Edgar Filing: Palo Alto Networks Inc

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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 April 30, 2016


¨	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 May 17, 2016 was 89,602,652.

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TABLE OF CONTENTS




		Page
	PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets as of April 30, 2016 and July 31, 2015	3
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended April 30, 2016 and April 30, 2015	4
	Condensed Consolidated Statements of Comprehensive Loss for the Three and Nine Months Ended April 30, 2016 and April 30, 2015	5
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended April 30, 2016 and April 30, 2015	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	26
Item 4.	Controls and Procedures	26

	PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	27
Item 1A.	Risk Factors	27
Item 6.	Exhibits	49
	Signatures	50

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PART I


ITEM 1.	FINANCIAL STATEMENTS

PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in millions, except per share data)



	April 30, 2016			July 31, 2015
Assets
Current assets:
Cash and cash equivalents	$	550.0		$	375.8
Short-term investments	537.5			413.2
Accounts receivable, net of allowance for doubtful accounts of $0.7 and $0.7 at April 30, 2016 and July 31, 2015, respectively	267.6			212.4
Prepaid expenses and other current assets	91.1			72.6
Total current assets	1,446.2			1,074.0
Property and equipment, net	100.5			62.9
Long-term investments	682.9			538.8
Goodwill	163.5			163.5
Intangible assets, net	46.4			52.7
Other assets	67.5			73.3
Total assets	$	2,507.0		$	1,965.2
Liabilities, temporary equity, and stockholders’ equity
Current liabilities:
Accounts payable	$	24.3		$	13.2
Accrued compensation	56.4			79.8
Accrued and other liabilities	45.1			28.2
Deferred revenue	610.4			423.9
Convertible senior notes, net	502.8			487.1
Total current liabilities	1,239.0			1,032.2
Long-term deferred revenue	458.8			289.8
Other long-term liabilities	78.0			67.4
Commitments and contingencies (Note 5)
Temporary equity	72.2			87.9
Stockholders’ equity:
Preferred stock; $0.0001 par value; 100.0 shares authorized; none issued and outstanding at April 30, 2016 and July 31, 2015	—			—
Common stock and additional paid-in capital; $0.0001 par value; 1,000.0 shares authorized; 89.6 and 84.8 shares issued and outstanding at April 30, 2016 and July 31, 2015, respectively	1,330.5			988.7
Accumulated other comprehensive income (loss)	0.6			(0.1		)
Accumulated deficit	(672.1		)	(500.7		)
Total stockholders’ equity	659.0			487.9
Total liabilities, temporary equity, and stockholders’ equity	$	2,507.0		$	1,965.2

See notes to condensed consolidated financial statements.

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PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in millions, except per share data)



	Three Months Ended						Nine Months Ended
	April 30,						April 30,
	2016			2015			2016			2015
Revenue:
Product	$	162.1		$	121.5		$	479.7		$	338.6
Services	183.7			112.7			498.0			305.6
Total revenue	345.8			234.2			977.7			644.2
Cost of revenue:
Product	43.2			32.8			126.9			92.6
Services	51.7			31.6			141.4			84.6
Total cost of revenue	94.9			64.4			268.3			177.2
Total gross profit	250.9			169.8			709.4			467.0
Operating expenses:
Research and development	74.0			48.4			207.7			132.7
Sales and marketing	202.0			131.1			547.9			360.3
General and administrative	33.5			27.0			98.5			73.0
Total operating expenses	309.5			206.5			854.1			566.0
Operating loss	(58.6		)	(36.7		)	(144.7		)	(99.0		)
Interest expense	(5.8		)	(5.7		)	(17.4		)	(16.7		)
Other income, net	1.0			—			5.7			0.7
Loss before income taxes	(63.4		)	(42.4		)	(156.4		)	(115.0		)
Provision for income taxes	6.8			3.5			15.0			4.0
Net loss	$	(70.2	)	$	(45.9	)	$	(171.4	)	$	(119.0	)
Net loss per share, basic and diluted	$	(0.80	)	$	(0.56	)	$	(1.98	)	$	(1.47	)
Weighted-average shares used to compute net loss per share, basic and diluted	87.8			82.3			86.5			80.8

See notes to condensed consolidated financial statements.

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PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(Unaudited, in millions)



	Three Months Ended						Nine Months Ended
	April 30,						April 30,
	2016			2015			2016			2015
Net loss	$	(70.2	)	$	(45.9	)	$	(171.4	)	$	(119.0	)
Other comprehensive income (loss), net of tax:
Change in unrealized gains (losses) on investments	1.3			(0.1		)	0.7			0.2
Comprehensive loss	$	(68.9	)	$	(46.0	)	$	(170.7	)	$	(118.8	)

See notes to condensed consolidated financial statements.

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PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in millions)



	Nine Months Ended
	April 30,
	2016			2015
Cash flows from operating activities
Net loss	$	(171.4	)	$	(119.0	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Share-based compensation for equity based awards	283.2			155.5
Depreciation and amortization	30.7			20.3
Amortization of investment premiums, net of accretion of purchase discounts	2.4			2.3
Amortization of debt discount and debt issuance costs	17.4			16.6
Excess tax benefit from share-based compensation arrangements	(0.7		)	(0.5		)
Changes in operating assets and liabilities:
Accounts receivable, net	(55.3		)	(15.0		)
Prepaid expenses and other assets	(7.1		)	(30.9		)
Accounts payable	11.7			(3.9		)
Accrued compensation	(23.4		)	4.8
Accrued and other liabilities	27.6			27.5
Deferred revenue	355.5			181.3
Net cash provided by operating activities	470.6			239.0
Cash flows from investing activities
Purchases of investments	(830.1		)	(666.5		)
Proceeds from sales of investments	137.4			7.0
Proceeds from maturities of investments	409.6			200.8
Purchases of property, equipment, and other assets	(56.2		)	(21.9		)
Net cash used in investing activities	(339.3		)	(480.6		)
Cash flows from financing activities
Proceeds from sales of shares through employee equity incentive plans	42.2			41.4
Excess tax benefit from share-based compensation arrangements	0.7			0.5
Net cash provided by financing activities	42.9			41.9
Net increase (decrease) in cash and cash equivalents	174.2			(199.7		)
Cash and cash equivalents—beginning of period	375.8			653.8
Cash and cash equivalents—end of period	$	550.0		$	454.1

See notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Description of Business and Summary of Significant Accounting Policies

Description of Business

Palo Alto Networks, Inc. (the “Company,” “we,” “us,” or “our”), located in Santa Clara, California, was incorporated in March 2005 under the laws of the State of Delaware and commenced operations in April 2005. We offer a next-generation security platform that empowers enterprises, service providers, and government entities to secure their organizations by safely enabling the increasingly complex and rapidly growing number of applications running on their networks and by preventing breaches in real-time that stem from targeted cyber attacks.

Basis of Presentation and Principles of Consolidation

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, 2015, filed with the Securities and Exchange Commission on September 17, 2015. Our condensed consolidated financial statements include our accounts and our wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Our condensed consolidated financial statements are unaudited, but include all adjustments of a normal recurring nature necessary for a fair presentation of our quarterly results. 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 to current period presentation.

Our condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes in our Annual Report on Form 10-K for the fiscal year ended July 31, 2015.

Summary of Significant Accounting Policies

There have been no material changes to our significant accounting policies as of and for the nine months ended April 30, 2016, as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended July 31, 2015.

Recent Accounting Pronouncements

In March 2016, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance simplifying several aspects of the accounting for employee share-based payment transactions, including the income tax consequences, accounting for forfeitures, and classification of excess tax benefits on the statement of cash flows. The standard is effective for us for our first quarter of fiscal 2018, however, early adoption is permitted. We are currently evaluating whether this standard will have a material impact on our condensed consolidated financial statements.

In February 2016, the FASB issued new authoritative guidance on lease accounting. Among its provisions, the standard requires lessees to recognize right-of-use assets and lease liabilities on the balance sheet for operating leases and also requires additional qualitative and quantitative disclosures about lease arrangements. The standard is effective for us for our first quarter of fiscal 2020 and will be applied on a modified retrospective basis, with the option to elect certain practical expedients. Early adoption is permitted. We are currently evaluating whether this standard will have a material impact on our condensed consolidated financial statements.

In April 2015, the FASB issued new authoritative guidance on fees paid in a cloud computing arrangement. The standard requires customers in a cloud computing arrangement to evaluate whether the arrangement includes a software license. If the arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If the arrangement does not include a software license, the customer should account for the arrangement as a service contract. The standard is effective for us for our first quarter of fiscal 2017 and will be applied on a prospective basis. We do not expect the adoption of the standard will have a material impact on our condensed consolidated financial statements.

In April 2015, the FASB issued updated authoritative guidance to simplify the presentation of debt issuance costs. The amended standard requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the related debt liability, consistent with the presentation of debt discounts, instead of being presented as an asset. The amended standard is effective for us for our first quarter of fiscal 2017 and will be applied on a retrospective basis. We do not expect the adoption of the standard will have a material impact on our condensed consolidated financial statements.

In May 2014, the FASB issued new authoritative guidance on revenue from contracts with customers. The new standard provides principles for recognizing revenue for the transfer of promised goods or services to customers with the consideration to

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which the entity expects to be entitled in exchange for those goods or services. The standard also requires significantly expanded disclosures about revenue recognition. The FASB subsequently delayed the effective date of the standard by one year and as a result, the standard is now effective for us for our first quarter of fiscal 2019 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 the guidance. Early adoption as of the original effective date is permitted. We are currently evaluating adoption methods and whether this standard will have a material 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 April 30, 2016 and July 31, 2015 (in millions):



	April 30, 2016								July 31, 2015
	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Short-term investments:
Certificates of deposit	$	—	$	—	$	—	$	—	$	—	$	1.0	$	—	$	1.0
Corporate debt securities	—		110.3		—		110.3		—		97.8		—		97.8
U.S. government and agency securities	—		427.2		—		427.2		—		314.4		—		314.4
Total short-term investments	—		537.5		—		537.5		—		413.2		—		413.2
Long-term investments:
Certificates of deposit	—		5.4		—		5.4		—		—		—		—
Corporate debt securities	—		190.0		—		190.0		—		92.9		—		92.9
U.S. government and agency securities	—		487.5		—		487.5		—		445.9		—		445.9
Total long-term investments	—		682.9		—		682.9		—		538.8		—		538.8
Total assets measured at fair value	$	—	$	1,220.4	$	—	$	1,220.4	$	—	$	952.0	$	—	$	952.0

Refer to Note 4. Convertible Senior Notes for the carrying amount and estimated fair value of our convertible senior notes as of April 30, 2016.

3. Investments

The following tables summarize the amortized cost, unrealized gains and losses, and fair value of our available-for-sale investments as of April 30, 2016 and July 31, 2015 (in millions):



	April 30, 2016
	Amortized Cost		Unrealized Gains		Unrealized Losses			Estimated Fair Value
Certificates of deposit	$	5.4	$	—	$	—		$	5.4
Corporate debt securities	299.8		0.5		—			300.3
U.S. government and agency securities	914.4		0.5		(0.2		)	914.7
Total	$	1,219.6	$	1.0	$	(0.2	)	$	1,220.4

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	July 31, 2015
	Amortized Cost		Unrealized Gains		Unrealized Losses			Estimated Fair Value
Certificates of deposit	$	1.0	$	—	$	—		$	1.0
Corporate debt securities	190.9		—		(0.2		)	190.7
U.S. government and agency securities	760.2		0.3		(0.2		)	760.3
Total	$	952.1	$	0.3	$	(0.4	)	$	952.0

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 likely 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 were no other-than-temporary impairments for these investments at April 30, 2016 and July 31, 2015.

The following table summarizes the amortized cost and fair value of our available-for-sale investments as of April 30, 2016, by contractual years-to-maturity (in millions):



	Amortized Cost		Fair Value
Due within one year	$	537.4	$	537.5
Due between one and three years	682.2		682.9
Total	$	1,219.6	$	1,220.4

4. Convertible Senior Notes

Convertible Senior Notes

On June 30, 2014, we issued $575.0 million aggregate principal amount of 0.0% Convertible Senior Notes due 2019 (the “Notes”). The Notes mature on July 1, 2019, unless converted or repurchased in accordance with their terms prior to such date. The Notes do not contain any financial covenants and we cannot redeem the Notes prior to maturity.

The Notes are convertible for up to 5.2 million shares of our common stock at 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:


•	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 (the “sale price condition”);


•	during the five business day period after any five consecutive trading day 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 sale price condition was initially met during the fiscal quarter ended April 30, 2015. The sale price condition continued to be met through the fiscal quarter ended April 30, 2016, and as a result, holders may convert their Notes at any time during the fiscal quarter ending July 31, 2016. Accordingly, the net carrying amount of the Notes was classified in current liabilities and a portion of the equity component representing the conversion option was classified as temporary equity in our condensed consolidated balance sheets as of April 30, 2016. The portion of the equity component classified as temporary equity is measured as the difference between the principal and net carrying amount of the Notes.

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The following table sets forth the components of the Notes as of April 30, 2016 and July 31, 2015 (in millions):



	April 30, 2016			July 31, 2015
Liability:
Principal	$	575.0		$	575.0
Less: debt discount, net of amortization	72.2			87.9
Net carrying amount	$	502.8		$	487.1

Equity (including temporary equity)	$	(109.8	)	$	(109.8	)

The total estimated fair value of the Notes was $844.4 million and $994.8 million at April 30, 2016 and July 31, 2015, 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 April 30, 2016 and July 31, 2015 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. As of April 30, 2016, the if-converted value of the Notes exceeded its principal amount by $210.9 million.

The following table sets forth interest expense recognized related to the Notes (dollars in millions):



	Three Months Ended April 30,						Nine Months Ended April 30,
	2016			2015			2016			2015
Amortization of debt discount	$	5.3		$	5.1		$	15.7		$	15.1
Amortization of debt issuance costs	0.6			0.5			1.7			1.5
Total interest expense recognized	$	5.9		$	5.6		$	17.4		$	16.6

Effective interest rate of the liability component	4.8		%	4.8		%	4.8		%	4.8		%

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 5.2 million shares of our common stock 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.

Warrants

Separately, but concurrently with our issuance of the Notes, we entered into transactions whereby we sold warrants (the “Warrants”) to acquire up to 5.2 million 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.

For more information on the Notes, the Note Hedges, and the Warrants, refer to Note 7. Convertible Senior Notes of Notes to Consolidated Financial Statements included in Part II, Item 8 of our Annual Report on Form 10-K for the fiscal year ended July 31, 2015.

5. Commitments and Contingencies

Leases

We lease our facilities under various non-cancelable operating leases, which expire through the year ending July 31, 2028.

In May 2015, we entered into three lease agreements for approximately 752,000 square feet of corporate office space in Santa Clara, California to serve as our future corporate headquarters. In October 2015, we entered into a fourth lease agreement for approximately 310,000 square feet of additional office space at the same location. The fourth lease will commence in December 2017 and expire in April 2028, however, the site is currently under construction and as a result, the lease commencement date may

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change based on progress of the construction project. The fourth lease agreement contains a rent holiday period, scheduled rent increases, lease incentives, and renewal options which allow the lease term to be extended through April 2046. Rental payments under the fourth lease agreement are approximately $101.2 million over the initial lease term. For more information on the three lease agreements entered into in May 2015, refer to Note 8. Commitments and Contingencies of Notes to Consolidated Financial Statements included in Part II, Item 8 of our Annual Report on Form 10-K for the fiscal year ended July 31, 2015.

The following table presents details of the aggregate future non-cancelable minimum rental payments under our operating leases as of April 30, 2016 (in millions):



	Amount
Fiscal years ending July 31:
Remaining 2016	$	6.4
2017	25.1
2018	28.4
2019	42.1
2020	46.1
2021 and thereafter	350.7
Committed gross lease payments	498.8
Less: proceeds from sublease rental	5.9
Net operating lease obligation	$	492.9

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 12 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. As of April 30, 2016, our purchase commitments under such orders were $54.5 million, excluding obligations under contracts that we can cancel without a significant penalty.

Litigation

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.

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 April 30, 2016, we have not recorded any significant accruals 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.

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6. Equity Award Plans

Stock Option Activities

The following table summarizes the stock option activity under our stock plans during the reporting period (in millions, except per share amounts):



	Options Outstanding
	Number of Shares		Weighted- Average Exercise Price Per Share		Weighted- Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value
Balance—July 31, 2015	3.3		$	13.74	6.2	$	562.9
Options granted	—		—
Options forfeited	—		—
Options exercised	(1.0	)	14.05
Balance—April 30, 2016	2.3		$	13.56	5.5	$	313.3
Options vested and expected to vest—April 30, 2016	2.3		$	13.56	5.5	$	313.3
Options exercisable—April 30, 2016	2.2		$	13.27	5.5	$	306.9

Restricted Stock Unit (RSU) and Restricted Stock Award (RSA) Activities

The following table summarizes the RSU and RSA activity under our stock plans during the reporting period (in millions, except per share amounts):



	RSAs Outstanding			RSUs Outstanding
	Number of Shares	Weighted- Average Grant-Date Fair Value Per Share		Number of Shares		Weighted- Average Grant-Date Fair Value Per Share		Weighted- Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value
Balance—July 31, 2015	—	$	—	7.2		$	95.66	1.2	$	1,334.8
Granted	1.1	170.97		2.8		165.24
Vested	—	—		(2.5	)	84.89
Forfeited	—	—		(0.5	)	98.78
Balance—April 30, 2016	1.1	$	170.97	7.0		$	126.97	1.2	$	1,049.3
RSUs vested and expected to vest—April 30, 2016				6.6		$	126.36	1.2	$	994.5

Share-Based Compensation

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



	Three Months Ended April 30,				Nine Months Ended April 30,
	2016		2015		2016		2015
Cost of product revenue	$	1.6	$	1.0	$	4.5	$	2.7
Cost of services revenue	11.5		5.6		29.0		14.2
Research and development	36.0		19.8		95.9		52.8
Sales and marketing	43.8		22.2		110.4		59.7
General and administrative	15.6		11.6		43.5		26.2
Total share-based compensation	$	108.5	$	60.2	$	283.3	$	155.6

At April 30, 2016, total compensation cost related to unvested share-based awards not yet recognized was $879.0 million, 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.

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7. Income Taxes

Our provision for income taxes for the three and nine months ended April 30, 2016 reflects an effective tax rate of (10.8)% and (9.6)%, respectively. Our effective tax rates for these periods were negative as we recorded a provision for income taxes on quarter and year to date losses. The key components of our income tax provision primarily consist of foreign income taxes, withholding taxes, U.S. federal and state income taxes, and amortization of our deferred tax charges. Our effective tax rate differs from the U.S. statutory tax rate primarily due to foreign tax losses which derive no benefit, non-deductible share-based compensation, and changes in our valuation allowance. As compared to the same periods last year, our effective tax rate changed primarily due to an increase in non-deductible share-based compensation, changes in our valuation allowance against deferred tax assets, and amortization of our deferred tax charges.

Our provision for income taxes for the three and nine months ended April 30, 2015 reflects an effective tax rate of (8.3)% and (3.5)%, respectively. Our effective tax rates for these periods were 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 taxes, foreign withholding taxes, U.S. federal and state income taxes, and amortization of our deferred tax charge. 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.

In December 2015, the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”) was signed into law. Among its provisions, the PATH Act retroactively extends the bonus depreciation and other corporate tax incentives through December 31, 2019, and permanently extends the federal research and development credit. The adjustment to our deferred tax assets as a result of the PATH Act was fully offset by our valuation allowance. The income tax benefit derived from the PATH Act for the fiscal year ending July 31, 2016 is dependent on actual results for the year.

As of April 30, 2016, we had $109.8 million of unrecognized tax benefits, $19.2 million of which would affect income tax expense if recognized, after consideration of our valuation allowance in the United States and other assets. As of July 31, 2015, we had $67.2 million of unrecognized tax benefits, $10.8 million of which would affect income tax expense if recognized, after consideration of our valuation allowance in the United States and other assets. The increase in unrecognized tax benefits since July 31, 2015 relates to positions taken in the current year. As of April 30, 2016, our federal, state, and foreign returns for the tax years 2008 through the current period remain open to examination. Fiscal years outside the normal statute of limitation remain open to audit by tax authorities due to tax attributes generated in earlier years, which have been carried forward and may be audited in subsequent years when utilized. We do not expect the unrecognized tax benefits to change significantly over the next 12 months. We recognize both interest and penalties associated with uncertain tax positions as a component of income tax expense. The ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty.

8. Net Income (Loss) Per Share

Basic net income (loss) per 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 millions, except per share data):



	Three Months Ended						Nine Months Ended
	April 30,						April 30,
	2016			2015			2016			2015
Net loss	$	(70.2	)	$	(45.9	)	$	(171.4	)	$	(119.0	)
Weighted-average shares used to compute net loss per share, basic and diluted	87.8			82.3			86.5			80.8
Net loss per share, basic and diluted	$	(0.80	)	$	(0.56	)	$	(1.98	)	$	(1.47	)

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



	Three and Nine Months Ended
	April 30,
	2016	2015
RSUs	7.0	7.3
Convertible senior notes	5.2	5.2
Warrants related to the issuance of convertible senior notes	5.2	5.2
Options to purchase common stock	2.3	3.8
RSAs	1.1	—
Total	20.8	21.5


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: expectations regarding drivers of and factors affecting growth in our business; statements regarding trends in billings, our mix of product and services revenue, cost of revenue, gross margin, cash flows, operating expenses, including future share-based compensation expense, income taxes, investments and liquidity; expectations regarding the seasonality and cyclicality of our revenues from quarter to quarter; expected impact of the adoption of certain recent accounting pronouncements and the anticipated timing of adopting such standards; 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 (“SEC”). 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.


•	Results of Operations. A discussion of the nature and trends in our financial results and an analysis of our financial results comparing the three and nine months ended April 30, 2016 to the three and nine months ended April 30, 2015.


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


•	Contractual Obligations and Commitments. An overview of our contractual obligations, contingent liabilities, commitments, and off-balance sheet arrangements outstanding as of April 30, 2016, including expected payment schedules.


•	Critical Accounting 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.

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Overview

We have pioneered the next-generation of security with our innovative platform that empowers enterprises, service providers, and government entities to secure their organizations by safely enabling the increasingly complex and rapidly growing number of applications running on their networks and by preventing breaches that stem from targeted cyber attacks. Our platform uses an innovative traffic classification engine that identifies network traffic by application, user, and content. As a result, it provides in-depth visibility into all traffic and all applications at the user level in order to control usage, content, risks, and cyber threats. Our 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, through our proprietary hardware and software architecture that is integrated within the firewall. Our Advanced Endpoint Protection prevents cyber attacks that aim to exploit software vulnerabilities on a broad variety of fixed and virtual endpoints and servers. Our Threat Intelligence Cloud provides central intelligence capabilities, security for software as a service (“SaaS”) applications, and automated delivery of preventative measures against cyber attacks.

The network-based element of our platform is delivered in the form of a physical or virtual appliance and includes a suite of subscription services. The cyber attack prevention capabilities of our platform are delivered in the form of subscription services that can be used either in the public cloud or in a private cloud using a dedicated appliance. Our subscription services can be easily activated on any of our appliances without requiring additional hardware or processing resources, thereby providing a seamless implementation path for our end-customers.

For the third quarter of fiscal 2016 and 2015, revenues were $345.8 million and $234.2 million, respectively, representing year-over-year growth of 47.7%. Our growth reflects the increased adoption of our hybrid SaaS revenue model, which consists of product, subscriptions, and support and maintenance. We believe this model will enable us to benefit from recurring revenues as we continue to grow our installed end-customer base. As of April 30, 2016, we had sold our products and services to more than 31,000 end-customers in over 140 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.

Our product revenue grew to $162.1 million or 46.9% of total revenue for the third quarter of fiscal 2016, representing year-over-year growth of 33.4%. Product revenue is generated from sales of our appliances, primarily our Next-Generation Firewall, which is available in physical and virtualized form. Our Next-Generation Firewall incorporates our proprietary PAN-OS operating system, which provides a consistent set of capabilities across our entire product line. Our products are designed for different performance requirements throughout an organization, ranging from our PA-200, which is designed for enterprise remote offices, to our top-of-the-line PA-7080, which was released in August 2015 and is especially suited for service provider customers. The same firewall functionality that is delivered in our physical appliances is also available in our VM-Series virtual firewalls, which secure virtualized and cloud-based computing environments.

Our recurring services revenue grew to $183.7 million or 53.1% of total revenue for the third quarter of fiscal 2016, representing year-over-year growth of 63.0%, led by revenue from subscription services, which grew 68.9% to $92.6 million, and followed by support and maintenance services, which grew 57.4% to $91.1 million. Our subscriptions include two new services released during the first quarter of fiscal 2016: our Aperture subscription service, which provides content control for IT-sanctioned SaaS applications that are used to store and share end-customer’s data, and our AutoFocus cyber threat intelligence service, which provides prioritized actionable intelligence on targeted cyber attacks. Our 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.

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. 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 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. 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. 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. For additional information regarding the challenges and risks we face, see the “Risk Factors” section in Part II, Item 1A of this Quarterly Report on Form 10-Q.

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Key Financial Metrics

We monitor the key financial metrics set forth in the tables 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 “—Results of Operations.”



	April 30, 2016		July 31, 2015
	(in millions)
Total deferred revenue	$	1,069.2	$	713.7
Cash, cash equivalents, and investments	$	1,770.4	$	1,327.8



	Three Months Ended April 30,						Nine Months Ended April 30,
	2016			2015			2016			2015
	(dollars in millions)
Total revenue	$	345.8		$	234.2		$	977.7		$	644.2
Year-over-year percentage increase	47.7		%	55.4		%	51.8		%	53.4		%
Gross margin percentage	72.6		%	72.5		%	72.6		%	72.5		%
Operating loss	$	(58.6	)	$	(36.7	)	$	(144.7	)	$	(99.0	)
Operating margin percentage	(16.9		)%	(15.7		)%	(14.8		)%	(15.4		)%
Billings (non-GAAP)	$	486.2		$	302.2		$	1,333.2		$	825.5
Cash flow provided by operating activities							$	470.6		$	239.0
Free cash flow (non-GAAP)							$	414.4		$	217.1

•

Deferred Revenue. Our deferred revenue consists of amounts that have been invoiced but have not 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.

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•

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 profitability and 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 productive assets, can be used for operational expenses and 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:



	Nine Months Ended April 30,
	2016			2015
	(in millions)
Free cash flow (non-GAAP):
Net cash provided by operating activities	$	470.6		$	239.0
Less: purchases of property, equipment, and other assets	56.2			21.9
Free cash flow (non-GAAP)	$	414.4		$	217.1
Net cash used in investing activities	$	(339.3	)	$	(480.6	)
Net cash provided by financing activities	$	42.9		$	41.9

•

Billings (non-GAAP). We define billings, a non-GAAP financial measure, as total revenue plus the change in deferred revenue during the period. We consider billings to be a key measure used by management to manage our business given our hybrid SaaS revenue model, and believe billings provides investors with an important indicator of the health and visibility of our business because it includes services revenue, which is recognized ratably over the subscription period or the period in which the services are expected to be performed, as the case may be, and product revenue, which is recognized at the time of shipment, provided that all other revenue recognition criteria have been met. We consider billings to be a useful metric for management and investors, particularly if we continue to experience increased sales of subscriptions and strong renewal rates for subscriptions and support and maintenance services, and as we monitor our near term cash flows. While 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, 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 April 30,				Nine Months Ended April 30,
	2016		2015		2016		2015
	(in millions)
Billings (non-GAAP):
Total revenue	$	345.8	$	234.2	$	977.7	$	644.2
Add: change in total deferred revenue	140.4		68.0		355.5		181.3
Billings (non-GAAP)	$	486.2	$	302.2	$	1,333.2	$	825.5

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Results of Operations

The following table summarizes our results of operations for the periods presented and as a percentage of our total revenue for those periods based on our condensed consolidated statements of operations data. The period to period comparison of results is not necessarily indicative of results for future periods.



	Three Months Ended April 30,										Nine Months Ended April 30,
	2016					2015					2016					2015
	Amount			% of Revenue		Amount			% of Revenue		Amount			% of Revenue		Amount			% of Revenue
	(dollars in millions)
Revenue:
Product	$	162.1		46.9	%	$	121.5		51.9	%	$	479.7		49.1	%	$	338.6		52.6	%
Services	183.7			53.1	%	112.7			48.1	%	498.0			50.9	%	305.6			47.4	%
Total revenue	345.8			100.0	%	234.2			100.0	%	977.7			100.0	%	644.2			100.0	%
Cost of revenue:
Product	43.2			12.5	%	32.8			14.0	%	126.9			13.0	%	92.6			14.4	%
Services	51.7			14.9	%	31.6			13.5	%	141.4			14.4	%	84.6			13.1	%
Total cost of revenue ⁽¹⁾	94.9			27.4	%	64.4			27.5	%	268.3			27.4	%	177.2			27.5	%
Total gross profit	250.9			72.6	%	169.8			72.5	%	709.4			72.6	%	467.0			72.5	%
Operating expenses:
Research and development	74.0			21.4	%	48.4			20.7	%	207.7			21.2	%	132.7			20.6	%
Sales and marketing	202.0			58.4	%	131.1			56.0	%	547.9			56.0	%	360.3			55.9	%
General and administrative	33.5			9.7	%	27.0			11.5	%	98.5			10.2	%	73.0			11.4	%
Total operating expenses ⁽¹⁾	309.5			89.5	%	206.5			88.2	%	854.1			87.4	%	566.0			87.9	%
Operating loss	(58.6		)	(16.9	)%	(36.7		)	(15.7	)%	(144.7		)	(14.8	)%	(99.0		)	(15.4	)%
Interest expense	(5.8		)	(1.7	)%	(5.7		)	(2.4	)%	(17.4		)	(1.8	)%	(16.7		)	(2.6	)%
Other income, net	1.0			0.3	%	—			—	%	5.7			0.6	%	0.7			0.1	%
Loss before income taxes	(63.4		)	(18.3	)%	(42.4		)	(18.1	)%	(156.4		)	(16.0	)%	(115.0		)	(17.9	)%
Provision for income taxes	6.8			2.0	%	3.5			1.5	%	15.0			1.5	%	4.0			0.6	%
Net loss	$	(70.2	)	(20.3	)%	$	(45.9	)	(19.6	)%	$	(171.4	)	(17.5	)%	$	(119.0	)	(18.5	)%

(1)Includes share-based compensation as follows:



	Three Months Ended April 30,				Nine Months Ended April 30,
	2016		2015		2016		2015
Cost of product revenue	$	1.6	$	1.0	$	4.5	$	2.7
Cost of services revenue	11.5		5.6		29.0		14.2
Research and development	36.0		19.8		95.9		52.8
Sales and marketing	43.8		22.2		110.4		59.7
General and administrative	15.6		11.6		43.5		26.2
Total share-based compensation	$	108.5	$	60.2	$	283.3	$	155.6

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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. We expect our revenue to vary from quarter to quarter based on seasonal and cyclical factors.

Our total revenue is comprised of the following:


•	Product Revenue. Product revenue is derived primarily 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.

•

Services Revenue. Services revenue is derived primarily from sales of our subscriptions and support and maintenance. Our contractual subscription and support and maintenance terms are typically one year, although we also offer three to five year terms. 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.



	Three Months Ended April 30,								Nine Months Ended April 30,
	2016		2015		Change				2016		2015		Change
	Amount		Amount		Amount		%		Amount		Amount		Amount		%
	(dollars in millions)
Revenue:
Product	$	162.1	$	121.5	$	40.6	33.4	%	$	479.7	$	338.6	$	141.1	41.7	%
Services
Subscription	92.6		54.8		37.8		68.9	%	250.5		148.6		101.9		68.6	%
Support and maintenance	91.1		57.9		33.2		57.4	%	247.5		157.0		90.5		57.7	%
Total services	183.7		112.7		71.0		63.0	%	498.0		305.6		192.4		63.0	%
Total revenue	$	345.8	$	234.2	$	111.6	47.7	%	$	977.7	$	644.2	$	333.5	51.8	%
Revenue by geographic theater:
Americas	$	246.3	$	157.7	$	88.6	56.2	%	$	687.3	$	436.6	$	250.7	57.4	%
EMEA	61.4		45.9		15.5		33.9	%	177.2		129.2		48.0		37.2	%
APAC	38.1		30.6		7.5		24.4	%	113.2		78.4		34.8		44.5	%
Total revenue	$	345.8	$	234.2	$	111.6	47.7	%	$	977.7	$	644.2	$	333.5	51.8	%

Product revenue increased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015. The increases in both periods were driven by increased demand for our higher end appliances. The change in product revenue due to pricing was not significant for either period.

Services revenue increased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015. The increases in both periods were due to the adoption of subscriptions and high renewal rates for both subscriptions and support and maintenance services. The mix between subscription revenue and support and maintenance revenue will fluctuate over time, depending on the introduction of new subscription offerings, renewals of support and maintenance services, and our ability to increase sales to new and existing customers. The change in services revenue due to pricing was not significant for either period.

With respect to geographic theaters, the Americas contributed the largest portion of the increase in revenue for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015, due to its larger and more established sales force compared to our other theaters. Revenue from both Europe, the Middle East, and Africa (“EMEA”) and Asia Pacific and Japan (“APAC”) increased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015, due to our investment in increasing the size of our sales force and number of channel partners in these theaters.

Cost of Revenue

Our cost of revenue consists of cost of product revenue and cost of services revenue.

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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, warranty costs, shipping costs, and personnel costs, which consist of salaries, benefits, bonuses, and share-based compensation associated with our operations organization. In addition, our cost of product revenue also includes allocated costs, which consist of certain facilities, depreciation, benefits, recruiting, and information technology costs that we allocate based on headcount. We expect our cost of product revenue to increase as our product revenue increases.



	Three Months Ended April 30,								Nine Months Ended April 30,
	2016		2015		Change				2016		2015		Change
	Amount		Amount		Amount		%		Amount		Amount		Amount		%
	(dollars in millions)
Cost of product revenue	$	43.2	$	32.8	$	10.4	31.5	%	$	126.9	$	92.6	$	34.3	37.0	%
Number of employees at period end	86		64		22		34.4	%	86		64		22		34.4	%

Cost of product revenue increased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015. The increases in both periods were due to an increase in product unit volume for our higher end appliances.

Cost of Services Revenue

Cost of services revenue includes personnel costs for our global customer support and technical operations organizations, amortization of acquired intangible assets, and allocated costs. We expect our cost of services revenue to increase as our installed end-customer base grows.



	Three Months Ended April 30,								Nine Months Ended April 30,
	2016		2015		Change				2016		2015		Change
	Amount		Amount		Amount		%		Amount		Amount		Amount		%
	(dollars in millions)
Cost of services revenue	$	51.7	$	31.6	$	20.1	63.8	%	$	141.4	$	84.6	$	56.8	67.2	%
Number of employees at period end	514		316		198		62.7	%	514		316		198		62.7	%

Cost of services revenue increased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015. The increases in both periods were driven by increases in personnel costs, which grew $11.7 million to $28.2 million for the three months ended April 30, 2016 compared to the three months ended April 30, 2015 and grew $30.8 million to $74.7 million for the nine months ended April 30, 2016 compared to the nine months ended April 30, 2015. The increases in personnel costs in both periods were due to headcount growth. The remaining increases in both periods were driven by increases in expenses incurred to expand our customer service capabilities and infrastructure to support our growing installed end-customer base.

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 end firewall products generally have higher gross margins than our lower end 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.

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	Three Months Ended April 30,								Nine Months Ended April 30,
	2016				2015				2016				2015
	Amount		Gross Margin		Amount		Gross Margin		Amount		Gross Margin		Amount		Gross Margin
	(dollars in millions)
Gross profit:
Product	$	118.9	73.4	%	$	88.7	73.0	%	$	352.8	73.5	%	$	246.0	72.6	%
Services	132.0		71.9	%	81.1		72.0	%	356.6		71.6	%	221.0		72.3	%
Total gross profit	$	250.9	72.6	%	$	169.8	72.5	%	$	709.4	72.6	%	$	467.0	72.5	%

Product gross margin increased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015. The increases in both periods were driven by our continued focus on material cost reductions. Services gross margin decreased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015. The decreases in both periods were driven by headcount growth within our global customer support organization in order to support our growing installed end-customer base.

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. Our operating expenses also include allocated costs, which consist of certain facilities, depreciation, benefits, recruiting, and information technology costs that we allocate based on headcount. 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 April 30, 2016, we expect to recognize approximately $879.0 million of share-based compensation expense over a weighted-average period of approximately 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.



	Three Months Ended April 30,								Nine Months Ended April 30,
	2016		2015		Change				2016		2015		Change
	Amount		Amount		Amount		%		Amount		Amount		Amount		%
	(dollars in millions)
Research and development	$	74.0	$	48.4	$	25.6	52.7	%	$	207.7	$	132.7	$	75.0	56.5	%
Number of employees at period end	601		412		189		45.9	%	601		412		189		45.9	%

Research and development expense increased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015. The increases in both periods were driven by increases in personnel costs, which grew $22.9 million to $61.9 million for the three months ended April 30, 2016 compared to the three months ended April 30, 2015 and grew $66.4 million to $172.8 million for the nine months ended April 30, 2016 compared to the nine months ended April 30, 2015. The increases in personnel costs in both periods were due to headcount growth.

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.

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	Three Months Ended April 30,								Nine Months Ended April 30,
	2016		2015		Change				2016		2015		Change
	Amount		Amount		Amount		%		Amount		Amount		Amount		%
	(dollars in millions)
Sales and marketing	$	202.0	$	131.1	$	70.9	54.2	%	$	547.9	$	360.3	$	187.6	52.1	%
Number of employees at period end	1,972		1,268		704		55.5	%	1,972		1,268		704		55.5	%

Sales and marketing expense increased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015. The increases in both periods were driven by increases in personnel costs, which grew $53.7 million to $145.1 million for the three months ended April 30, 2016 compared to the three months ended April 30, 2015 and grew $132.7 million to $380.4 million for the nine months ended April 30, 2016 compared to the nine months ended April 30, 2015. The increases in personnel costs in both periods were due to headcount growth.

General and Administrative

General and administrative expense consists of personnel costs for our executive, finance, human resources, legal, and information technology organizations, professional services costs, which consist primarily of legal, auditing, accounting, and other consulting costs, and certain non-recurring general expenses. Certain facilities, depreciation, benefits, recruiting, and information technology costs are allocated to other organizations based on headcount. 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.



	Three Months Ended April 30,								Nine Months Ended April 30,
	2016		2015		Change				2016		2015		Change
	Amount		Amount		Amount		%		Amount		Amount		Amount		%
	(dollars in millions)
General and administrative	$	33.5	$	27.0	$	6.5	23.7	%	$	98.5	$	73.0	$	25.5	35.0	%
Number of employees at period end	418		257		161		62.6	%	418		257		161		62.6	%

General and administrative expense increased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015. The increases in both periods were driven by increases in personnel costs, which grew $6.3 million to $24.2 million for the three months ended April 30, 2016 compared to the three months ended April 30, 2015 and grew $24.3 million to $68.7 million for the nine months ended April 30, 2016 compared to the nine months ended April 30, 2015. The increases in personnel costs in both periods were due to headcount growth.

Other Income, Net

Other income, net includes interest income earned on our cash, cash equivalents, and investments, foreign currency remeasurement gains and losses, and foreign currency transaction gains and losses.



	Three Months Ended April 30,							Nine Months Ended April 30,
	2016		2015		Change			2016		2015		Change
	Amount		Amount		Amount		%	Amount		Amount		Amount		%
	(dollars in millions)
Other income, net	$	1.0	$	—	$	1.0	NM	$	5.7	$	0.7	$	5.0	NM

Other income, net increased for the three months ended April 30, 2016 compared to the three months April 30, 2015 due to an increase in interest income.

Other income, net increased for the nine months ended April 30, 2016 compared to the nine months ended April 30, 2015, due to an increase in interest income and higher foreign currency remeasurement gains.

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Provision for Income Taxes

Provision for income taxes consists primarily of income taxes in foreign jurisdictions in which we conduct business, withholding taxes, federal and state income taxes in the United States, and amortization of our deferred tax charges. We maintain a full valuation allowance for domestic deferred tax assets, including net operating loss carryforwards and tax credits.



	Three Months Ended April 30,						Change				Nine Months Ended April 30,						Change
	2016			2015			Amount		%		2016			2015			Amount		%
	(dollars in millions)
Provision for income taxes	$	6.8		$	3.5		$	3.3	94.3	%	$	15.0		$	4.0		$	11.0	279.1	%
Effective tax rate	(10.8		)%	(8.3		)%					(9.6		)%	(3.5		)%

We recorded an income tax provision for the three and nine months ended April 30, 2016, due to federal, state, and foreign income taxes, withholding taxes, and amortization of our deferred tax charges. The provision for income taxes increased for the three and nine months ended April 30, 2016 compared to the three and nine months ended April 30, 2015, primarily due to an increase in non-deductible share-based compensation, changes in our valuation allowance against deferred tax assets, and amortization of our deferred tax charges.

Liquidity and Capital Resources



	April 30, 2016				July 31, 2015