Palo Alto Networks, Inc.

Good day, everyone. Welcome to the Palo Alto Network's Fiscal Second Quarter 2020 Earnings Conference. Today's call is being recorded. At this time, I'd like to turn things over to Mr. David Nederman, Vice President of Investor Relations. Please go ahead, sir.

Good afternoon, and thank you for joining us on today's conference call to discuss Palo Alto Network's Fiscal Second Quarter 2020 financial results. This call is being broadcast live over the web and can be accessed on the Investors section of our website at investors.paloalternetworks.com. With me on today's call are Nikesh Arora, our Chairman and Chief Executive Officer, Kathy Bonanno, our Chief Financial Officer, and Lee Claridge, our Chief Product Officer. This afternoon, we issued a press release announcing our results for the fiscal second quarter ended January 31, 2020. If you would like a copy of the release, you can access it online on our website at We would like to remind you that during the course of this conference call, management will make forward-looking statements, including statements regarding our financial guidance and modeling points for the fiscal third quarter, full fiscal year 2020 and our next three years, our competitive position, our proposed accelerated share repurchase, and the demand and market opportunity for our products and subscriptions, benefits and timing of new products and subscription offerings and trends, and certain financial results and operating metrics. These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today. You should not rely on them as representing your views in the future, and we undertake no obligation to update these statements after this call. For a more detailed description of factors that could cause actual results to differ, please refer to our quarterly report on Form 10-Q filed with the SEC on November 26, 2019, and our earnings release posted a few minutes ago on our website and filed with the SEC on Form 8K. Also, please note that certain GAAP financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. For historical periods, we have provided reconciliations of these non-GAAP financial measures to GAAP financial measures and the supplemental financial information that can be found in the Investors section of our website, located at investors.palatinetworks.com. And finally, once we have completed our formal remarks, we will be posting them to our Ambassador Relations website under the Quarterly Results section. We'd also like to inform you that we will be attending the Morgan Stanley TMT Conference in San Francisco on March 5th. And with that, I'll turn the call over to Nikesh.

Thank you, David. Good afternoon, and thank you, everyone, for joining our call. I was talking to our President, Amit Singh, earlier today. He had just finished a two-day review of our sales teams around the world. He was excited. More than I've ever seen him excited since he started Palo Alto Networks. He was excited that we are in more strategic conversations than ever around the world. And our strategy around cloud security, securing the SOC, and adding capability to our firewalls is resonating with customers. They are launching more integrated capabilities than ever before, and our customers are responding well to our efforts. And in the presence of all that enthusiasm, our billings are up 17% year-over-year. including strong performance from our next generation security offerings, which grew 101% in Q2. I was thinking about this earnings call. It's definitely a contrast. We are executing well on our transformation. We're becoming more relevant to our customers and building a second and third leg to our security business, which is the hardest thing to do. But I do know that you all want to talk about products, so let's cut to the chase. Am I disappointed with what happened with our product revenues?

Yes.

We talked about the impact of sales incentive changes last year, which had impacted our sales team's focus on product versus next-generation security. We, of course, corrected that and balanced their focus. We knew that the problem would take some time to correct, as we discussed last quarter. In all fairness, we were expecting improvement this quarter, which hasn't arrived. Product performance did improve, partly because the sales incentive change is going to take longer than expected, and partly because we were too optimistic about some of the deals closing in the quarter. Upon deep inspection, I feel that this softness will take a little more time. So what are we going to do about this and what gives us comfort that performance will improve? First, we're following up with the success of our Prisma and Cortex speedboats and have created a new speedboat for firewalls to drive entrepreneurial energy and momentum. The leadership for this speedboat is now in place. We've hired Andy Elder, who joined us from Riverbed, and Alan Oswald, who joined us from Cisco, who will be leading this speedboat. Secondly, we recently launched SD-WAN across our entire firewall estate, and with combined Prisma access, we believe this is a great, savvy solution. We're still in early stages, but we have closed some deals, and we're seeing heightened interest from our customers and positive feedback on the vision and simplicity of our SD-WAN solution. Along with our technology partners, we have the capability to bring a full-branch architecture solution and feel good about our ability to compete. Finally, we're seeing signs and early indicators that we track, across our business, where we are likely to see some product growth resume in the fiscal fourth order. So let me revisit that in terms of what it means to our outlook going forward in product and its impact upon our networks. We expect product growth to improve in the second half of fiscal 20 and turn positive in fiscal Q4. However, product will still be below our internal expectations. We expect that product will return to market growth next year in fiscal 21. We have put cost containment measures into place to match our investment trajectory with our profitability expectations, and Kathy will give you more details around this versus our EPS forecast. Lower product growth will, of course, impact our firewall as a platform metric, and I expect double-digit growth this year. The management team and I have revisited our three-year guidance that we gave at Analyst Day. We're only two quarters in to that guidance. Upon deep inspection, we still feel confident in our long-term outlook for fiscal 2022. Now that we've talked about the product issue and the impact of financials, let's talk about what's working. Amit, Lee, Nia, and I have seen over 100 customers this quarter. Our strategy is resonating. Organizations everywhere are undergoing a profound digital transformation, fundamentally reshaping the way they operate, innovate, and connect with the people they serve. These transformations are helping drive the need for Prisma and Corpix. I'd like to share a few key wins in the quarter. In fiscal Q2, a number of customer wins illustrate the power of our comprehensive approach to security, including a large U.S. retailer who expanded their power to network footprint this quarter with an eight-figure deal, spanning each of our three pillars, including Prisma Cloud, Prisma Access, and SaaS, Cortex, and our next-generation firewalls. This is one of our largest deals in recent times and a true cross-platform buy on Prisma, Cortex, and firewalls. A multinational travel management company expanded their next-generation firewalls at Prisma Access following the purchase of Demistral last fiscal quarter. This is a great example of how one of our next-generation security services opens the door with a major account for feature firewall purchases. I also love this example because the client was pursuing the goal of building a network that will support a significant number of remote employees and also transition away from MPLS. Our solution not only provides significant flexibility and increased visibility, savings compared to prior architectures. We want to deal with a large German automotive company, which is Prisma Cloud Compute, formerly known as Prisma. Prisma will be a critical pillar of the customer's move to 100% cloud-first architecture and shift left security models. These wins are excellent examples of our success in articulating our vision of security and being able to demonstrate our value proposition to customers. As a final indication of our momentum, in the first half of fiscal 20, we closed two of our top 20 largest deals in the company's history. Additionally, Prisma Cloud had another record-setting quarter and closed an eight-figure deal with the U.S. retailer I highlighted earlier, the largest deal in the history of Prisma Cloud. During the quarter, we also continued to drive innovation across our products. Let's start with our firewalls. In December, we launched SPLAN for our next-generation firewalls. Customers are currently testing this offering, and feedback is positive, as they appreciate our vision and the simplicity of the solution. We will continue to add new firewall subscriptions in 2020, including IoT labels here. Earlier today, we announced Cortex XSOAR, an extended security orchestration automation response platform that natively integrates threat intelligence management. Cortex XSOAR is a significant evolution of the Demisto platform, and we believe it will redefine the SOAR category by making threat intelligence much more actionable at scale. In Prisma Cloud, we have launched the first version of our integrated product where SaaS customers of Prisma Cloud who are using it for workload security have seamlessly leveraged the capability to deploy container security. In a short period since launch, we have seen 10% of our customers take up both modules. This is exciting because we are hard at work to develop, integrate, and deploy four modules over the course of this year, including the integration of Apparetto. During our marketing efforts, if you will be attending RSA, you will likely notice the refreshed look and feel of the new Palo Alto Network's branding. Additionally, we have launched a standalone brand for our firewall business, Strata. For the past several months, we have launched and built two of the premier brands in cybersecurity, Prisma and Cortex. When we took a step back and reviewed our position, it became clear that the firewalls needed their own brand. All three brands were up to the Palo Alto Network, which also sports a new updated logo. On the people front, we're continuing to prioritize our culture and workplace environment. We're highly focused on making Palo Alto Networks a place where everyone feels inspired to do their best work. We're extremely pleased to earn a perfect score on the Human Rights Campaign Foundation's 2020 Corporate Equality Index and also the designation of the best place to work for LGBTQ equality. We are very, very proud of this achievement. Finally, I want to highlight our proposed accelerated share repurchase transactions. or ASR that we announced earlier today in our earnings press release. The proposed ASR was in the amount of $1 billion. It is expected to occur in our fiscal third quarter and represents a capital allocation strategy that we believe returns value to shareholders while still allowing us sufficient flexibility to achieve our goal. The proposed ASR is in addition to the $1 billion repurchase authorization that we announced in February 2019. As of today, approximately $800 million remains available for future share purchases under the February authorization. In closing, we continue to chart new territory in cybersecurity with our three platform strategies taking shape. We have a lot of work to do, but it is heartening to see our customers partnering with us in a more strategic manner. We are the largest cybersecurity company providing industry-leading growth, while transforming our business to protect our customers as they go through this transition. The new data center will be the cloud, and we will be there for our customers as prisoners. The new frontier in AI and ML and Cortex will solve our customers' needs there with security automation. Last but definitely not the least, firewall technology will continue to protect our customers in their data centers or in the cloud, and we will be there besides them in Strata. With that, I turn the call over to Kathy.

Thank you, Nikesh. Before I start, I'd like to note that except for revenue and billing figures, all financial figures are non-gaps, and growth rates are compared to the prior year period, unless stated otherwise. As Nikesh indicated, we believe our overall business remains healthy despite our Q2 product revenue performance. In the second quarter, we continued to add new customers at a healthy clip, and sales of our next-gen security offerings continued to be strong. In Q2, total revenue grew 15% to $816.7 million. Looking at growth by geography, the Americas grew 15%, EMEA grew 12%, and APAC grew 20%. QQ product revenue of $246.5 million declined 9% compared to the prior year. QQ SaaS-based subscription revenue of $342.6 million increased 37%. Support revenue of $227.6 million increased 20%. In total, subscription and support revenue of $570.2 million increased 30% and accounted for a 70% share of total revenue. Turning to billings, Q2 total billings of $998.9 million net of acquired deferred revenue increased 17%. The dollar-weighted contract duration for new subscription and support billings in the quarter remained at approximately three years, up by approximately one month year over year. For the first half of fiscal 2020, billings of $1.9 billion increased 18% year-over-year. Product billings were $479.8 million, down 7%, and accounted for 25% of total billings. Subscription billings were $868.9 million, up 34%. Support billings were $547.6 million, up 22%. Total deferred revenue at the end of Q2 was $3.2 billion, an increase of 27% year-over-year. In addition to adding over 2,500 new customers in the quarter, we continue to increase our wallet share with existing customers. Our top 25 customers, 24 of which made a purchase this quarter, spent a minimum of $46.2 million in lifetime value through the end of Q2 2020. This is a 30% increase over the $35.6 million in the comparable prior year period. Q2 gross margin was 76.4%, which was up 10 basis points compared to last year. Q2 operating margin was 17.9%, a decline of 670 basis points year over year, and includes a headwind of approximately $9 million of net expense associated with our recent acquisitions. We ended the second quarter with 7,643 employees. On a GAAP basis for the second quarter, net loss increased to $73.7 million, or 75 cents per basic and diluted share. Non-GAAP net income for the second quarter declined 18%, to $120.3 million or $1.19 per diluted share. Our non-GAAP effective tax rate for Q2 was 22%. Turning to cash flows and balance sheet items, we finished January with cash equivalents and investments of $3.5 billion. Q2 cash flow from operations of $306.9 million increased by 11% year-over-year. Free cash flow was $257.8 million, up 2% at a margin of 31.6%. Adjusted free cash flow in the quarter was $275.6 million, representing a margin of 33.7%, excluding cash charges associated with our headquarters in Santa Clara. Capital expenditures in the quarter were $49.1 million, of which $17.8 million was associated with our headquarters in Santa Clara. DSO was 57 days, an increase of seven days from the prior year period. Turning now to guidance and modeling points. As Nikesh noted earlier, we anticipate that product revenue growth will improve in the second half of fiscal 2020, but will remain below our initial expectations. As such, we are modifying our guidance for the full fiscal year. Please note that our guidance does not reflect any potential disruptions in our global supply chain that could result from the coronavirus, which we are carefully monitoring. For the third fiscal quarter of 2020, we expect revenue to be in the range of $835 to $850 million, an increase of 15 to 17% year over year. We expect billings to be in the range of $980 million to $1 billion, an increase of 19% to 22% year over year. We expect Q320 non-GAAP EPS to be in the range of $0.96 to $0.98, using approximately 99.5 to 101.5 million shares. For the full fiscal year, we expect revenue to be in the range of $3.350 to 3.390 billion dollars, representing year-over-year growth of 16 to 17 percent. Billings to be in the range of 4.075 to 4.125 billion dollars, representing growth of 17 to 18 percent year-over-year. Next-gen security billings to be in the range of 810 to 820 million dollars, representing year-over-year growth of 79 to 82 percent. We expect fiscal 20 non-GAAP EPS to be in the range of $4.55 to $4.65, using approximately 99 to 101 million shares. Finally, turning to free cash flow, for the full year, we expect an adjusted free cash flow margin of approximately 28%. Before I conclude, I'd like to provide some additional modeling points. We expect our Q3 and Fiscal 20 non-GAAP effective tax rate to remain at 22%. CapEx in Q3 will be approximately $85 to $90 million, with approximately $50 million related to real estate purchased to accommodate future expansion of our headquarters in Santa Clara. As a result, we are increasing our expected full-year CapEx to approximately $220 to $230 million, with approximately $100 million related to our headquarters. Finally, our adjusted free cash flow in Q3 and fiscal 2020 will exclude costs associated with the expansion of our headquarters, including the real estate purchase I just described, as well as a $50 million cash payment for litigation-related settlement. With that, I'd like to open the call for questions. Operator, please poll for questions.

Thank you. At this time, if you do have a question, please send those by pressing star 1. Again, that will be star 1 for questions. We'll hear first today from Keith Weiss with Morgan Stanley.

Hi, this is Hamza Fadawalla, and for Keith Weiss, thank you for taking my questions. Just a couple of ones from me. First, on the product revenue side, Nikesh, is there anything else that you're seeing in terms of any unforeseen challenges within the firewall business? Has there been any change to the competitive landscape at all? You mentioned launching SD-WAN. Obviously, there's another vendor that's had some pretty strong traction there. So any more color would be really helpful.

Thanks for the question, yes. Look, as we highlighted in the prior quarter, We made changes in our sales incentives last year to drive Prisma and Cortex because, honestly, there's very few examples when I came to enterprise security of companies building a second or third product line to rival the first product line. And we spent a lot of effort as a team trying to figure out how could we build where the opportunities were. We relied on cloud. We relied on automation and machine learning. And we made some significant bets both in terms of acquisition resources in driving Prisma and Cortex. That changed, and trying to get salespeople to learn, appreciate, understand, and sell these things caused them to pivot hard because they were going to make a lot of money selling Prisma and Cortex, and they did. What they did was, because their focus on this is only finite resources, they didn't go and knock on enough doors to create firewall demand. And as you know, there's a cycle from demand to closure which has its own motion we had been systematically eroding the opportunity to have a large pipeline going into Q1, which is why you saw Q1 results. We were optimistic that we would be able to accelerate that effort and try and get deals closed sooner, but unfortunately it was hard to fight the tape. There is a cycle, there is a motion, and our customers are used to it, and that's what is in front of us. Hence, we have had to revise our product efforts. In terms of what's going on in the market, yes, as D1 is a trend, as you see it, There are other people out there who are doing well with SD-WAN. There are SD-WAN companies out there doing well with SD-WAN. We have SD-WAN partners. Every time we go sell Prisma Access as part of a SACI solution, either we now use our own SD-WAN, or customers choose other SD-WAN partners. Definitely SD-WAN is a trend, and we think as people go to the cloud, as network architectures change, MPLS starts to get pulled off, and the Internet becomes a new network, we will see people leverage more SD-WAN capabilities. It is an area of focus. It continues to remain an area of focus, and we're excited by the progress we've made since December in terms of getting customers interested in our solution. Other than that, honestly, I think this is an execution issue at our end. I don't see that the market is changing, so we've got to take our medicine and we've got to go ahead and go execute.

I just have one follow-up question on the next-gen side. On Cortex, it seems like there's been Some really strong traction there. I was curious to know, you know, the announcement that you made earlier today on that product, how do you expect that to translate to further pipeline into the second half of this year, and what are some of the early trends that you're seeing there? And that's it for me.

Yeah, so as you know, on Cortex we have two products. In the larger category of security automation, applying AI and machine learning, We have a product called Cortex XDR, which in the simplest form competes in the XDR category, which is the next generation of EDR category, where some of the newer endpoint vendors have migrated to. And there we keep adding more data sources into our ingestion capabilities. So XDR is doing well. Our primary customers have come mostly from Palo Alto customers who have had our firewalls and some new customers who want our endpoint capabilities from the XDR perspective. And that business is doing well. What we announced this morning was the Cortex XSOR, which is the next evolution of what was Dynisto. In the past, we sold Dynisto to our customers, and the constant feedback we got was it would be amazing if threat intelligence management would be part of this capability, and we would have to go stitch it on top of our capability to automate and write playbooks on. So the Dynisto team has rallied and merged threat intelligence management in the capability of what was Dynisto, and hence we've defined the XSOR. Silicon Valley industry analysts have been calling for this. They've been calling for this trend. So we are first in launching that capability. Purely from a mechanical perspective, every customer who is a customer of Domisto should want an upgrade to this capability. Additionally, it should open up a larger market for us with Domisto, which is an Intel market, which is, we think, probably the same size as the sole market. So we're very excited about it.

Thank you.

Thank you for asking a Cortex question. I was thinking that question wouldn't come until the end of the call.

We'll hear next from Walter Pritchard with Citi.

Hi, thanks. Nikesh, question for you just on the, if we're thinking about this not from a sales incentive perspective and what behavior you're driving, but just from a customer demand perspective, how do you think about, I guess, you know, we all understand, I think, that firewall demand is not what it was two, three years ago. But, you know, certainly I think we hear in the industry that customers spend on firewall is, you know, flatter or maybe slightly up. And I'm wondering as it relates to your customer base with firewall revenue down two quarters here now, are customers, did they buy last year and they're holding off their purchases or they're holding their purchases in the future? I'm just wondering how we think about it from the buyer perspective. I think we well understand everything you've done from the sales incentive side, from the sort of supply side.

Yeah, thanks, Walter. I think that's a good question. From the buyer perspective, Every customer is on a different life cycle in terms of both where their infrastructure is today and where they're trying to go tomorrow, whether they're adding more data centers or going to the cloud or trying to replace their traffic coming back home and trying to build some sort of a hybrid cloud plus data center infrastructure. So the trend, as I highlighted in the last answer, is that we are seeing SD-WAN being asked for. We are seeing buyers looking for SD-WAN solutions with security. In some cases, that involves a box solution. In some cases, it involves a software solution. In our case, we have the opportunity now with SD-WAN to deliver both. We can give you a box that gives you SD-WAN capability. We can give you Prisma access that allows you to deploy SD-WAN into the cloud. From that perspective, there's definitely activity on the network. Re-architecting the network and trying to get more... evolution underway. Customers who have large data centers go through their own refresh cycle. So we're not seeing anything big that would give us a reason to believe that things are shifting. On the margin, are the solutions given by cloud versus boxes going to cause some difference? Probably, but nothing we see at this point in time.

Great. And then, Kathy, just on the long-term goals, I know you're not revisiting those here, but As we think about the three-year CAGR you talked about, I mean, can you help us understand maybe what level of firewall or product sales you were anticipating in there and sort of, I don't know, any color you can provide us around sensitivity of that overall growth number given the performance you've seen here on the product side in your term?

Yeah, Walter, thanks for that question. We did obviously not guide explicitly on product, but I think for the most part, the analysts were projecting less growth than we have seen historically on the product line, which was appropriate and reflected in our guidance. And, you know, so obviously that's changed a little bit, and we've had to adjust our guidance this quarter But we still feel really great about the longer-term view, especially given the performance of our next-gen security. And we definitely think, as Nikesh mentioned, that we believe that what we have is an execution issue and that we know how to compete in firewall sales and that we'll be able to correct the situation and improve that growth as well.

Okay. Thanks for taking the questions.

And from J.P. Morgan, we'll move next to Sterling Otte.

Hi, guys. This is Matt on for Sterling. Thanks for taking my question. You know, if we're looking at product revenue, assuming that product revenue is just flat from here on out, how long do you guys think it would take to get the next-gen security to parity with that revenue run rate? Thanks.

Okay. You know what, I'm going to let Kathy answer the parity question, but I will tell you from our product revenue forecast, we've looked at the pipeline and looked at the early indicators. We think that Q3 is going to continue to be tough, but we should be able to get to positive growth by Q4. And our teams are hard at work to make sure that we divert these trends and that next year we're back to at market or above market growth in the firewall space. In terms of how long it takes for parity for NGS, I think that's a math problem. If you look at our forecast we've given you for NGS and look at our firewall forecast, you should be able to derive that answer. But I'm going to let Kathy answer that question in case.

And I really don't have much more to add. That was a great answer.

Great, great. Thanks for that. And then just one follow-up. Geographically, it looks like there are some issues in the year. Are there any macro impacts or anything that you guys can point to geographically?

Again, I think on a geographic basis, there's no trend thing. As you know, Europe and Asia generally have lagged the cloud trend globally, but they're slowly getting on board. We're seeing companies in Europe also talk about hybrid cloud solutions, talk about thinking about changing network architectures. They generally lag some of the U.S. companies in that context, but we're seeing traction in different parts of the world of varying degrees. So, no, I think the market's only going to get bigger on an international basis. And as Kathy said, you know, we're all watching the coronavirus thing. You all watch the market today. I think whatever impact happens, because that will happen across the industry, will not be specific to any one company. We have some that we might have less exposure compared to others, but I think that will be more of a global impact around that trend.

Great. Thanks, guys. I appreciate the color.

We'll move next to Carl Kirstead with Deutsche Bank.

Thanks, Kathy. I just wanted to make sure, just given the attention on the product revenue side, that I understand the outlook for the second half where you said the product revenue growth should improve. So just to be clear, the year-over-year decline you anticipate in 3Q, there would still be a decline but less than negative 9, so better than negative 9, I should say. And then in the fourth quarter, you think the year-over-year growth rate for product could move positive. Is that correct? I just want to be clear that you anticipate negative nine as being, you know, the floor, let's say.

Yes, that's correct, Carl.

Okay, got it. And then maybe my other one.

Okay, thank you, Nikesh.

Okay, great. And just so I'm clear, the $50 million litigation-related settlement was related to what, Kathy?

Yeah, the details of the settlement are confidential, so we won't be describing a lot in our queue or on this call, but it was related to an IP settlement, which is pretty common in the industry.

Okay, got it. Okay, terrific. Thank you.

From Raymond James, we'll move to Michael Turretz.

Hey, guys. Good evening. So two competitive questions and then one on the incentives. So can you be more specific, Nikesh, about whether or not you're actually losing because you don't have any SD-WAN? It's just coming into play for you now. And what's going on in the market against Zscaler specifically for what's called cloud-delivered network security competitively?

All right. Well, let me start with the SD-WAN question, and I can try and give you some color on the network transformation architecture market. I generally prefer not to talk about other companies because I don't understand their businesses as much as I understand ours. But on the SD-WAN front, we are seeing customers require talk about SD-WAN. Now, remember, customers have a choice of taking best-of-breed SD-WAN in the market, which are independent players. or taking that as part of an integrated firewall solution. And we've seen customers offer either, depending on the complexity of their needs, for SD-WAN. If you're going to deploy SD-WAN across 10,000 sites, 8,000 sites, you go get a specialist SD-WAN vendor because he has a whole bunch of stuff that he wants to deploy, configure, and set up, which is a much more complex product that is not available in the market. Sometimes customers want to do a simpler architecture and just have the capability in their firewalls, and we're seeing a market for that too, and that is the market we will be able to address with our evolution of our firewall capability and our VN that does my access capability with the SD-LAN that we've launched. So, yes, we are seeing that need come in. Honestly, I've not seen many large deals in the market where we've seen a competitive situation where the customer says, I cannot solve this problem with the power of the firewall. I'm going to go elsewhere. But clearly, other people are doing well. Now, that may be some of the market segment issue. I haven't seen that much in the large enterprise space. In terms of what it does to the network transformation market, remember, let's say when I came to follow networks, we had a product called GPCS, which we deployed a lot of resource against, and we worked really hard over the last 18 months. Lee and his team did a great job in launching Prisma Access and delivering it. We've had this product in the market almost only for three quarters. And in that three-quarter time frame, we have made some progress. reaching out to the very large customers that deployed very large deals. I highlighted some of the deals earlier in my prepared remarks, and I was a large Prisma Access competent with that deal. So a market where people weren't seeing us, they probably had more share. In a market where they see us and we get deals, other people get less of that pie. And, you know, it's one of our strongest pipelines in that space. We have a lot of expectations from that space, so expect us to continue to be aggressive in the SAFI space because we believe that we have one of the most comprehensive solutions.

Was that a third part to your question?

Yeah, that was all from the cash. My follow-up was, did you make any additional incremental changes to the incentive structures as you saw that things were taking longer at this quarter?

Look, we have a very capable, responsible, intelligent sales team out there, and they understood the math when we did the math in the last year in terms of taking the multiples we gave them to go sell Prisma and Cortex, and they did as we requested them to do. We have balanced those. We have a lot of scrutiny. We have a lot of inspections going on in the firewall space, and our teams are responding. It's just, honestly, it takes time. The firewall cycle has a time element to it. And call it misjudgment in the last quarter when we looked at the deals in the pipeline, we were being too optimistic that we could close a lot more of them in this quarter than we have been able to. The deals haven't gone away. They're just going to take time. And we're just trying to make sure that we're no longer – setting unrealistic expectations of closing deals in our pipeline and giving a reasonable forecast both to you and setting the right expectations of our teams.

Okay, thanks, Kesh.

We'll move next to Brent Sill with Jefferies.

Hi, this is Howard on for Brent. Thanks for taking the question. Nikesh, in your prepared remarks, you mentioned you had gathered feedback from about 100 key customers. Could you share any additional details around, I guess, customer requests for either more product functionality or flexibility or even on the pricing side? So, for example, is there any demand for a subscription pricing model for on-prem firewalls?

Yeah, thank you for the question. Look, I'll tell you a funny story. When I did the customer tour, when I started Apollo Networks, I got a lot of curiosity meetings because people wanted to know who's this new guy who's coming to cybersecurity and want to talk to me. And I went there and talked to them about firewalls, and I told them about all of our subscriptions, and many of them were polite and listened to me nicely and nodded their heads. But they've been buying firewalls for 15 years, and it might have been new and exciting for me. They've been buying it for a long time, and the CIOs and CISOs were interested, but this wasn't top of mind. What has changed the last 18 months is that we talk about cloud transformations and how the cloud transformation has to be secured with Prisma Access and Prisma Cloud. We talk about their SOC and how their SOC is getting too much data and then it makes sense of that data to be able to be more secure. So now we're having real conversations where they want to talk about these transformations and slowly and steadily it's emerging that we're one of the few companies which have those products and are committing to developing them further with our customers than anybody else in the market and I would challenge the industry to show us who else is out there talking about these topics with our customers. So the conversations are really good. They're actually meaningful. We are seeing a lot of conversation around network transformation. We are seeing a lot of conversation with customers wanting to be in multiple clouds. One year ago, they were going to a single cloud. A year later, they found they have instances of different cloud infrastructures being used by different parts of the organization. So they want a multi-cloud security solution. So the conversations are changing in terms of what people are talking about. In terms of what they want, I don't think you're going to see rateable on-prem firewalls anytime soon because there are many players in the space and customers have a notion and a way of buying these things and capitalizing them. So if somebody wants it, I'm sure we can construct a financial solution for them that allows them to buy it that way. But honestly, we're not seeing demand for financial creativity to buy our firewalls. I think there is going to be some conversation in the future about how these architectures over time need to be fungible, that if I'm going to have a data center and a cloud install, how do I make sure I can move things fungibly between them? And our teams are working hard at trying to understand that need and see if we need to make any forays in that direction.

Okay, thanks, Mukesh. That's really great color. I've got a related follow-up for Kathy. It seems like subscription billings were very strong and driven a lot by the Cortex XDR. And so if we were to If product billings had performed in line with your expectations, because the overall billings number was actually towards the high end of your guidance, and despite the revenue, the full year red guide down, billings is actually, you know, you guys only guided it down 20 or 30 million. So if we saw product was in line with expectations, would total billings have actually, you know, could we have seen a billings raise?

Well, I think that's a very good question, and I'm going to let Kathy respond in a second, but I think this is a point I tried to highlight in my beginning of the remarks, that our teams are really excited. We're delivering the billing numbers we have on tap. We're just delivering them in the wrong box, as per your expectations. We're delivering them on Cortex and Prisma more aggressively than we expected, and we're seeing a product miss. So we're making a hole, which is interesting, because a short-term financial impact changes our revenue and EPS in the very short term. But this is phenomenal news for the long term. We have, the further revenue is rising, the better than it has in the past. So I will let Kathy add more color to that.

Yeah, we've, you know, obviously been really thrilled with the strong subscription performance, not just NGS, but also our attached subscriptions are growing nicely. And, you know, we've introduced some new subscriptions, DNS and SUN, which is just very new. And in addition, we've introduced a platinum support product as well. So all of those are helping contribute to strong subscription growth, which we feel really terrific about, obviously. So, look, we left our NGS full-year guidance the same. We didn't move that this time. But we are feeling really terrific about all of those numbers. And, you know, the product... the product decline is certainly the driver of all of the change to our revenue and billings guidance.

Okay, thanks a lot.

Moving on to Nihal Chokshi with Maxim Group.

Yeah, thank you. I'd like to ask about the accelerated share repurchase timing and also What's been the thinking on why have you only repurchased $200 million of a billion-dollar original share repurchased to play so far?

Yeah, thanks for the question. Look, we have a 10b-5-1 plan filed, which buys stock back out of billion-dollar authorization at certain levels. And when we looked at the strength of our billings, we looked at the growth trajectory of the company and our comfort of the management team, and we looked at the product thing. We anticipated that you would not take kindly to our product execution issue. We think this is a very good company in the long term. So we feel the best thing we can do for our shareholders is to return capital by buying back shares because we think they're very, very attractive at these levels.

And it will take place in Q3. Okay. Thank you, Trey.

And if you look, we have $3.5 billion of cash in our balance sheet. So we've already outlined our M&A strategy, which says we're going to be doing tuck-ins to our product strategy as opposed to try and go do any big M&A. So from that perspective, we felt, you know, given that we generate close to a billion dollars of free cash flow every year, that gives us enough financial flexibility to be able to do this at this point in time.

Great. Thank you.

We'll hear next from Shaul Ayal with Hiner.

Thank you for taking my question. This is Yi in for Shaul. We'll get two quick questions. First one's for Nikesh. I think you talked about in the preparing remarks that there's certain key indicators that are tracking, you know, infecting positivity on the firewall side. Nikesh, can you help us?

Hey, we're having a hard time hearing you. Sorry. Can you speak up? We're having a hard time hearing you.

Sorry, thank you for taking my question. This is you and for Shao. Nikesh, I think on the prepare remarks you talked about, there are some key indicators that's tracking positively on the firewall side. Can you elaborate on what are some of the metrics you're looking at?

Yeah, look, as in any good sales organization, you have to look at your deals. You have to look at your pipeline. You have to look at your conversion capabilities. You have to look at the stages of deals that progress. You have to look at how many customers are evaluating your firewalls versus how many customers are up for reprice. So we track all those metrics, and we're seeing positive indications of those metrics that our pipeline is robust. And, you know, as I said, we were optimistic in this quarter that we would have been able to close a lot more sooner than normal. but we think they're going to take the normal time. But we are seeing those indicators trend up. It gives us confidence about our Q3 and Q4 revival expectations from our product business. Albeit not as much as we had expected earlier, but we still believe that, as somebody earlier asked, it's minus 9% of the trough. Yes, we believe it is a trough, and we believe by Q4 we will be in positive territory and hopefully revive back to market-plus growth next year.

Thank you for that, Nikesh. And then a quick one for Kathy. On the geographic breakdown, I think you mentioned that Nia and APAC lagged for the quarter. Any chance you could give us the growth rate for, you know, the individual regions, U.S., Nia, as well as APAC, and maybe comment a little bit on the distribution pipeline going forward?

Yeah, I'm sorry. I'm really struggling to hear you, but I think you asked for our revenue growth by geography. Is that correct?

Yes, that's correct, Kathy. Whether the traditional breakdown, U.S., EMEA, as well as APAC, you know, if we could get some color on the growth rate and maybe comment a little bit on the distribution channels going forward.

Yeah, so our growth by theater was 15% in the Americas. EMEA's growth was 12%. And APAC was 20%. Thanks.

Thank you.

And from Guggenheim Partners, we'll move next to Taz Kujalji. Hey, guys.

Thanks for taking my question. I had a question on your guidance revision. So, Kathy, if I do my math right here, You're guiding down revenues by about $90 million for the year, but your billings are being guided down by only $35 million. So what's the offset, given that you're guiding down park revenues, I think, by $90 million? And you're not even raising your next-gen billings guide. So what is the offset for billings versus the decline in park revenues?

Yeah, you know, as I mentioned in the response to the last question, we are seeing strong subscription growth. not just in our NGS subscriptions, but also in our attached subscriptions, including some of the newer subscriptions that we've launched, which are contributing.

And will launch.

And will launch, yeah, in the future.

Got it. And then one second question. Just to clarify, you mentioned that part revenues would be positive in 4Q, right, because If I do the math on your full-year revenue guide and then assume typical seasonality on your supported subscription revenues, it still leads to negative product growth for obviously QT and also Q4. So can you just clarify if Q4 should be, should we expect Q4 to be positive product growth?

Yes, we are expecting positive growth in Q4, positive product year-over-year revenue growth.

Thanks, Abby.

Yep. And Keith Bachman with Bank of Montreal has our next question.

Hi, thank you very much. I have two questions I'm going to ask you currently. The first is how Alto has had trouble establishing and then hitting targets. And so while on the subscription side things have gone quite well, the performance of the products has been very different. So you're guiding those a lesson to find, if you will, in Q3 and then product growth in Q4. But what's the process that you think that you've either approved upon or have more information? Because candidly, you haven't been very effective at hitting targets. So what's different now that gives you confidence in terms of a process or a higher discount rate, so to speak, on the targets that you establish? And then the corollary question is, I know you're saying this is more internal than external, but if you look at the growth rate between Fortinet's product growth that are double digits revenue growth, and you're down 9%, it's a 20% spread on your product growth rates. It's just hard to believe that there's not competitive activities there that are causing meaningful share loss. So I just... One of the corollary question is what gives you the confidence that you're not actually losing share and this is more internal and external and that's it for me. Thank you. Alright, well thank you for your question.

Yeah, look, I think I'll repeat some of what I said. Last year when we did our forecast. We would be delighted with. some level of next-generation security growth, and we expected product growth to continue. And the majority of that happened, but in Q4, we saw product slow down a bit, and we saw next-generation security take up because our teams have been focusing on generating a lot of commissions for themselves. And we looked at the number in absolute, and as the prior analyst indicated, in absolute, we are delivering the billing. We are still delivering industry-leading growth in cybersecurity. There's no other company of our scale and size delivering the numbers that we are. So, I know you're very focused on the product piece, and so are we. Let's focus on that. You talked about the competitive activity. I think it's unfair to look at spreads. The base numbers are different. Fortinet has a different revenue than we do. And absolutely, yes, there is still a spread. They operate in different segments. We operate in different segments. They've been seeing strength in SD-WAN. They've been seeing strength in the low-end market where the computer price. We've looked at the entire market. We inspect every deal. And you know every deal where we're competing with other people or not. So part of our competitive data is based on customer by customer understanding who we're competing with and if they're not. So, you know, two things.

One is, sorry, giving... Yeah, Nick, just to jump in, though, but in terms of the forecast, you've missed the last two product forecasts. Have you put a higher, a bit more conservatism, you think, as we look out for the next two quarters? Yes.

You know, Kathy, you want to say something?

Yeah, I just want to be clear that we haven't guided to product revenue. And I think if you go back and look at our history of actually when we've missed, you really won't find very many quarters where we missed. And probably we do pretty well compared to most companies would be my guess.

All right. Okay. I will see you before. Thank you.

We'll hear now from Patrick Colville with Arete Research.

Hi there. Thank you for taking the question. I just want to talk about SD-WAN because, you know, that was the big launch back in December last year. And I'm just wondering if you could share any anecdotes on, you know, SD-WAN kind of early feedback. And I guess, you know, not to flog a dead horse in this product stuff, but is that a contributing factor or, you know, just... Any call there would be great.

As I mentioned, there is a lot of interest out of the market from SD-WAN perspective. Because remember, there's a very large installed base of MPLS. And as people are going down the cloud journey, they are looking at the facts of why do I need to bring all my traffic back home to my data center? Why can't I just send it from my branches, my remote offices, my other data centers straight to the cloud? And that is causing the SD-WAN conversation to happen. It's pretty standard now that people will replace that MPLS solution with Internet access and SD-WAN, but then they need security. So with that as the background, since Lee is here on the call, I feel like he has to earn his keep as well. Lee, can you talk more about the SD-WAN market? Sure, Nikesh. Happy to earn my keep.

Patrick, as you mentioned, SD-WAN was released in December, so it's still very early days, but we are seeing a lot of interest, a lot of very positive reaction from customers. We have dozens of customers already that are deployed. In the quarter, we had a multimillion-dollar SD-WAN deployment, which gives us a lot of excitement to see the larger deals coming through as well. And I would say even perhaps more exciting is that while these initial deals and deployments are more of the do-it-yourself kind of variety, which is how the SD-WAN market has operated in the past, what we're hearing from our customers is that they really like our ability to combine this with Prisma Access in a more of the SASE kind of variety solution where we're providing the network and the networking and the security from the cloud and lighter weight branch deployments to connect to that cloud. That's the promise of SASE, and we're getting a lot of very good feedback from customers about that is the future of how these architectures, these network transformations should happen.

Great. And can I talk about internal segmentation? because I do a bit of work speaking to CISOs, and one of the trends that I've been picking up of late is that ransomware has become an increasingly prevalent threat, and one of the ways to combat it has been increasing use of internal segmentation. So I was wondering if you've seen that as well, and what kind of boxes people are buying to segment their networks internally.

Yeah, so

I actually separate those two things. Ransomware is generally a solvable problem, and we have a number of ways of preventing ransomware from getting into a customer's enterprise to begin with. Segmentation can be a backstop to that, but to me, segmentation is a much broader initiative that's focused more on building zero-trust architectures designed around increasingly mobile workforce, increased number of devices, locations of devices, increasing cloud deployments, public cloud and SaaS deployments where customers as they have their enterprise architectures transformed are looking to move to an increasingly zero trust architecture, which then leads down the path of needing to do better segmentation to have the right enforcement points in the right part of the network. We're very well suited for this because in that architecture it's not just about location device, it's about being able to build context-oriented policy everywhere and consistently. And we are unique and have been unique for many years in the ability to meet that requirement. Great.

Thank you very much.

And for Mizuho, we'll hear from Greg Moskowitz.

Okay, thank you very much and good afternoon. So, Nikesh, you mentioned earlier that product revenue would return to market growth in fiscal 21. But as I think we all know, for many years, Palo Alto has been growing significantly above market rates. And I realize that you're digging out from the go-to-market issues, but can you shed some light on how you're thinking about your firewall market share over a medium to longer-term basis? And then also, what do you think the firewall market growth rate will look like over that period of time?

Oh, I thought I had you by saying market growth are better because I didn't want to predict the firewall market growth. But that's a very good question. Thank you. But the reason we're not expecting to grow faster than market from a share perspective is because we believe we will be taking share. We will be taking share in the software form factor. Every solution that is solved by a box by some of our competitors, we solve by a VM. We solve by a container VM. We solve by a Prisma access delivered by the cloud solution. All these things do not classify as product revenue in the way we record these. All these things end up in next generation security. So, you know, This is the fallacy, this is the trap we fall into in terms of how you recognize box sales versus software sales and the transition companies like ours have to go through. So yes, we definitely expect to be taking market share from everybody else. We'll be recommending software solutions to our customers with SD-WAN, with VMs for the cloud, with container VMs for containers, but they're not going to fall in the product box. So do I believe I can sustain product growth at market levels? Yes, which means I will not lose share and the market on my boxes, and I will take share with software form factors because most transitions are being discussed in software form factors and not as straightforward replace the box A and box B. Okay, that's helpful.

Thanks, Nikesh. And then just a follow-up for Kathy. Can you comment just on how discounting rates were this quarter and related to that? Was there any pushback at all from customers or from the channel on the recent appliance price increases? Thank you.

Sorry, what were the rates you asked me about?

Sorry, Kathy.

Sorry, you asked me about discount rates?

Correct, and just if there was any pushback from customers on the recent appliance price increases.

Yeah, you know, we did see a small uptick in our discount rates this quarter. We feel like on the balance with the price increase that we took on product, we were still at least on par, maybe a little bit better off with the price increase.

Okay, thank you.

Yep.

Our final question today will be from Gray Powell with BTIG.

Oh, great. Thanks for welcoming me in. Yes, I just had a quick one. So how should we think about the growth rate of attached subscriptions given what's going on on the product side? And then what do you see as the key levers to drive that component of the business going forward? Thanks.

Yeah, well, you know, our attached subscriptions have obviously performed really well in the most recent quarter, along with the NGS subscription growth, as I've already talked about. You know, the reality is we've sold, you know, a number of enterprise agreements, which customers buy are subscriptions in advance, and then they tend to buy more product as time goes on. That's sort of part of the agreement that we strike with them. And so we are expecting subscription growth to continue to be strong with the new subscriptions that we're adding and with continued strong attach rates. And then as we return product growth to higher levels, obviously that will help with the general attach subscriptions as well.

Got it. I guess what I was trying to get at would be with the new subscriptions coming online, should attached subscription be faster than maintenance?

Yes, definitely. Yeah, and we've seen that historically. Yeah, for sure.

Okay, cool. Thank you.

Yeah, you bet.

Anything further, Mr. Powell?

I'm sorry. I'm good.

Thank you. And everyone, I'll turn the conference back to you all for closing remarks.

Thank you. Before I close, I want to thank everybody again for joining us. We look forward to seeing many of you at RSA in our upcoming investor conferences, but I also would like to thank our customers, our partners, and most importantly, our employees around the world who worked hard to deliver the quarter. Thank you, everyone. Have a great evening.

Again, that does conclude today's conference. Thank you all for joining us.