based on the closing price of our common stock of $105.70 on October 31, 2014, the if-converted value of the Notes was less than its principal amount.

The following table sets forth interest expense recognized related to the Notes for the three months ended October 31, 2014 (dollars in thousands):



	Amount
Amortization of debt issuance costs	$	497
Amortization of debt discount	4,981
Total interest expense recognized	$	5,478

Effective interest rate of the liability component	4.8		%

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Note Hedges

To minimize the impact of potential economic dilution upon conversion of the Notes, we entered into convertible note hedge transactions (the “Note Hedges”) with respect to our common stock concurrent with the issuance of the Notes. The Note Hedges cover up to 5,214,000 shares of our common stock at a strike price per share that corresponds to the initial conversion price of the Notes, which are also subject to adjustment, and are exercisable upon conversion of the Notes. The Note Hedges will expire upon maturity of the Notes. The Note Hedges are separate transactions and are not part of the terms of the Notes. Holders of the Notes will not have any rights with respect to the Note Hedges. The shares receivable related to the Note Hedges are excluded from the calculation of diluted earnings per share as they are antidilutive.

We paid an aggregate amount of $110,975,000 for the Note Hedges, which is included in additional paid-in capital in the condensed consolidated balance sheets.

Warrants

Separately, but concurrently with our issuance of the Notes, we entered into warrant transactions (the “Warrants”) whereby we sold warrants to acquire up to 5,214,000 shares of our common stock at a strike price of approximately $137.85 per share, subject to adjustments. The shares issuable under the Warrants will be included in the calculation of diluted earnings per share when the average market value per share of our common stock for the reporting period exceeds the strike price of the Warrants. The Warrants are separate transactions and are not part of the Notes or Notes Hedges, and are not remeasured through earnings each reporting period. Holders of the Notes and Note Hedges will not have any rights with respect to the Warrants.

We received aggregate proceeds of $78,258,000 from the sale of the Warrants, which is included in additional paid-in capital in the condensed consolidated balance sheets.

6. Commitments and Contingencies

Leases

We lease our facilities under various non-cancelable operating leases, which expire through the year ending July 31, 2023.

The following table presents details of the aggregate future non-cancelable minimum rental payments on our operating leases as of October 31, 2014 (in thousands):



	Amount
Fiscal years ending July 31:
Remaining 2015	$	11,686
2016	15,629
2017	14,549
2018	12,016
2019	9,697
2020 and thereafter	42,603
Committed gross lease payments	106,180
Less: proceeds from sublease rental	10,282
Net operating lease obligation	$	95,898

Contract Manufacturer Commitments

Our independent contract manufacturer procures components and assembles our products based on our forecasts. These forecasts are based on estimates of demand for our products primarily for the next twelve months, which are in turn based on historical trends and an analysis from our sales and product marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate supply, we may issue forecasts and orders for components and products that are non-cancelable. Obligations under contracts that we can cancel without a significant penalty are not included. As of October 31, 2014, we had $39,018,000 of open orders.

Litigation

In December 2011, Juniper Networks, Inc. (“Juniper”) filed a complaint against us in the United States District Court for the District of Delaware alleging patent infringement, which sought preliminary and permanent injunctions against infringement, treble damages, and attorneys' fees. On September 30, 2013, we filed a lawsuit against Juniper in the United States District Court

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for the Northern District of California alleging that Juniper’s products infringe three of our U.S. patents, and sought monetary damages and a permanent injunction.

On May 27, 2014, we entered into a Settlement, Release and Cross-License Agreement (the “settlement agreement”) with Juniper to resolve all pending litigation between the parties, including those discussed above. Under the terms of the settlement agreement, we agreed to pay Juniper a one-time settlement amount of approximately $175,000,000, which was comprised of $75,000,000 in cash, 1,081,000 shares of our common stock with an approximate value of $70,000,000, and a warrant to purchase 463,000 shares of our common stock with an approximate value of $30,000,000, in exchange for the following:


•	Mutual dismissal with prejudice of all pending litigation between the parties and general release of all liability for Palo Alto Networks and Juniper,


•	Cross-license between both parties for the patents-in-suit and associated family members and counterparts worldwide for the life of the patents, and


•	Mutual covenant not to sue for infringement of any other patents for a period of eight years.

For accounting purposes, the fair value of the total consideration as of the settlement date was $182,473,000, which was comprised of $75,000,000 in cash, $75,231,000 in common stock, and $32,242,000 in warrant. The fair values of the common stock and warrant were measured using the closing price of our common stock on the settlement date.

The warrant was issued on June 3, 2014 and entitled Juniper to purchase up to 463,000 shares of common stock at an exercise price of $0.0001 per share and was classified as a liability during the period it was outstanding. On July 1, 2014, Juniper exercised the warrant in full. Accordingly, we recorded the change in the fair value of the warrant liability through the exercise date of $5,859,000 within other income (expense), net in the consolidated statement of operations for the year ended July 31, 2014.

We accounted for the settlement agreement as a multiple-element arrangement and allocated the fair value of the consideration as of the settlement date to the identifiable elements based on their estimated fair values. Of the total settlement amount, $61,300,000 was allocated to the licensing of intellectual property, $54,300,000 was allocated to the mutual dismissal of claims, and the remaining amount was allocated to the mutual covenant not to sue. The mutual dismissal of claims and the mutual covenant not to sue have no identifiable future benefit, and as a result we recorded a settlement charge within operating expenses in the consolidated statements of operations for the year ended July 31, 2014. The licensing of intellectual property is being amortized over the estimated period of benefit of five years.

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. As of October 31, 2014, we have not recorded any accrual for loss contingencies associated with such legal proceedings, determined that an unfavorable outcome is probable or reasonably possible, or determined that the amount or range of any possible loss is reasonably estimable.

7. Equity Award Plans

Stock Option Activities

A summary of the activity under our stock plans during the reporting period and a summary of information related to options exercisable, vested, and expected to vest are presented below (in thousands, except per share amounts):

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	Options Outstanding
	Number of Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value
Balance—July 31, 2014	5,830		$	13.02	7.0	$	395,507
Options granted	—		—
Options forfeited	(17	)	13.17
Options exercised	(618	)	12.86
Balance—October 31, 2014	5,195		$	13.04	6.8	$	481,369
Options vested and expected to vest—October 31, 2014	5,105		$	12.95	6.8	$	473,489
Options exercisable—October 31, 2014	3,247		$	10.63	6.6	$	308,692

Restricted Stock Unit (RSU) Activities

A summary of the activity under our stock plans during the reporting period and a summary of information related to RSUs vested and expected to vest are presented below (in thousands, except per share amounts):



	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, 2014	6,046		$	59.84	1.4	$	488,880
RSUs granted	511		92.61
RSUs vested	(265	)	50.88
RSUs forfeited	(99	)	59.39
Balance—October 31, 2014	6,193		$	62.93	1.3	$	654,600
RSUs vested and expected to vest—October 31, 2014	5,658		$	62.64	1.2	$	598,051

Share-Based Compensation

The following table summarizes share-based compensation included in costs and expenses (in thousands):



	Three Months Ended October 31,
	2014		2013
Cost of product revenue	$	749	$	250
Cost of services revenue	3,495		1,413
Research and development	13,999		3,262
Sales and marketing	15,799		6,628
General and administrative	4,433		2,858
Total	$	38,475	$	14,411

At October 31, 2014, total compensation cost related to unvested share-based awards not yet recognized was $327,189,000, net of estimated forfeitures. This cost is expected to be amortized on a straight-line basis over a weighted-average period of approximately three years. Future grants will increase the amount of compensation expense to be recorded in these periods.

8. Income Taxes

Our provision for income taxes for the three months ended October 31, 2014 reflects an effective tax rate of negative 4.0%. Our effective tax rate for this period was negative as we recorded a provision for income taxes on year to date losses. The key components of our income tax provision consist of foreign income, foreign withholding taxes, and limited US federal and state income tax due

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primarily to our net operating loss carryforward. Key components of our effective tax rate consist of foreign tax losses which derive no benefit, non-deductible share-based compensation, and changes in our valuation allowance. As compared to the three months ended October 31, 2013, our negative effective tax rate changed due to fluctuations in our overall loss before income taxes and the geographic mix of income due to global expansion.

Our provision for income taxes for the three months ended October 31, 2013 reflects an effective tax rate of negative 18.9%, and consists of foreign income, withholding taxes, and limited state income tax due to our net operating loss carryforwards and other tax attributes.

9. Net Income (Loss) Per Share

Basic net income (loss) per common share is computed by dividing net income (loss) by basic weighted-average shares outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by diluted weighted-average shares outstanding, including potentially dilutive securities.

The following table presents the computation of basic and diluted net loss per share of common stock (in thousands, except per share data):



	Three Months Ended
	October 31,
	2014			2013
Net loss	$	(30,068	)	$	(7,861	)
Weighted-average shares used to compute net loss per share, basic and diluted	79,388			71,681
Net loss per share, basic and diluted	$	(0.38	)	$	(0.11	)

The following securities were excluded from the computation of diluted net income (loss) per share of common stock for the periods presented as their effect would have been antidilutive (in thousands):



	October 31,
	2014	2013
Options to purchase common stock	5,195	9,203
RSUs	6,193	2,565
ESPP shares	35	53
Convertible senior notes	5,214	—
Warrants related to the issuance of the convertible senior notes	5,214	—

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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 trends in billings, revenue, cost of revenue, gross margin, cash flows, operating expenses, including future share-based compensation expense, interest expense, income taxes, investments and liquidity; expectations regarding billings and revenue from our Advanced Endpoint Protection offering; expected recurring revenues resulting from expected growth in our installed base; the sufficiency of our existing cash and investments to meet our cash needs for the foreseeable future; and 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,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “predicts,” “projects,” “would,” “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.

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is organized as follows:


•	Overview. A discussion of our business and overall analysis of financial and other highlights in order to provide context for the remainder of MD&A.


•	Key Financial Metrics. An analysis of our generally accepted accounting principles (GAAP) and non-GAAP key financial metrics, which management monitors to evaluate our performance.


•	Financial Overview. A discussion of the nature and trends of components of our financial results.


•	Results of Operations. An analysis of our financial results comparing the three months ended October 31, 2014 to the three months ended October 31, 2013.


•	Liquidity and Capital Resources. An analysis of changes in our balance sheets and cash flows, and discussion of our financial condition and our ability to meet cash needs.


•	Critical Accounting Policies and Estimates. A discussion of accounting policies that require critical estimates, assumptions, and judgments.


•	Recent Accounting Pronouncements. A discussion of expected impacts of impending accounting changes on financial information to be reported in the future.


•	Available Information. A discussion of sources of additional information available to investors.

Overview

We have pioneered the next-generation of enterprise security with our innovative platform that allows enterprises, service providers, and government entities to simultaneously empower and secure their organizations by safely enabling the increasingly complex and rapidly growing number of applications running on their networks and by preventing breaches stemming from targeted cyber attacks. Our enterprise security platform consists of three major elements: our Next-Generation Firewall, our Advanced Endpoint Protection, and our Threat Intelligence Cloud. Our Next-Generation Firewall delivers application, user, and content visibility and control as well as protection against network-based cyber threats integrated within the firewall through our proprietary hardware and software architecture. Our Advanced Endpoint Protection prevents cyber attacks that aim to exploit software vulnerabilities on a broad variety of fixed and virtual endpoints. Our Threat Intelligence Cloud provides central intelligence capabilities as well as automated delivery of preventative measures against cyber attacks. The cloud-based element of our platform is delivered in the form of a service that can be used either in the public cloud or in a private cloud using a dedicated appliance.

We derive revenue from sales of our products and services, which together comprise our platform. Product revenue is generated from sales of our Next-Generation Firewall, which is available in hardware and virtualized form factors. Our Next-Generation Firewall incorporates our proprietary PAN-OS operating system, which provides a consistent set of capabilities across our entire product line. These capabilities include: application visibility and control (App-ID), user identification (User-ID), site-

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to-site virtual private network (VPN), remote access Secure Sockets Layer (SSL) VPN, and Quality-of-Service (QoS). Our products are designed for different performance requirements throughout an organization, ranging from the PA-200, which is designed for enterprise remote offices, to the PA-7050, which is designed for data centers and high-speed networks. The same firewall functionality that is delivered in the hardware appliances is also available in the VM-Series virtual firewalls, which secure virtualized and cloud-based computing environments. Multiple firewalls can jointly use our WildFire appliance, WF-500, which identifies, analyzes, and blocks known and unknown malware in a private cloud-based environment. Our platform can be centrally managed in both virtualized and hardware appliances across an organization with our Panorama product. In addition, our GlobalProtect appliance, GP-100, provides mobile device management, malware detection, and shares device state information to safely enable mobile devices for business use.

Services revenue is generated from sales of 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. Our Advanced Endpoint Protection subscription protects against cyber attacks that exploit software vulnerabilities in Windows-based fixed and virtual endpoints through the use of its unique capability of stopping the underlying exploit techniques, and can prevent cyber attacks without relying on prior knowledge of the attack.

When end-customers purchase an appliance, 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. We leverage our appliances to sell software as a service (SaaS) subscription services to meet our customers’ evolving enterprise security requirements. Our hybrid SaaS revenue model consists of product, subscriptions, and support and maintenance, which we believe will enable us to benefit from recurring revenues as we continue to grow our installed end-customer base.

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.

We continue to invest in innovation and strengthening our product portfolio. For example, in September 2014, we announced the availability of Traps, our Advanced Endpoint Protection offering, designed to prevent sophisticated cyber attacks on endpoints. In addition, in October 2014, we expanded our partnership with VMware, Inc. (“VMware”) by extending our advanced security to VMware’s public cloud platform, vCloud Air.

As of October 31, 2014, we had sold to approximately 21,000 end-customers in over 130 countries. Our end-customers represent a broad range of industries including education, energy, financial services, government entities, healthcare, Internet and media, manufacturing, public sector, and telecommunications, and include some of the largest Fortune 100 and Global 2000 companies in the world. Also, during the first quarter of fiscal 2015, our headcount increased by 178 to 1,900 employees.

For the first quarter of fiscal 2015 and 2014, revenues were $192.3 million and $128.2 million, respectively, representing year-over-year growth of 50.1%. All three components of our hybrid SaaS revenue model experienced year-over-year growth, led by revenue from subscription services, which grew 76.2% to $43.7 million, followed by support and maintenance services, which grew 69.1% to $47.2 million, and product, which grew 34.4% to $101.5 million. Revenue growth reflected rapid adoption of our Next-Generation Firewall and related support and maintenance, as well as increasing momentum in our subscription services business. We believe the growth was also driven by increased security spending by customers, as security continues to be a critical business imperative for every business in the world.

We believe that the growth of our business and our short-term 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 and services within existing end-customers, extend the length of service terms 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.

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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 loss and margin below under “—Financial Overview” and “—Results of Operations.” The following tables summarize deferred revenue, cash flow provided by operating activities, free cash flow (non-GAAP), and billings (non-GAAP).



	October 31, 2014		July 31, 2014
	(in thousands)
Total deferred revenue	$	470,720	$	422,578
Cash, cash equivalents, and investments	$	1,060,510	$	974,382



	Three Months Ended October 31,
	2014			2013
	(dollars in thousands)
Total revenue	$	192,346		$	128,180
Year over year percentage increase	50.1		%	49.2		%
Gross margin percentage	72.2		%	73.6		%
Operating loss	$	(23,763	)	$	(7,011	)
Operating margin percentage	(12.4		)%	(5.5		)%
Billings (non-GAAP)	$	240,488		$	157,906
Cash flow provided by operating activities	$	74,928		$	38,881
Free cash flow (non-GAAP)	$	68,993		$	23,201

•

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 services. 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 (non-GAAP). 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. A limitation of the utility of free cash flow as a measure of our financial performance and liquidity is that it does not represent the total increase or decrease in our cash balance for the period. In addition, it is important to note that other companies, including companies in our industry, may not use free cash flow, may calculate free cash flow in a different manner than we do, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a comparative measure. A reconciliation of free cash flow to cash flow provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

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	Three Months Ended October 31,
	2014			2013
	(in thousands)
Free cash flow (non-GAAP):
Cash flow provided by operating activities	$	74,928		$	38,881
Less: purchase of property, equipment, and other assets	5,935			15,680
Free cash flow (non-GAAP)	$	68,993		$	23,201
Net cash used in investing activities	$	(201,093	)	$	(93,959	)
Net cash provided by financing activities	$	16,100		$	10,646

•

Billings (non-GAAP). We define billings, a non-GAAP financial measure, as total revenue plus the change in deferred revenue during the period. Billings is a key measure used by our management to manage our business because billings drive deferred revenue, which is an important indicator of the health and visibility of our business. We consider billings to be a useful metric for management and investors, particularly as we experience increased sales of subscriptions and strong renewal rates for subscriptions and support and maintenance services, and monitor our near term cash flows. We believe that billings provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management. However, it is important to note that other companies, including companies in our industry, may not use billings, may calculate billings differently, may have different billing frequencies, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of billings as a comparative measure. A reconciliation of billings to revenue, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:



	Three Months Ended October 31,
	2014		2013
	(in thousands)
Billings (non-GAAP):
Total revenue	$	192,346	$	128,180
Add: change in total deferred revenue	48,142		29,726
Billings (non-GAAP)	$	240,488	$	157,906

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, GlobalProtect, and the VM-Series. 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.

•

Services Revenue. Services revenue is derived primarily from Threat Prevention, URL Filtering, GlobalProtect, and WildFire subscriptions and support and maintenance. In addition, in September 2014, we released Traps, our Advanced Endpoint Protection subscription. We anticipate billings (non-GAAP) from Traps will begin ramping in the second half of fiscal 2015 with a more meaningful revenue contribution in fiscal 2016. Our contractual subscription and support and maintenance terms are typically one year, with three to five year terms available. 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 vary from quarter to quarter and increase over the long term as we introduce new subscriptions, renew existing services contracts, and expand our installed end-customer base.

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Cost of Revenue

Our total cost of revenue consists of cost of product revenue and cost of services revenue. Our cost of revenue includes costs paid to our third-party contract manufacturer and 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, and amortization of intangible assets.

•

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 amortization of intellectual property licenses, 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, amortization of intangible assets acquired, allocated costs, and URL filtering database service fees. We expect our cost of services revenue to increase as our installed 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, and decrease over the long term as a percentage of revenue as we continue to scale our business. As of October 31, 2014, we expect to recognize approximately $327.2 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, professional services, and allocated costs. We continue to increase the size of our sales force and have also substantially grown our 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, professional services, and certain non-recurring general expenses. General and administrative personnel include our executive, finance, human resources, legal, and IT organizations. Professional services consist primarily of legal, auditing, accounting, and other consulting costs. We expect general and administrative expense to increase in absolute dollars due to additional costs associated with accounting, compliance, insurance, and investor relations, although our general and administrative expense may fluctuate as a percentage of total revenue.

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Interest Expense

Interest expense consists of the amortization of the debt discount and debt issuance costs related to our 0.0% convertible senior notes due 2019 (the “Notes”). This interest expense is non-cash and will range from $22.3 million to $25.7 million per year through fiscal 2019.

Other Income (Expense), Net

Other income (expense), net includes interest income earned on our cash, cash equivalents, and investments, foreign currency re-measurement gains and losses, and foreign currency transaction gains and losses.

Provision for Income Taxes

Provision for income taxes consists primarily of income taxes in foreign jurisdictions in which we conduct business, withholding taxes, and federal and state income taxes in the United States. We maintain a full valuation allowance for domestic deferred tax assets, including net operating loss carryforwards and tax credits. We implemented our corporate structure and intercompany relationships to more closely align with the international nature of our business in the fourth quarter of fiscal 2013. Income in certain countries may be taxed at statutory tax rates that are lower than the U.S. statutory tax rate. As a result, our overall effective tax rate over the long term may be lower than the U.S. federal statutory tax rate on positive income 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.



	Three Months Ended October 31,
	2014			2013
	(dollars in thousands)
Condensed Consolidated Statements of Operations Data:
Revenue:
Product	$	101,476		$	75,485
Services	90,870			52,695
Total revenue	192,346			128,180
Cost of revenue:
Product	29,141			17,954
Services	24,320			15,853
Total cost of revenue	53,461			33,807
Total gross profit	138,885			94,373
Operating expenses:
Research and development	37,305			19,893
Sales and marketing	106,366			67,366
General and administrative	18,977			14,125
Total operating expenses	162,648			101,384
Operating loss	(23,763		)	(7,011		)
Interest expense	(5,489		)	(8		)
Other income, net	341			405
Loss before income taxes	(28,911		)	(6,614		)
Provision for income taxes	1,157			1,247
Net loss	$	(30,068	)	$	(7,861	)

Number of employees at period end	1,900			1,264

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	Three Months Ended October 31,
	2014		2013
	(as a percentage of revenue)
Condensed Consolidated Statements of Operations Data:
Revenue:
Product	52.8	%	58.9	%
Services	47.2	%	41.1	%
Total revenue	100.0	%	100.0	%
Cost of revenue:
Product	15.2	%	14.0	%
Services	12.6	%	12.4	%
Total cost of revenue	27.8	%	26.4	%
Total gross profit	72.2	%	73.6	%
Operating expenses:
Research and development	19.4	%	15.5	%
Sales and marketing	55.3	%	52.6	%
General and administrative	9.9	%	11.0	%
Total operating expenses	84.6	%	79.1	%
Operating loss	(12.4	)%	(5.5	)%
Interest expense	(2.9	)%	—	%
Other income, net	0.2	%	0.3	%
Loss before income taxes	(15.1	)%	(5.2	)%
Provision for income taxes	0.5	%	1.0	%
Net loss	(15.6	)%	(6.2	)%

Comparison of the Three Month Periods Ended October 31, 2014 and 2013

Revenue



	Three Months Ended October 31,
	2014				2013				Change
	Amount		% of Revenue		Amount		% of Revenue		Amount		%
	(dollars in thousands)
Revenue:
Product	$	101,476	52.8	%	$	75,485	58.9	%	$	25,991	34.4	%
Services
Subscription	43,698		22.7	%	24,796		19.3	%	18,902		76.2	%
Support and maintenance	47,172		24.5	%	27,899		21.8	%	19,273		69.1	%
Total services	90,870		47.2	%	52,695		41.1	%	38,175		72.4	%
Total revenue	$	192,346	100.0	%	$	128,180	100.0	%	$	64,166	50.1	%
Revenue by geographic theater:
Americas	$	131,855	68.6	%	$	86,166	67.2	%	$	45,689	53.0	%
EMEA	38,484		20.0	%	23,875		18.6	%	14,609		61.2	%
APAC	22,007		11.4	%	18,139		14.2	%	3,868		21.3	%
Total revenue	$	192,346	100.0	%	$	128,180	100.0	%	$	64,166	50.1	%

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Product revenue increased $26.0 million, or 34.4%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013. The increase was driven by increased demand, including broader adoption of our newly introduced PA-7050 firewall. The impact of changes in pricing on our product revenue was insignificant.

Services revenue increased $38.2 million, or 72.4%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013. The increase was driven by a 76.2% increase in our subscription revenue and a 69.1% increase in our support and maintenance revenue due to increased sales to new and existing end-customers. The relative increases in subscription and support and maintenance revenue will fluctuate over time, depending on the mix of services revenue and the introduction of new subscription offerings. The impact of changes in pricing on our services revenue was insignificant.

With respect to geographic theaters, the Americas contributed the largest portion of the increase in revenue for the three months ended October 31, 2014 compared to the three months ended October 31, 2013 due to its larger and more established sales force compared to our other theaters. Revenue from both EMEA and APAC increased for the three months ended October 31, 2014 compared to the three months ended October 31, 2013 due to our investment in increasing the size of our sales force and number of channel partners in these theaters.

Cost of Revenue and Gross Margin



	Three Months Ended October 31,
	2014				2013				Change
	Amount		Gross Margin		Amount		Gross Margin		Amount		Percentage
	(dollars in thousands)
Cost of revenue:
Product	$	29,141			$	17,954			$	11,187	62.3	%
Services	24,320				15,853				8,467		53.4	%
Total cost of revenue	$	53,461			$	33,807			$	19,654	58.1	%
Includes share-based compensation of:
Product	$	749			$	250			$	499	199.6	%
Services	3,495				1,413				2,082		147.3	%
Total	$	4,244			$	1,663			$	2,581	155.2	%
Gross profit:
Product	$	72,335	71.3	%	$	57,531	76.2	%	$	14,804	(4.9	)%
Services	66,550		73.2	%	36,842		69.9	%	29,708		3.3	%
Total gross profit	$	138,885	72.2	%	$	94,373	73.6	%	$	44,512	(1.4	)%

Product cost increased $11.2 million, or 62.3%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013 due to an increase in product unit volume.

Service cost increased $8.5 million, or 53.4%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013 due to an increase in personnel costs of $4.2 million related to increasing our headcount, amortization of acquired intangible assets of $1.3 million, allocated costs of $1.1 million, and other costs incurred to expand our customer service capabilities to support our growing installed end-customer base.

Gross margin decreased 140 basis points for the three months ended October 31, 2014 compared to the three months ended October 31, 2013. The decrease of 490 basis points in product margin was driven by a decrease of 300 basis points due to amortization of intellectual property licenses of $3.1 million. The remaining decrease was due to higher product cost as a result of new product introductions, including the PA-7050 firewalls, which will have lower product margins until increased volume drives better economies of scale. The increase of 330 basis points in services margin was driven by an increase of 480 basis points due to contributions from our higher margin subscription services, partially offset by a 150 basis points decrease due to amortization of purchased intangible assets.

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Operating Expenses



	Three Months Ended October 31,
	2014				2013				Change
	Amount		% of Revenue		Amount		% of Revenue		Amount		%
	(dollars in thousands)
Operating expenses:
Research and development	$	37,305	19.4	%	$	19,893	15.5	%	$	17,412	87.5	%
Sales and marketing	106,366		55.3	%	67,366		52.6	%	39,000		57.9	%
General and administrative	18,977		9.9	%	14,125		11.0	%	4,852		34.4	%
Total operating expenses	$	162,648	84.6	%	$	101,384	79.1	%	$	61,264	60.4	%
Includes share-based compensation of:
Research and development	$	13,999			$	3,262			$	10,737	329.2	%
Sales and marketing	15,799				6,628				9,171		138.4	%
General and administrative	4,433				2,858				1,575		55.1	%
Total	$	34,231			$	12,748			$	21,483	168.5	%

Research and development expense increased $17.4 million, or 87.5%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013, due to an increase in personnel costs of $15.6 million largely due to an increase in headcount and an increase in allocated costs of $1.2 million.

Sales and marketing expense increased $39.0 million, or 57.9%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013, due to an increase in personnel costs of $23.5 million largely due to an increase in headcount, an increase in demand generation activities, trade shows, and other marketing activities of $4.9 million, an increase in allocated costs of $3.4 million, and an increase in travel and entertainment costs of $3.3 million.

General and administrative expense increased $4.9 million, or 34.4%, for the three months ended October 31, 2014 compared to the three months ended October 31, 2013, due to an increase in personnel costs of $3.8 million, largely due to an increase in headcount.

Interest Expense



	Three Months Ended October 31,
	2014		2013		Change
	Amount		Amount		Amount		%
	(dollars in thousands)
Interest expense	$	5,489	$	8	$	5,481	NM

Interest expense increased $5.5 million for the three months ended October 31, 2014 compared to the three months ended October 31, 2013 due to the amortization of the debt discount and debt issuance costs related to the Notes. This interest expense is non-cash and will range from $22.3 million to $25.7 million per year through fiscal 2019.

Provision for Income Taxes



	Three Months Ended October 31,
	2014			2013			Change
	(dollars in thousands)
Provision for income taxes	$	1,157		$	1,247		$	(90	)	(7.2	)%
Effective tax rate	(4.0		)%	(18.9		)%

We recorded an income tax provision for the three months ended October 31, 2014 due to federal, state, and foreign income taxes and foreign withholding taxes. The provision for income taxes decreased for the three months ended October 31, 2014 compared

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to the three months ended October 31, 2013 due to increased U.S. taxable income and a shift in geographical mix of income due to global expansion.

Liquidity and Capital Resources



	October 31, 2014		July 31, 2014
	(in thousands)
Working capital	$	572,601	$	610,155
Cash, cash equivalents, and investments:
Cash and cash equivalents	$	543,747	$	653,812
Investments	516,763		320,570
Total cash, cash equivalents, and investments	$	1,060,510	$	974,382

At October 31, 2014, our cash, cash equivalents, and investments of $1.1 billion were held for general corporate purposes, of which approximately $140.5 million was held outside the United States. Our current plans do not include repatriating these funds. However, if these funds were needed for our domestic operations, we would be required to accrue and pay U.S. taxes on undistributed earnings of foreign subsidiaries. There are no other restrictions on the use of these funds. We do not provide for federal income taxes on the undistributed earnings of our foreign subsidiaries, all of which we expect to reinvest outside of the United States indefinitely. If we were to repatriate these earnings to the United States, any associated income tax liability would be insignificant.

In June 2014, we issued the Notes with an aggregate principal amount of $575.0 million. The Notes will mature on July 1, 2019. Prior to January 1, 2019, holders may surrender their Notes for early conversion under certain circumstances. Upon conversion of the Notes, we will pay cash up to the aggregate principal amount of the Notes to be converted and we may choose to pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock with respect to the remainder of our conversion obligation in excess of the aggregate principal amount of the Notes being converted. As of October 31, 2014, the Notes were not convertible. Refer to Note 5. Convertible Senior Notes of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for information on the Notes.

The following table summarizes our cash flows for the three months ended October 31, 2014 and 2013.



	Three Months Ended October 31,
	2014			2013
	(in thousands)
Cash provided by operating activities	$	74,928		$	38,881
Cash used in investing activities	(201,093		)	(93,959		)
Cash provided by financing activities	16,100			10,646
Net decrease in cash and cash equivalents	$	(110,065	)	$	(44,432	)

We believe that our cash flow from operations with existing cash and cash equivalents will be sufficient to meet our anticipated cash needs for the foreseeable future. Our future capital requirements will depend on many factors including our growth rate, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced products and services offerings, the costs to acquire or invest in complementary businesses and technologies, the costs to ensure access to adequate manufacturing capacity, and the continuing market acceptance of our products. In addition, from time to time we may incur additional tax liability in connection with certain tax structuring decisions, for example, we may be required to pay additional taxes related to the acquisition of Cyvera Ltd. if we transfer the acquired intellectual property out of Israel.

We may also choose to seek additional equity or debt financing. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results, and financial condition may be adversely affected.

Operating Activities

Our operating activities have consisted of net loss adjusted for certain non-cash items and changes in assets and liabilities.

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Cash provided by operating activities during the three months ended October 31, 2014 was $74.9 million, an increase of $36.0 million compared to the three months ended October 31, 2013 due to changes in our assets and liabilities and growth of our business during the three months ended October 31, 2014. Changes in assets and liabilities during the three months ended October 31, 2014 compared to the three months ended October 31, 2013 include an increase in collections on accounts receivable and an increase in sales of subscriptions and support and maintenance contracts to new and existing customers as reflected by an increase in deferred revenue, partially offset by an increase in commissions paid during the three months ended October 31, 2014.

Investing Activities

Our investing activities have consisted of capital expenditures and net investment purchases, sales, and maturities. We expect to continue such activities as our business grows.

Cash used in investing activities during the three months ended October 31, 2014 was $201.1 million, an increase of $107.1 million as compared to the three months ended October 31, 2013. The increase was primarily due to higher net purchases of available-for-sale investments, partially offset by decreased purchases of property, equipment, and other assets during the three months ended October 31, 2014.

Financing Activities

Our financing activities have consisted of proceeds from sales of shares through employee equity incentive plans.

Cash provided by financing activities during the three months ended October 31, 2014 was $16.1 million, an increase of $5.5 million as compared to the three months ended October 31, 2013. The increase was due to higher proceeds from the sale of shares through employee equity incentive plans during the three months ended October 31, 2014.

Off-Balance Sheet Arrangements

Through October 31, 2014, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Critical Accounting Policies and Estimates

Our condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

We believe the critical accounting policies and estimates discussed under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC) on September 18, 2014, reflect our more significant judgments and estimates used in the preparation of the condensed consolidated financial statements. See “Available Information” below for instructions on how to access our Annual Report on Form 10-K. There have been no significant changes to our critical accounting policies and estimates as filed in such report.

Recent Accounting Pronouncements

Refer to “Recent Accounting Pronouncements” in Note 1. Description of Business and Summary of Significant Accounting Policies of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Available Information

Our website is located at www.paloaltonetworks.com, and our investor relations website is located at http://investors.paloaltonetworks.com. Copies of Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are available, free of charge, on our investor relations website as soon as reasonably practicable after we file such material electronically with or furnish it to the SEC. The SEC also maintains a website that contains our SEC filings. The address of the site is www.sec.gov. Further, a copy of this Quarterly Report on Form 10-Q is located at the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330.

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Webcasts of our earnings calls and certain events we participate in or host with members of the investment community are on our investor relations website. Additionally, we announce investor information, including news and commentary about our business and financial performance, SEC filings, notices of investor events, and our press and earnings releases, on our investor relations website. Investors and others can receive notifications of new information posted on our investor relations website in real time by signing up for email alerts and RSS feeds. Further corporate governance information, including our certificate of incorporation, bylaws, corporate governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading “Corporate Governance.” The contents of our websites are not incorporated by reference into this Quarterly Report on Form 10-Q or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only.


ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposures to market risk have not changed materially since July 31, 2014. For our quantitative and qualitative disclosures about market risk, see the disclosures in Part II, Item 7A in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on September 18, 2014.


ITEM 4.	CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Based on our evaluation, our chief executive officer and chief financial officer concluded that, as of October 31, 2014, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended October 31, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II


ITEM 1.	LEGAL PROCEEDINGS

The information set forth under the “Litigation” subheading in Note 6. Commitments and Contingencies of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.


ITEM 1A.	RISK FACTORS

Our operations and financial results are subject to various risks and uncertainties including those described below. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, also may become important factors that affect us. If any of the following risks or others not specified below materialize, our business, financial condition, and results of operations could be materially adversely affected. In that case, the market price of our common stock could decline.

Risks Related to Our Business and Our Industry

Our business and operations have experienced rapid growth in recent periods, and if we do not effectively manage any future growth or are unable to improve our systems, processes, and controls, our operating results will be adversely affected.

We have experienced rapid growth and increased demand for our products over the last few years. Our employee headcount and number of end-customers have increased significantly, and we expect to continue to grow our headcount significantly over the next year. For example, from the end of fiscal 2014 to the end of the first quarter of fiscal 2015, our headcount increased from 1,722 to 1,900 employees, and our number of end-customers increased from more than 19,000 to approximately 21,000. The growth and expansion of our business and product and service offerings places a continuous significant strain on our management, operational, and financial resources. As we have grown, we have increasingly managed more complex deployments of our products and services with larger end-customers. 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 our ability to manage headcount, capital, and processes in an efficient manner.

We may not be able to successfully scale improvements to our enterprise resource planning system or implement or scale improvements to our other systems, processes, and controls in an efficient or timely manner or in a manner that does not negatively affect our operating results. In addition, our existing systems, processes, and controls may not prevent or detect all errors, omissions, or fraud. We have licensed technology from third parties to help us accomplish this objective. We may experience difficulties in managing improvements to our systems, processes, and controls or in connection with third-party software, which could disrupt existing customer relationships, cause us to lose customers, limit us to smaller deployments of our products, or increase our technical support costs. Our failure to improve our systems, processes, and controls, or their failure to operate in the intended manner, may result in our inability to manage the growth of our business and to accurately forecast our revenue, expenses, and earnings, or to prevent certain losses. For example, we are implementing certain new enterprise management systems and any failure to implement these systems may disrupt our operations and our operating expenses could increase. Additionally, our productivity and the quality of our products and services may be adversely affected if we do not integrate and train our new employees quickly and effectively, including employees we acquired in connection with our acquisition of Cyvera Ltd. (“Cyvera”). Any future growth would add complexity to our organization and require effective coordination throughout our organization. For example, as a result of growth in our employee headcount, we relocated our corporate headquarters to a larger office space in Santa Clara, California in November 2013. Failure to manage any future growth effectively could result in increased costs, negatively impact our end-customers’ satisfaction with our products and services, and harm our operating results.

Our operating results are likely to vary significantly from period to period and be unpredictable, which could cause the market price of our common stock to decline.

Our operating results, in particular, our revenues, gross margins, operating margins, and operating expenses, have historically varied from period to period, and we expect that this trend will continue as a result of a number of factors, many of which are outside of our control and may be difficult to predict, including:


•	our ability to attract and retain new end-customers;


•	the budgeting cycles and purchasing practices of end-customers;


•	changes in end-customer, distributor or reseller requirements, or market needs;


•	changes in the growth rate of the enterprise security market;

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•	the timing and success of new product and service introductions by us or our competitors or any other change in the competitive landscape of our industry, including consolidation among our competitors or end-customers;


•	changes in mix of our products and services including increases in multi-year subscriptions and support and maintenance;


•	price competition;


•	deferral of orders from end-customers in anticipation of new products or product enhancements announced by us or our competitors;


•	our ability to successfully expand our business domestically and internationally;


•	the timing and costs related to the development or acquisition of technologies or businesses;


•	lack of synergy, or the inability to realize expected synergies, resulting from recent acquisitions;


•	our inability to complete or integrate efficiently any acquisitions that we have completed, or that we may undertake;


•	our ability to increase the size of our distribution channel;


•	decisions by potential end-customers to purchase enterprise security solutions from larger, more established security vendors or from their primary network equipment vendors;


•	changes in end-customer attach rates and renewal rates for our services;


•	timing of revenue recognition and revenue deferrals;


•	our ability to manage production and manufacturing related costs, global customer service organization costs, inventory excess and obsolescence costs, and warranty costs;


•	insolvency or credit difficulties confronting our customers, which could adversely affect their ability to purchase or pay for our products and services, or confronting our key suppliers, including our sole source suppliers, which could disrupt our supply chain;


•	any disruption in our channel or termination of our relationship with important channel partners, including as a result of consolidation among distributors and resellers of enterprise security solutions;


•	our inability to fulfill our end-customers’ orders due to supply chain delays or events that impact our manufacturers or their suppliers;


•	increased expenses, unforeseen liabilities, or write-downs and any impact on our results of operations from any acquisition consummated;


•	the cost and potential outcomes of litigation, which could have a material adverse effect on our business;


•	seasonality or cyclical fluctuations in our markets;


•	future accounting pronouncements or changes in our accounting policies, including the potential impact of the adoption and implementation of the May 2014 Financial Accounting Standards Board’s (FASB) Accounting Standards Update (ASU) No. 2014-09 regarding revenue recognition;


•	the impact on our overall effective tax rate caused by any reorganization in our corporate structure or any changes in our valuation allowance for domestic deferred assets;


•	increases or decreases in our expenses caused by fluctuations in foreign currency exchange rates, as an increasing portion of our expenses are incurred and paid in currencies other than the U.S. dollar;


•	political, economic and social instability, including continued hostilities in the Middle East and any disruption these events may cause to broader global industrial economy; and


•	general macroeconomic conditions, both domestically and in our foreign markets.

Any one of the factors above, or the cumulative effect of some of the factors referred to above, may result in significant fluctuations in our financial and other operating results. This variability and unpredictability could result in our failure to meet our revenue, margin, or other operating result expectations or those of securities analysts or investors for a particular period. If we fail to meet or exceed such expectations for these or any other reasons, the market price of our common stock could fall substantially, and we could face costly lawsuits, including securities class action suits.

Our revenue growth rate in recent periods may not be indicative of our future performance.

We have recently experienced revenue growth rates of 50% and 49% in the first quarter of fiscal 2015 and 2014, respectively. You should not rely on our revenue for any prior quarterly or annual periods as any indication of our future revenue or revenue

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growth. If we are unable to maintain consistent revenue or revenue growth, the market price of our common stock could be volatile, and it may be difficult to achieve and maintain profitability.

We have a history of losses, anticipate increasing our operating expenses in the future, and may not be able to achieve or maintain profitability or maintain or increase cash flow on a consistent basis. If we cannot achieve or maintain profitability or maintain or increase our cash flow, our business, financial condition, and operating results may suffer.

Other than fiscal 2012, we have incurred losses in all fiscal years since our inception. We incurred a net loss of $30.1 million in the first quarter of fiscal 2015, $226.5 million in fiscal 2014, and $29.2 million in fiscal 2013. As a result, we had an accumulated deficit of $365.8 million at October 31, 2014. We anticipate that our operating expenses will increase substantially in the foreseeable future as we continue to enhance our product and service offerings, broaden our installed end-customer base, expand our sales channels, expand our operations, hire additional employees, and continue to develop our technology. These efforts may prove more expensive than we currently anticipate, and we may not succeed in increasing our revenues sufficiently, or at all, to offset these higher expenses. Revenue growth may slow or revenue may decline for a number of possible reasons, including slowing demand for our products or services, increasing competition, a decrease in the growth of our overall market, or a failure to capitalize on growth opportunities. Any failure to increase our revenues as we grow our business could prevent us from achieving or maintaining profitability or maintaining or increasing cash flow on a consistent basis. If we are unable to meet these risks and challenges as we encounter them, our business, financial condition, and operating results may suffer.

Our limited operating history makes it difficult to evaluate our current business and future prospects, and may increase the risk of your investment.

We were founded in 2005 and shipped our first products in 2007. The majority of our revenue growth has occurred since 2009. Our limited operating history makes it difficult to evaluate our current business and our future prospects, including our ability to plan for and model future growth. We have encountered and will continue to encounter risks and difficulties frequently experienced by rapidly growing companies in constantly evolving industries, including the risks described in this Quarterly Report on Form 10-Q. If we do not address these risks successfully, our business and operating results will be adversely affected, and the market price of our common stock could decline. Further, we have limited historical financial data and we operate in a rapidly evolving market. As such, any predictions about our future revenue and expenses may not be as accurate as they would be if we had a longer operating history or operated in a more predictable market.

If we are unable to sell additional products and services to our end-customers or maintain or increase our installed end-customer base, our future revenue and operating results will be harmed.

Our future success depends, in part, on our ability to expand the deployment of our platform with existing end-customers by selling additional products, to secure other areas of our end-customers’ network and endpoints, and by upselling additional subscription services to provide increasing levels of enterprise security. This may require increasingly sophisticated and costly sales efforts and may not result in additional sales. In addition, the rate at which our end-customers purchase additional products and services depends on a number of factors, including the perceived need for additional enterprise security products and services as well as general economic conditions. If our efforts to sell additional products and services to our end-customers are not successful, our business may suffer.

Further, existing end-customers that purchase our subscriptions have no contractual obligation to renew their contracts after the completion of their initial contract period, which is typically one year, and we cannot accurately predict renewal rates. Our end-customers’ renewal rates may decline or fluctuate as a result of a number of factors, including their satisfaction with our services and our end-customer support, the frequency and severity of subscription outages, our product uptime or latency, and the pricing of our, or competing, services. If our end-customers renew their subscriptions, they may renew for shorter contract lengths or on other terms that are less economically beneficial to us. We have limited historical data with respect to rates of end-customer renewals, so we may not accurately predict future renewal trends. We cannot assure you that our end-customers will renew their subscriptions, and if our end-customers do not renew their agreements or renew on less favorable terms, our revenues may grow more slowly than expected or decline.

We also depend on our installed end-customer base for future support and maintenance revenues. Our support and maintenance agreements are typically one year. If end-customers choose not to continue renewing their support and maintenance or seek to renegotiate the terms of support and maintenance agreements prior to renewing such agreements, our revenue may decline.

We face intense competition in our market, especially from larger, well-established companies, and we may lack sufficient financial or other resources to maintain or improve our competitive position.

The market for enterprise security products is intensely competitive, and we expect competition to increase in the future from established competitors and new market entrants. Our main competitors fall into four categories:

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•	large networking vendors such as Cisco Systems, Inc. (“Cisco”) and Juniper Networks, Inc. (“Juniper”) that incorporate enterprise security features in their products;


•	large companies such as Intel Corporation (“Intel”), International Business Machines (“IBM”), and Hewlett-Packard Company (“HP”) that have acquired large network and endpoint security specialist vendors in recent years and have the technical and financial resources to bring competitive solutions to the market;


•	independent security vendors such as Check Point Software Technologies Ltd. (“Check Point”), Fortinet, Inc. (“Fortinet”), and FireEye, Inc. (“FireEye”) that offer network security products, and Symantec Corporation (“Symantec”), that offers endpoint security products; and


•	small and large companies that offer point solutions that compete with some of the features present in our platform.

Many of our existing competitors have, and some of our potential competitors could have, substantial competitive advantages such as:


•	greater name recognition and longer operating histories;


•	larger sales and marketing budgets and resources;


•	broader distribution and established relationships with distribution partners and end-customers;


•	greater customer support resources;


•	greater resources to make acquisitions;


•	lower labor and development costs;


•	larger and more mature intellectual property portfolios; and


•	substantially greater financial, technical, and other resources.

In addition, some of our larger competitors have substantially broader and more diverse product offerings and leverage their relationships based on other products or incorporate functionality into existing products to gain business in a manner that discourages users from purchasing our products, including through selling at zero or negative margins, product bundling, or closed technology platforms. Potential end-customers may also prefer to purchase from their existing suppliers rather than a new supplier regardless of product performance or features. These larger competitors often have broader product lines and market focus and may therefore not be as susceptible to downturns in a particular market. Many of our smaller competitors that specialize in providing protection from a single type of enterprise security threat are often able to deliver these specialized enterprise security products to the market more quickly than we can. Conditions in our market could change rapidly and significantly as a result of technological advancements, partnering by our competitors, or continuing market consolidation. New start-up companies that innovate and large competitors that are making significant investments in research and development may invent similar or superior products and technologies that compete with our products and technology. Our current and potential competitors may also establish cooperative relationships among themselves or with third parties that may further enhance their resources.

Some of our competitors have made acquisitions of businesses that may allow them to offer more directly competitive and comprehensive solutions than they had previously offered, such as Intel’s acquisition of McAfee, Inc. and Stonesoft Oyj, Cisco's acquisition of SourceFire, Inc., and FireEye's acquisitions of Mandiant Corporation and nPulse Technologies, Inc. As a result of such acquisitions, our current or potential competitors might be able to adapt more quickly to new technologies and end-customer needs, devote greater resources to the promotion or sale of their products and services, initiate or withstand substantial price competition, take advantage of acquisition or other opportunities more readily, or develop and expand their product and service offerings more quickly than we do. Due to various reasons, organizations may be more willing to incrementally add solutions to their existing enterprise security infrastructure from competitors than to replace it with our solutions. These competitive pressures in our market or our failure to compete effectively may result in price reductions, fewer orders, reduced revenue and gross margins, and loss of market share. Any failure to meet and address these factors could seriously harm our business and operating results.

If functionality similar to that offered by our products is incorporated into existing network infrastructure products, organizations may decide against adding our appliances to their network, which would have an adverse effect on our business.

Large, well-established providers of networking equipment such as Cisco and Juniper offer, and may continue to introduce, enterprise security features that compete with our products, either in stand-alone security products or as additional features in their network infrastructure products. The inclusion of, or the announcement of an intent to include, functionality perceived to be similar to that offered by our security solutions in networking products that are already generally accepted as necessary components of network architecture may have an adverse effect on our ability to market and sell our products. Furthermore, even if the functionality offered by network infrastructure providers is more limited than our products, a significant number of end-customers may elect to accept such limited functionality in lieu of adding appliances from an additional vendor such as us. Many organizations have invested substantial personnel and financial resources to design and operate their networks and have established deep relationships with other providers of

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networking products, which may make them reluctant to add new components to their networks, particularly from other vendors such as us. In addition, an organization’s existing vendors or new vendors with a broad product offering may be able to offer concessions that we are not able to match because we currently offer only enterprise security products and have fewer resources than many of our competitors. If organizations are reluctant to add additional network infrastructure from new vendors or otherwise decide to work with their existing vendors, our ability to increase our market share and improve our financial condition and operating results will be adversely affected.

Reliance on shipments at the end of the quarter could cause our revenue for the applicable period to fall below expected levels.

As a result of end-customer buying patterns and the efforts of our sales force and channel partners to meet or exceed their sales objectives, we have historically received a substantial portion of sales orders and generated a substantial portion of revenue during the last few weeks of each fiscal quarter. If expected revenue at the end of any fiscal quarter is delayed for any reason, including the failure of anticipated purchase orders to materialize, our logistics partners’ inability to ship products prior to fiscal quarter-end to fulfill purchase orders received near the end of the fiscal quarter, our failure to manage inventory to meet demand, our inability to release new products on schedule, any failure of our systems related to order review and processing, or any delays in shipments based on trade compliance requirements, our revenue for that quarter could fall below our expectations and the estimates of analysts, which could adversely impact our business and results of operations and cause a decline in the market price of our common stock.

If we are unable to hire, retain, train, and motivate qualified personnel and senior management, our business could suffer.

Our future success depends, in part, on our ability to continue to attract and retain highly skilled personnel. The loss of the services of any of our key personnel, the inability to attract or retain qualified personnel, or delays in hiring required personnel, particularly in engineering and sales, may seriously harm our business, financial condition, and operating results. Although we have entered into employment offer letters with our key personnel, these agreements have no specific duration and constitute at-will employment. We are also substantially dependent on the continued service of our existing development personnel because of the complexity of our platform. Additionally, any failure to hire, train, and adequately incentivize our sales personnel could negatively impact our growth. Further, the inability of our recently hired sales personnel to effectively ramp to target productivity levels could negatively impact our operating margins. If we are not effective in managing any leadership transition in our sales organization, our business could be adversely impacted and our operating results and financial condition could be harmed.

Competition for highly skilled personnel is often intense, especially in the San Francisco Bay Area, where we have a substantial presence and need for highly skilled personnel. Additionally, the industry in which we operate generally experiences high employee attrition. We may not be successful in attracting, integrating, or retaining qualified personnel to fulfill our current or future needs. Also, to the extent we hire personnel from competitors, we may be subject to allegations that they have been improperly solicited, that they have divulged proprietary or other confidential information, or that their former employers own their inventions or other work product.

Our future performance also depends on the continued services and continuing contributions of our senior management to execute on our business plan and to identify and pursue new opportunities and product innovations. The loss of services of senior management could significantly delay or prevent the achievement of our development and strategic objectives, which could adversely affect our business, financial condition, and operating results.

Our employees do not have employment arrangements that require them to continue to work for us for any specified period, and therefore, they could terminate their employment with us at any time. We do not maintain key person life insurance policies on any of our employees. The loss of one or more of our key employees could seriously harm our business.

We rely on third-party channel partners to sell substantially all of our products, and if our partners fail to perform, our ability to sell and distribute our products and services will be limited, and our operating results will be harmed.

Substantially all of our revenue is generated by sales through our channel partners, including distributors and resellers. We provide our sales channel partners with specific training and programs to assist them in selling our products, but there can be no assurance that these steps will be effective. In addition, our channel partners may be unsuccessful in marketing, selling, and supporting our products and services. If we are unable to develop and maintain effective sales incentive programs for our third-party channel partners, we may not be able to incentivize these partners to sell our products to end-customers and, in particular, to large enterprises. These partners may also market, sell, and support products and services that are competitive with ours and may devote more resources to the marketing, sales, and support of such competitive products. These partners may have incentives to promote our competitors’ products to the detriment of our own or may cease selling our products altogether. Our agreements with our channel partners may generally be terminated for any reason by either party with advance notice prior to each annual renewal date. We cannot assure you that we will retain these channel partners or that we will be able to secure additional or replacement channel partners. The loss of one or more of our significant channel partners or a decline in the number or size of orders from them could harm our operating results. In addition, any new sales channel partner requires extensive training and may take several months or more to achieve productivity. Our channel partner sales structure could subject us to lawsuits, potential liability, and reputational harm if, for example, any of our channel partners misrepresent the functionality of our products or services to end-customers or violate laws or our corporate policies.

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If we fail to effectively manage our existing sales channels, if our channel partners are unsuccessful in fulfilling the orders for our products, or if we are unable to enter into arrangements with, and retain a sufficient number of, high quality channel partners in each of the regions in which we sell products and keep them motivated to sell our products, our ability to sell our products and operating results will be harmed.

Because we depend on third-party manufacturers to build and ship our products, we are susceptible to manufacturing and logistics delays and pricing fluctuations that could prevent us from shipping customer orders on time, if at all, or on a cost-effective basis, which may result in the loss of sales and customers.

We depend on third-party manufacturers, primarily Flextronics International Ltd. (“Flextronics”), our contract manufacturer, as sole source manufacturers for our product lines. Our reliance on these third-party manufacturers reduces our control over the manufacturing process and exposes us to risks, including reduced control over quality assurance, product costs, and product supply and timing, as well as the risk that minerals which originate from the Democratic Republic of the Congo and adjoining countries, or conflict minerals, may be included in our products. In addition, while the majority of our products are manufactured by our contract manufacturers at facilities located in the United States, any growth or expansion of such manufacturing at facilities in foreign countries may subject us to additional risks associated with complying with local rules and regulations. Any manufacturing and logistics disruption by these third-party manufacturers could severely impair our ability to fulfill orders. In addition, we are subject to requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that require us to diligence, disclose, and report whether or not our products contain conflicts minerals. These requirements could adversely affect the sourcing, availability, and pricing of minerals used in the manufacture of semiconductor devices or other components used in our products. We may also encounter customers who require that all of the components of our products be certified as conflict free. If we are not able to meet this requirement, such customers may choose not to purchase our products, which could adversely impact sales of our products. In addition, we incur additional costs to comply with these disclosure requirements, including costs related to determining the source of any of the relevant minerals and metals used in our products.

These manufacturers typically fulfill our supply requirements on the basis of individual orders. We do not have long term contracts with our third-party manufacturers that guarantee capacity, the continuation of particular pricing terms, or the extension of credit limits. Accordingly, they are not obligated to continue to fulfill our supply requirements, which could result in supply shortages, and the prices we are charged for manufacturing services could be increased on short notice. Our contract with Flextronics permits them to terminate the agreement for their convenience, subject to prior notice requirements. If we are required to change contract manufacturers, our ability to meet our scheduled product deliveries to our customers could be adversely affected, which could cause the loss of sales to existing or potential customers, delayed revenue or an increase in our costs which could adversely affect our gross margins. Any production interruptions for any reason, such as a natural disaster, epidemic, capacity shortages, or quality problems, at one of our manufacturing partners would negatively affect sales of our product lines manufactured by that manufacturing partner and adversely affect our business and operating results.

Managing the supply of our products and product components is complex. Insufficient supply and inventory may result in lost sales opportunities or delayed revenue, while excess inventory may harm our gross margins.

Our third-party manufacturers procure components and build our products based on our forecasts, and we generally do not hold inventory for a prolonged period of time. These forecasts are based on estimates of future demand for our products, which are in turn based on historical trends and analyses from our sales and marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate component supply, from time to time we may issue forecasts for components and products that are non-cancelable and non-returnable.

Our inventory management systems and related supply chain visibility tools may be inadequate to enable us to forecast accurately and effectively manage supply of our products and product components. Supply management remains an increased area of focus as we balance the need to maintain supply levels that are sufficient to ensure competitive lead times against the risk of obsolescence because of rapidly changing technology and end-customer requirements. If we ultimately determine that we have excess supply, we may have to reduce our prices and write-down inventory, which in turn could result in lower gross margins. If our actual component usage and product demand are lower than the forecast we provide to our third-party manufacturers, we accrue for losses on manufacturing commitments in excess of forecasted demand. Alternatively, insufficient supply levels may lead to shortages that result in delayed revenue or loss of sales opportunities altogether as potential end-customers turn to competitors’ products that are readily available. Additionally, any increases in the time required to manufacture our products or ship products could result in supply shortfalls. If we are unable to effectively manage our supply and inventory, our operating results could be adversely affected.

Because some of the key components in our products come from limited sources of supply, we are susceptible to supply shortages or supply changes, which could disrupt or delay our scheduled product deliveries to our customers and may result in the loss of sales and customers.

Our products rely on key components, including integrated circuit components, which our contract manufacturers purchase on our behalf from a limited number of suppliers, including sole source providers. The manufacturing operations of some of our

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component suppliers are geographically concentrated in Asia and elsewhere, which makes our supply chain vulnerable to regional disruptions. A fire, flood, earthquake, tsunami or other disaster, condition or event such as political instability, civil unrest or a power outage that adversely affects any of these component suppliers’ facilities could significantly affect our ability to obtain the necessary components for our products, which could result in a substantial loss of sales and revenue and a substantial harm to our operating results. Similarly, a localized health risk affecting employees at these facilities, such as the spread of a pandemic influenza, could impair the volume of components that we are able to obtain, which could result in substantial harm to our operating results.

We do not have volume purchase contracts with any of our component suppliers, and they could cease selling to us at any time. In addition, our component suppliers change their selling prices frequently in response to market trends, including industry-wide increases in demand, and because we do not have volume purchase contracts with these suppliers, we are susceptible to price fluctuations related to raw materials and components. If we are unable to pass component price increases along to our customers or maintain stable pricing, our gross margins and operating results could be negatively impacted. If we are unable to obtain a sufficient quantity of these components in a timely manner for any reason, sales of our products could be delayed or halted or we could be forced to expedite shipment of such components or our products at dramatically increased costs, which would negatively impact our revenue and gross margins. Additionally, poor quality in any of the sole-sourced components in our products could result in lost sales or lost sales opportunities. If the quality of the components does not meet our or our end-customers’ requirements, if we are unable to obtain components from our existing suppliers on commercially reasonable terms, or if any of our sole source providers cease to remain in business or continue to manufacture such components, we could be forced to redesign our products and qualify new components from alternate suppliers. The resulting stoppage or delay in selling our products and the expense of redesigning our products could result in lost sales opportunities and damage to customer relationships, which would adversely affect our business and operating results.

If we are not successful in executing our strategy to increase sales of our products to new and existing medium and large enterprise end-customers, our operating results may suffer.

Our growth strategy is dependent, in part, upon increasing sales of our products to medium and large enterprises. Sales to these types of end-customers involve risks that may not be present (or that are present to a lesser extent) with sales to smaller entities. These risks include:


•	competition from larger competitors, such as Cisco, Check Point, and Juniper, that traditionally target larger enterprises, service providers, and government entities and that may have pre-existing relationships or purchase commitments from those end-customers;


•	increased purchasing power and leverage held by large end-customers in negotiating contractual arrangements with us;


•	more stringent requirements in our worldwide support service contracts, including stricter support response times and penalties for any failure to meet support requirements; and


•